Behavioral Finance: Inside the Client’s Brain

"I admit to a prurient interest in behavioral finance. Perhaps this is due to my background in psychology—or just from having dealt with a broad range of clients for many years. Investor behavior is sometimes amazing, and behavioral finance, the academic specialty that has grown up to examine it, is equally interesting. One of the most practical discussions of behavioral finance I have seen appeared recently on AdvisorOne. It was written by Michael Finke, the coordinator for the financial planning program at Texas Tech.
It is my strong recommendation that you read the entire article, but here are a few of the behavioral finance highlights that jumped out at me:

• Breaking habits requires deliberate intention to change routines by using our rider to change the direction of the elephant. How do we motivate people to change behavior to meet long-term goals? Neuroscience suggests that the worst way to motivate people is to focus on numbers. Telling someone they need to save a certain amount to achieve an adequate retirement accumulation goal may be convincing to the rational brain, but not so convincing to the elephant.
• Explaining a concept in a visual or emotional sense uses much more of our brain functions than is used by numbers. If you think of people as being emotional and visual, you’ve essentially tapped into 70% of the brain real estate. There is that rational side, but that rational side might be more like 20% of the real estate. The rational side used to solve math problems might be 8% of the real estate.
• It can be useful to frame desired actions as the status quo in order to take advantage of this preference. For example, setting defaults that are beneficial can have an unexpectedly large impact on improving behavior.
• The most powerful emotional response related to financial choice is fear. Fear leads to a number of observed decision anomalies identified in behavioral finance such as the excessive attention paid to a loss. Framing decisions so that they do not necessarily involve a loss is an important tool advisors can use to avoid bringing the amygdala to the table.
• “Dollar cost averaging is an illusion,” notes James. “Unless we have mean reversion in the market (and if we do we can make lots of market timing bets and make ourselves rich), dollar cost averaging does not work. But if people believe that they are buying shares cheaper in a recession, the story makes people stay in the market at the times when their fear-driven emotional side wants them to get out of the market. We have a story that, even if it’s completely false, is generating the behavior that is going to be portfolio maximizing in the end. So maybe the answer to the usefulness of dollar cost averaging isn’t ‘well we’ve figured it out and it doesn’t work, so don’t use it,’ the answer is ‘actually it’s not true but it gets your clients to behave the right way so keep telling them that.’”

The biggest impediment to good returns is typically investor psychology. If behavioral finance ideas can help clients control their behavior better—and thus lead to better investment outcomes—some of these ideas may prove useful."

Source: Lean Frog (click on image to enlarge)

at http://systematicrelativestrength.com/2012/11/27/behavioral-finance-inside-clients-brain/