Margaret (Peggy) Doviak, Ph.D., CFP®, is founder of D.M. Wealth Management Inc., a financial planning and portfolio management firm in Norman, Oklahoma. She is an associate graduate professor for the College for Financial Planning and a co-host of the FPA Theory in Practice Knowledge Circle.
The field of financial planning is complex, and practitioners intellectually understand that they should be offering their clients holistic advice grounded in theory. Even when beliefs and actions may be very different among financial planning practices, many planners try to stay within the guidelines of theories they follow. Problems arise when market behavior and current events strain the theories and the nerves of the planner.
It’s easy to forget that practitioners are subject to the same emotional stress as their clients. In meetings, they remind their clients of the importance of “staying the course,” but in practice, they may have trouble doing it themselves. How do financial planners keep the activities in their practices aligned with the theories they believe, especially when times get tough? Some answers and strategies can be taken from the field of behavioral finance.
In 1999, Richard Thaler published an article in Financial Analysts Journal with the interesting title, “The End of Behavioral Finance.” However, instead of calling for a rejection of the theory, Thaler proposed that in the near future (from 1999), all finance would be seen as being grounded in human behavior, and there would be no need for the distinction of behavioral finance.
Seventeen years later, it appears that the broad acceptance of behavioral finance has been more difficult for the financial world to embrace. Perhaps one reason for the delay is the possibility that if all finance is behavioral, then financial professionals are just as prone to errors in logic as their clients. An understanding of some of the areas where behavior can be impacted by events might help a planner better serve the families who trust them.
We’re Only Human
An initial issue involves the valuing of gains and losses. In the 2000 book, Choices, Values, and Frames, behavioral finance giants Daniel Kahneman and Amos Tversky found that satisfaction curves and dissatisfaction curves are not mirrors of each other. When an investment is behaving as we expect, we are pleased, but our satisfaction can be measured as a slow, gentle, upward curve. However, when an investment is not performing well, our dissatisfaction falls sharply and quickly. In other words, investment gains do not please us as much as investment losses concern us.
The media doesn’t help, either. Two days of market decline and our favorite business news channels are calling for Armageddon, and this can quickly lead to client phone calls. As planners, if we can remember that everyone’s panic is partly a product of human nature, we may be able to more easily ignore the din of noise and explain our perspective when the phone rings.
Know Your Limitations
A second potential pitfall involves personality traits common in financial planning—confidence and optimism. A financial planner who is unsure, dismal, and gloomy will have trouble attracting and retaining clients. Confidence and optimism are valued traits, as long as the planner remains aware of their limitations.
In an excellent summary of important behavioral finance concepts, Nicholas Barberis and Richard Thaler addressed the dangers of overconfidence and excessive optimism. In their 2002 National Bureau of Economic Research paper, “A Survey of Behavioral Finance,” they cite that events people believe at a 98 percent confidence level only occur 60 percent of the time. Additionally, events that people are sure cannot occur happen 20 percent of the time. Financial planners may be less impacted by events surrounding financial theory if they acknowledge the possibility that their interpretation of the events might be wrong.
Finally, when situations seem overwhelming and panic is flying at a planner from all sides, Kahneman offers a straightforward solution in his bestselling book, Thinking, Fast and Slow—slow down. Kahneman divides our brains into two parts—system one, the automatic and intuitive side; and system two, the thoughtful and rational side. In most of our lives, system one handles the mundane, repetitive tasks, while system two is reserved for those events that need analysis. Unfortunately, when we are under stress, system one cranks into full gear and generates instant and often drastic suggestions. It never even gives system two an opportunity for input, which pleases system two because it is lazy and tires easily—however, it can be engaged.
A financial planner who is faced with a stressful situation can more easily engage a proven theory base by simply slowing down, avoiding the first behavior that springs to mind, and letting system two make a logical judgment. Additionally, the metaphor is easy to explain, and a planner can have a discussion of system one and system two with clients, helping their decision-making processes, as well.
It’s easy to see where our clients make errors in judgment that derail their financial plans, but it can be harder to see how our errors cause us to lose sight of the theories that guide our practice. By taking some time to consider how behavioral finance suggests that we are vulnerable, we can create strategies that will help us provide better planning for our clients just when they need it the most.