Behavioral finance, a field that combines psychology with economic decision-making, offers deep insights into the complexities of human behavior in the financial realm. I've been interested in this topic for years, and my interest has only grown since working in financial services. It was there that I managed to meet Dr. Daniel Crosby, Ph.D., a well-known and respected thought leader on this topic and Chief Behavior Officer at Orion Advisor Solutions.
I recently had the opportunity to sit down with Dr. Crosby and discuss how our minds influence financial decisions. He believes this is a fundamental element of investing that every financial advisor should better understand. This kind of thinking affects the way we think about our business and our offerings at Flourish, and I know I'm not alone in this, so I wanted to share some industry highlights on what I learned from our conversation. (The following has been edited for length and clarity.)
Max Lane: Let's start with the basics. What is behavioral finance?
Dr. Crosby: Behavioral finance acknowledges the inherent messiness of human nature. Traditional models of finance assume rationality, expecting individuals to maximize utility and always act in their own best interest. However, psychologists have long observed that human behavior often deviates from these rational models in predictable ways. This intersection of psychology and finance creates behavioral finance, which seeks to understand and address the psychological underpinnings of financial decision-making.
ML: Why is it important for advisors to care about behavioral finance?
DC: Understanding behavioral finance can significantly increase the value financial advisors bring to their clients. Research from Merrill Lynch points out that the behavioral and relational aspects of advising contribute more to client satisfaction and financial success than the technical aspects alone.
However, integrating behavioral finance into advisory practices is not a one-time endeavor. Customers tend to forget most of what they learn unless it is reinforced and personalized. Therefore, advisors must incorporate the principles of financial behavior throughout the client relationship. This includes continuing education and using technology to regularly reinforce these concepts.
For example, when dealing with clients with strong emotional attachments to certain financial decisions, advisors should adopt an attitude of curiosity rather than judgment. Understanding the emotional motivations behind financial choices allows advisors to provide more empathetic and practical guidance.
M: What are some biases counselors should be aware of?
DC: In my book, The behavioral investorI categorize the many cognitive biases that influence a person's financial decisions into four broad areas, which I call the “Four Pillars of Irrationality”:
- Ego (overconfidence): Many individuals, especially men, tend to overestimate their abilities and knowledge. This overconfidence can lead to poor investment choices, as people believe they can predict market movements and identify winning investments more accurately than they can. Furthermore, this bias can cause an underestimation of risk, exacerbating potential financial pitfalls.
- Emotion: Our brains form likes and dislikes in milliseconds, often before we're even aware of them. These initial emotional reactions can greatly influence financial decisions, leading to choices that feel right but are not necessarily logical or beneficial in the long run.
- Conservatism (status quo bias): People tend to stick with what they know. This can manifest itself in various ways, such as regional biases in investment portfolios or reluctance to sell losing investments due to fear of realizing a loss. The pain of a loss is often felt more deeply than the joy of a gain, leading to overly conservative financial behavior.
- Attention: We are naturally drawn to the sensational and the eye-catching. This bias means that investors often follow hot stocks or trends that get a lot of media attention while ignoring more common but potentially profitable opportunities.
M: Where does money come into this discussion?
DC: Money has a unique place in people's financial lives, often associated with security and stability. This emotional attachment can lead to overly conservative behavior, where individuals hold cash investments even when better alternatives exist. Counselors can help clients overcome this bias by suggesting incremental changes rather than large, overwhelming shifts. Money is rational, but it is also emotional. When advisors view money as purely rational and overlook the emotional component, they miss a valuable opportunity to deepen the level of their advice and the relationship with the client.
M: Have you ever had a client make a questionable decision? Most of the advisors we work with have experienced this. So how do you handle emotional decision making?
DC: There are times when customers make certain decisions based on emotions. Consider a scenario where a customer wants to pay off their mortgage despite earning better returns on their investments. From a mathematical point of view, this may seem suboptimal. However, the counselor's role is to understand the emotional motivations behind this decision. Perhaps the client has a deep-seated fear of debt due to past experiences.
M: We have recently collected data showing that customers understand the irrationality of holding excess cash, but the emotional benefits, such as a sense of security and control over spending, outweigh logical considerations.
DC: Advisers must assume that clients may have more money than is revealed and create a non-judgmental space to understand their behavior. Rather than immediately trying to change behavior, advisors need to get to the root of the client's decisions, fostering trust and positioning themselves as comprehensive financial support. By approaching the conversation with curiosity and sensitivity, advisors can better tailor their advice to the client's emotional needs and financial goals.
M: So how will “BeFi” evolve?
DC: I believe the trajectory of behavioral finance mirrors that of psychology. Originally focused on understanding and addressing human fallibility, the field is now shifting toward exploring how financial decisions can improve overall well-being and happiness.
CONCLUSION
Behavioral finance provides financial advisors with invaluable insights into the psychological factors that influence consumer financial decision-making. By integrating these principles into advisory practices, financial professionals can better serve their clients, helping them achieve financial success, personal fulfillment, and happiness.
Max Lane is the CEO of Flourish.