Leveraging behavioral finance to better understand clients during market volatility

Investors have watched the news and headlines these past few months, and opening their 401(k) statements at quarter-end was probably not a pleasant experience.

Many advisors are under considerable pressure these days to explain the stock market swings and what is happening to their clients. They probably can’t, and that’s because markets aren’t always rational – and investors seldom are.

Behavioral finance is the intersection between psychology and economics, and it seeks to understand the real-world financial decisions that are made when people are under pressure (in other words, what could be prompting your clients’ emotional roller coasters lately).

To help you with your communications with clients and understand them a bit more, it’s important to recognize what might be happening internally. We know that the brain is a very complex organ. For the sake of this article, we are going to look at three parts of the brain that often work cooperatively together but sometimes act antagonistically.

First is the “reptilian brain,” which is shared with all creatures that have vertebrae (e.g., mammals and reptiles). It controls the basic things required for survival, like breathing, heartbeat, and body temperature. These are things you do without ever consciously thinking about them. Picture this part of the brain at the bottom and center.

Next, the “mammalian brain” is our instinct center. Only warm-blooded creatures have this part of the brain, and it is where our warm and fuzzy feelings and emotions, such as love, fear, surprise, anger, and hurt, reside. This is also where our “fight or flight” reflex is controlled. Visualize the mammalian brain as a large middle section above the reptilian brain.

And finally, we have the “hominid brain,” which is only present in humans and a few great apes. This is where higher human thought resides―it’s our language and reason center and also where our mathematical abilities lie. Picture the hominid brain at the very top of the brain, above mammalian and reptilian.

What happens when people are in a state of great emotion like fear or surprise is that the blood literally drains from the hominid brain, containing the reasoning center, and flows instead to the mammalian and reptilian brains. So, people’s ability to reason and apply logic is directly impacted while their emotional centers are flooded and their flight or fight reflex is activated.

Sharp drops in the markets could be considered stressful events and why your clients may call you, panicking over the news and asking for help. It can take hours to regain ability in the hominid brain, and simply thinking about a stressful situation is enough to start the process all over again.

Now that you know what scientifically is happening with investors’ brains and decision-making abilities, what can you do?

• Be understanding. Clients may not need their funds for anything near term, but a loss still hurts. Loss aversion is a behavioral bias that can be described as people’s tendency to strongly prefer avoiding losses to acquiring gains. Some studies suggest that losses are twice as powerful psychologically than gains. Loss aversion is also an emotional bias, so data and charts won’t necessarily resonate with clients. Instead, reframe the situation; perhaps ask, “If your children were in your circumstances, with the same market conditions, what advice would you give them?”
• Redirect clients toward their goals. More than likely, the funds were invested because clients said they didn’t need the money in the near term. Remind them of their long-term goals and how they are now buying the same stocks or funds at much lower prices.
• Reframe their choices. If clients ask to keep excess funds out during a downturn, ask them if they would prefer to try to time the market or to miss out on upside potential when the market conditions change.
• Focus on what is controllable. Suggest that clients turn off any negative news and noise and consider other strategies, such as dollar-cost-averaging, that might help them over time.

While the current markets are volatile, keeping your clients on track and encouraging them to make good decisions is a big part of every financial advisor’s value proposition. Make sure that you are leveraging behavioral finance principles to help achieve the best possible outcomes for your clients!

Kristine McManus is the chief advisor growth officer at Commonwealth Financial Network, where she helps financial advisors expand their businesses and achieve sustainable growth.