Clients undergo a ‘significant shift to austerity’

Something has changed in the minds of affluent, free-spending financial advisory clients: They have become frugal.

“People got very scared in 2008, and it caused a behavioral shift” in favor of saving rather than spending, said Gary Klaben, a financial adviser and president of Coyle Asset Management in Glenview, Ill. “There has been a significant shift to austerity.”

Even clients in a strong financial position are being careful, and if they have loosened the purse strings as the economy slowly has improved, it is “not by much,” Mr. Klaben said.

The adviser said that he sees more anxiety than ever about debt, noting that many who receive annual bonuses, tax refunds or big cash gifts are using the money to pay off loans, credit card balances and mortgages rather than treating it as found money to be spent, as many did during bull market years.

Advisers are finding that the same behavioral-finance drivers that contributed to irrational optimism and overspending during boom times are now leading investors to hunker down.

Mr. Klaben’s observation about how clients now view bonuses is an example of one pillar of behavioral finance — mental accounting, which explains the tendency of individuals to divide their assets mentally into separate accounts and value them according to nonfinancial factors such as the source of the money or its purpose.

The new frugality also illustrates the role of prospect theory, which says that the pain of a loss is twice as great as the pleasure of an equal-size gain, suggesting that the losses incurred in 2008 were so searing that investors now want to avoid risks that could lead to more losses. They also want to eliminate losses (debts) they already have.

Finally, given our confirmation bias, or the behavioral finance tenet that says we give greater weight to our most recent experiences, advisers are finding that most investors believe that the economy and markets are not going to get much better anytime soon.

“No one knows how bad things have to get before they have a lasting effect on a generation,” said Michael Goldman, an industrial psychologist and financial planner who is founder of Wealth Gathering LLC in Gorham, Maine.

While it took a psychologist — Daniel Kahneman, who won the 2002 Nobel Memorial Prize in Economic Sciences for his work on prospect theory with economist Amos Tversky — to hypothesize that economic decision making is not entirely rational, advisers are seeing financial irrationality at work every day.

For example, most of the debt held by adviser Ara Oghoorian’s physician client base is in low-interest-rate student loans, but many of them are putting their extra funds toward paying off the principal ahead of schedule, despite the fact that it isn’t the most efficient use of the money, he said.

“I explain that they theoretically would get a much better rate of return if they put the money in a retirement account, and it makes sense to them,” said Mr. Oghoorian, who is president of ACap Asset Management in Sherman Oaks, Calif. “But they have a psychological aversion to debt.”

To Mr. Klaben, who has written about the impact of emotions on financial decisions, the change in investor thinking is “wonderful,” especially for formerly profligate baby boomers. He contends that it mirrors the attitudes of the Great Depression, even though the economy never sank to the levels of the 1930s.

Advisers can use investor anxiety positively by helping structure investment account statements to match a client’s internal mental accounts, said Larry Sinsimer, senior vice president for practice management for Fidelity Financial Advisor Solutions, a unit of Fidelity Investments.

USING A BUCKET LIST

Fidelity’s retirement income planning guide encourages advisers to separate accounts into three “buckets,” with one invested in very liquid assets to provide cash flow over the next three years, a second invested somewhat conservatively for capital preservation, and a third invested more aggressively for long-term growth.

Clients will be comfortable about having some risk in their holdings only if they feel secure about having enough “safe” money to meet their day-to-day needs, Mr. Sinsimer said.

“We spend a lot of time with tools and methodology, and in the end, sometimes we forget we are dealing with people, and that when emotion comes into conflict with logic, emotion wins every time,” he said.

Although the behavior of the wealthiest 1% or so of his clients hasn’t much changed, adviser Scott Bell, chief executive of Gross Domestic Product Inc. in Manhattan Beach, Calif., thinks that for the rest, the new frugality may last quite some time.

“They are very cautious,” he said.

[email protected]