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The Power of Behavioral Finance on Decision-Making

Julie Willoughby and Syl Flood discuss the role of behavioral finance as a science in managing wealth client relationships. Joining them are guests Sarah Newcomb, Director of Financial Psychology for Morningstar, and Stan Treger, a behavioral insights advisor with Northern Trust.

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In This Episode, You’ll Hear...

0:55 – Defining Behavioral Finance

Behavioral finance is the natural intersection of psychology and finance—especially psychology’s influence on financial decision-making. Behavioral finance can apply to both individuals and families trying to manage wealth together.

2:45 – Stan’s Journey to Northern Trust

Stan started as an academic specializing in social psychology. At Morningstar, he spent two years as a senior behavioral scientist, researching how people make financial decisions. In his current role at Northern Trust, he applies his scientific research to direct advice for ultra-high-net-worth families. He helps his clients make multigenerational plans and uncover their goals.

Stan believes that concepts like purpose, autonomy, and competence all influence the way his clients think about money and make financial decisions. For example, “psychological ownership” refers to how a person feels about money that belongs to them, and some have a hard time accepting their net worth. Psychologically, there can be a lot to unpack.

Other popular topics include helping a family bond and working together to make financial decisions.

5:46 – Advisors’ Views on Behavioral Finance

Sarah notes that while many advisors recognize that psychology does impact client decision-making, they might wonder if it’s their place to have conversations that aren’t just “about the numbers.”

Sometimes, this decision comes down to the type of client. If an advisor is coaching many individuals, then perhaps there’s less need to dive into behavioral finance. However, if an advisor supports families, behavioral finance research can help them set up an intergenerational asset machine and avoid cultural or generational miscommunication.

Stan agrees that while some advisors would like to keep the numbers and emotions of their clients separate, others understand that it’s impossible to separate a person’s psychology from their financial decision-making. He points out that humans have been around a long time, but the decisions that we’re being asked to make in the markets are comparatively new. Therefore, our cognitive architecture isn't necessarily “designed” to handle these kinds of decisions, which leads to cognitive biases that advisors need to understand in order to communicate well with clients.

By understanding a person’s three basic psychological needs—the need for autonomy, competence, and relatedness—advisors can improve their ability to connect with clients.

12:07 – Social Psychology, Meme Stocks, and Cryptocurrency

According to Stan, social learning has always been at the fundamental root of human experience. People look to social cues to help them make decisions, especially in ambiguous situations. However, when it comes to meme stocks, this cognitive architecture might work against investors. By the time people realize that meme stocks are popular, it might already be too late for investing to be the best course of action.

Sarah thinks there’s a powerful social narrative behind cryptocurrency, and people are buying into this narrative of “sticking it to the man.” However, she points out that while cryptocurrency claims to be a currency, a currency is only as strong as its backing. This means that to invest in cryptocurrency, someone needs to trust the underlying computer science and encryption technology and prefer it to the backing of legal and government systems.

Advisors need to help investors dig past “three-word slogans” and understand the narratives they’re buying into so they can manage their resources well. Sarah suggests that they have conversations where the advisor listens to and understands their clients’ underlying beliefs. For example, “can you sum up what you believe about cryptocurrency in one sentence?”

From there, advisors can help investors figure out whether these fundamental beliefs are based on accurate or skewed information. She points out that there’s nothing wrong with speculation if investors think critically about what they’re speculating with, and how much they can afford to lose.

19:26 – Using Behavior Modes to Support Clients

The Behavior Modes framework breaks down seven possible financial states an investor might be at any given time of their life: Chaos, Survival, Stability, Growth, Acceleration, Decumulation, and Legacy. These modes are defined by the magnitude and slope of a person's net worth line over time.

Unlike the traditional “financial life cycle” framework, behavior modes don’t assume that a client will start in one mode and make a linear, left-to-right journey that ends in another mode. Some people are born into legacy mode, and others will never get out of survival mode. With this model, however, advisors can help their clients identify where they are financially and learn the important skills of that mode so they can move into the next mode.

23:22 – Why Haven’t Robo-Advisors Taken Over?

According to Sarah, there are some financial decisions we want to “set and forget,” where automation and algorithms do a better job than people. There are also major life decisions that algorithms aren’t equipped to handle because they can’t measure all the things that are important to humans.

Big decisions that people make throughout their lives—major financial events, major psychological events, getting married, starting a business, raising children, dealing with death in the family and inheritance, etc.—involve a lot more than numeric outcomes. In these situations, investors need to speak to a human advisor who can help them figure out their goals, and then mobilize their resources to meet those goals. Automation simply isn’t there yet.

Stan’s perspective is that robo-advisors don’t have emotions and can’t provide the human connection investors want. He cited his previous research on Gen Z’s attitudes about finance, where his findings showed that even the youngest and most tech-friendly generation preferred human advisors to robo-advisors.

26:01 – Clearing Up Myths Around Behavioral Finance

Sarah emphasizes that behavioral finance is not a “cure-all.” When someone makes a financial decision, they have a particular reference point. If that reference point changes, their decision-making may change. Everyone has a unique and moving reference point; understanding how people make trade-offs based on their perspectives will inform better models and tools that help with decision-making.

Stan shared one of his favorite quotes: “All models are wrong. Some are just useful to us.” Every psychological study is about finding out what usually happens, and so every model that a psychologist proposes about the way humans work will be wrong because it’s impossible to account for every single degree of freedom of the human experience.

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