Regular FWR correspondent Charles Paikert takes a look at the world of behavioral finance, a topic that we have examined before. The turbulent financial and economic situation has thrown a sharp spotlight on this discipline.
Behavioral finance, the stepchild of behavioral economics, appears to have found its moment.
Clients are less likely to panic during times of crisis such as the coronavirus-fueled market plunge in March, say wealth managers using behavioral finance techniques.
“The current crisis puts the value of providing clients with the behavioral finance approach under the spotlight,” says Jonathan Blau, CEO of Fusion Family Wealth in Long Island, New York. “We’re not getting panic calls. Instead of having to talk people off the edge of the cliff, we’re able to use our time more efficiently, like making tax trades or rebalancing portfolios.”
The COVID-19 pandemic has underscored the need for implementing behavioral finance practices, says Paul Pagnato, CEO of Reston, Virginia-based wealth management firm PagnatoKarp.
“We’ve already had the dialog with clients about how fast things can change and what that means,” Pagnato says. “They know that what people call 100-year floods can come every three years. They’re prepared.”
Indeed, the coronavirus presents a unique challenge for advisors, says Daniel Crosby, chief behavioral officer at Brinker Capital in Atlanta and author of The Behavioral Investor.
“The pandemic threatens both the health and wealth of all of us,” Crosby says. “Fear has been pervasive…and the toll the pandemic has taken is dramatic. It’s the perfect time for financial professionals to demonstrate the value that they add outside of strictly giving financial advice.”
Where does behavioral finance come in?
The field grew out of the work of Nobel Prize winner Daniel Kahneman, the Israeli-American psychologist and economist who, with Amos Tversky, Richard Thaler and others, established a cognitive basis for common human error that arise from biases that people are not aware they have.
Kahneman’s empirical research was groundbreaking, challenging the widespread assumption by economists - and asset managers - of human rationality when it came to making decisions. Thinking Fast and Slow, Kahneman’s best-selling book, summarized his findings in everyday language for a general audience.
The role of bias
The concepts of understanding the role of biases in making decisions about money and life choices has been increasingly embraced by wealth managers and psychologists specializing in the field.
“Advisors need to know what motivates people,” says psychologist and financial behavior specialist Szifra Birke, principal of Birke Consulting, who has worked with a number of wealth management firms. “They need to understand their clients, be good listeners and have emotional awareness. Clients can make emotional decisions and not be aware of their impact. Advisors need to be the steady hand and not let clients’ irrational behavior take over.”
Client’s behavioral problems are driven by feelings and thinking that aren’t well controlled, according to Jim Grubman, who specializes in working with wealthy families as head of Family Wealth Consulting. Moreover, both clients and advisors themselves are over confident that they can predict the future.
“The best firms have learned communication skills for listening and explaining in ways that help the client avoid panic, decision fatigue and reactivity,” Grubman says.
What wealth managers shouldn’t do is “throw massive amounts of detailed explanation at the client,” he adds. “Jargon, data and troves of charts make clients tune out just when they need to focus and calm down.”