There are a variety everyday applications for the principles of behavioral finance.
The field of behavioral finance has developed with a goal of understanding and explaining how human emotions and cognitive errors--errors in logical thought processes--influence the movement of stock markets. While the field was originally promulgated by academia and by those interested in increasing their profits in the markets, analysis of this field's principles shows that there is a broad applicability to a variety of everyday settings and decisions.
The study of behavioral finance tells us that humans often become irrational in the face of the social, cognitive, and emotional factors that affect psychological functioning during the decision-making process. So why do so many advisors treat the individual advisory process as one built solely on rational economic modeling? Because that is what advisors are taught.
Through experience we all learn that many relationships are doomed to fail if we forget the human nature of fear, greed, and other emotions attached to money. As Deena Katz once said, "If too much focus is given to the strategies, solutions, and implementation while ignoring the client needs, wants, and wishes; we risk the relevance of the advisory process and its ability to reflect the client's unique degree of reality." Experience as financial advisors has taught us that truly meaningful and productive advisory relationships are created when we place ourselves as architects of the client's financial decision-making process rather than as the judge and jury of the best and most-rational economic outcome.
Colleagues like Michael Pompian have helped us elucidate the concept of behavioral finance as it applies to asset allocation and other investment-management and risk-profiling functions. Pompian has explained some of the common obstacles in the psychology of human decision-making on MorningstarAdvisor.com. Academics like Richard Thaler and Dan Ariely have helped us understand the prevalence of emotions and cognitive processes in decision-making and how these affect the otherwise rational economic decision-making process. Their research and publications such as Thaler's "Nudge" and Ariely's "Predictably Irrational" offer the financial advisory world a glimpse into the human psyche at the very moment they are engaging in their craft as architects of the financial decision-making process. There are many other great minds that have and will continue to contribute to the field.
Behavioral finance combines the disciplines of psychology and finance to explain why people make seemingly irrational or illogical decisions when they spend, invest, save, and borrow money. Since psychology systematically explores human judgment, behavior, motivation, emotion, and well being; it is teaching us important facts about how human functioning differs from traditional rational economic assumptions. We originally teamed up to explore these dynamics in the world of divorce--Dr. Simon as a Forensic Psychologist helping to facilitate communication and coparenting, and Reckers as a Certified Divorce Financial Analyst and advisor to divorcing couples and individuals. We regularly work together in the no-court divorce fields of collaborative divorce and divorce mediation as peacemakers and dispute-resolution experts. This work led us to the realization that if there was ever a set of financial decisions affected by fear, loss, and utter chaos, divorce would be it. Social, cognitive, and emotional factors all play roles in the decisions of divorce. We realized that we found ourselves on the battlefield of the largest financial transaction in most people's lives, conflicted with the greatest emotional upheaval most will ever experience. Divorce is a legal process, but money is what most people fight about. A client once said "marriage is about love; divorce is about money." Nothing has ever been more true.
It is relatively new for financial advisor s and psychologists to be involved in resolutions of divorce, probate, and other common, dispute-laden transitions. Advisors are more accustomed to investment, insurance, and retirement-planning decisions. All carry a heavy load of emotions and conflicted thought processes, but some are more receptive to the analytical processes of the old-school financial advisor. We believe that everyone is a natural fit for the emerging financial advisory world, which is interested in facilitating more-rational resolutions to financial decisions. Some clients can be comforted by repetitive modeling of scenarios, and some can quiet their fears by listening to a trusted expert. Effective and rewarding client relationships require the comfort of factual data, trust in experts, and a personal relationship reinforced by the advisor's ability to recognize and address the cognitive and emotional barriers that clients face in decision-making.
We often find that those involved in financial disputes such as divorce or marital discord actually have a difficult decision-making process complicated by the social, cognitive, and emotional factors that characterize their lives and personalities. It is not the dispute, per se, that is the problem. Instead it is the cognitive, social, and emotional factors that are present. These decision-making processes become disputes when the parties allow fear of loss or an unknown future into their hearts and minds by focusing on winning rather than resolving problems. We can make a world of difference by simply helping them realize that the term "dispute" does not have to characterize their current predicament. This is done, in its simplest form, by creating a decision-making process in which the parties are armed with all available information, their options are brainstormed and detailed by the advisors, and the individuals are guided through a comparison of alternatives based on objective criteria.
Behavioral finance will teach us how to build the process detailed above with barriers, biases, and internal conflicts of the human psyche at the forefront of the advisor's, peacemaker's, and mediator's mind. Our application of behavioral finance relaxes the traditional assumptions of financial economics by incorporating the observable human departures from rationality into conflict resolution, negotiation coaching, guidance of the decision-making process, and successful client relationships.
We will be writing more on this topic in the coming months and hope that the independent financial advisory world takes notice of their opportunity to positively affect the psychology of money across the globe.
Next month: As architects of rational decision-making processes, advisors must decide whether to attempt to change or moderate a client's biased behavior or adapt to it. Discussion of emotions, thought processes and tolerance of risk will help shape a guide to working with clients in the midst of conflict, fear and loss.