The human factor

A client of financial adviser Michelle Spaziani recently proposed a plan to recoup money on a past land purchase that didn’t pan out.

But a red flag went up.

The couple’s scheme involved borrowing money to build an income-producing house on the land, now worth 50% less than they paid before the 2008 housing bust. But taking out a big loan was at odds with their financial plan, and would undo all their hard work to get debt-free before retirement.

Ms. Spaziani, a proponent of behavioral finance, an increasingly popular field of study that contends that peoples’ biases, emotions and irrational behavior can lead to poor investment decisions, thought it was a bad idea. After hearing them out, she concluded their plan was driven by a behavioral bias.

As part of Ms. Spaziani’s intervention, she introduced the couple to the behavioral finance concept known as loss aversion, or the tendency to avoid taking a loss because it’s too psychologically painful.

“I told them they were exhibiting all the signs of loss aversion,” recalls Ms. Spaziani, a veteran financial adviser who in 2018 founded Summit Behavioral Wealth in Greenfield, Mass. “They were avoiding the idea of selling the land now at a depressed price [to] avoid pain. The husband was totally fascinated by the concept. He had never heard of this before. I told them about the pain they were feeling, and that research shows it’s a real thing.”

Her clients got the message. They decided not to borrow money to build the house, although they were unwilling to sell the land at a loss. “They’re still not there,” Ms. Spaziani said, “but at least they’re not doing more damage to their retirement plan.”

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Ms. Spaziani is one of a growing number of financial advisers who are incorporating behavioral finance, or BeFi, concepts into their practices. There’s increasing recognition among advisers of there being more to the adviser-client relationship than selecting funds, focusing on returns, drawing up asset allocations or bombarding clients with spreadsheets and pie charts.

While it’s hard to pinpoint the tipping point, there’s been increasing interest in and greater adoption of behavioral finance by financial advisers since the Great Recession, said Ms. Spaziani, mainly because coaching people to make the right financial decisions was “desperately required” during and after the worst financial crisis since the Great Depression.

They’re embracing the idea that there’s a greater chance a
client will both stay with them longer and stick to their long-term plan if
they add a behavioral finance “coaching” component to their services.

The goal is to improve the client experience and portfolio returns by helping clients avoid emotion-driven miscues, such as selling at the bottom in a bear market or holding on to a losing investment that has little chance of bouncing back.

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Nearly three-quarters (71%) of advisers say they incorporate behavioral financial principles into their “client communications and interactions,” according to “BeFi Barometer 2019,” a survey of 300-plus advisers sponsored by Charles Schwab Investment Management (CSIM). Another 58% say they apply the concepts when building client portfolios. Advisers that InvestmentNews interviewed who offer these non-portfolio-driven services to combat biases say they don’t charge extra for the service.

Other behavioral biases include:

• Recency bias — Being easily influenced by recent news events or experiences like the S&P 500’s nearly 30% rise in 2019.
• Confirmation bias — Seeking information that reinforces your own views.
• Anchoring — A tendency to focus on a specific reference point when making investment decisions.

Advisers identified a few ways incorporating behavioral
finance is beneficial. Nearly half (46%) say it helps them better manage client
expectations. Four out of 10 say it helps reduce their client’s short-term
emotional decisions. And three in 10 say it helps keep clients invested during
periods of volatility.

Better returns are another benefit of not making financial
decisions based on emotions. A Vanguard study in 2016 estimated that financial
advisers that provide behavioral coaching added a net return of 150 basis
points to a client’s annual return.

“You don’t want to have to talk someone off the ledge — you make sure they never get close to the ledge in the first place,” said Jay Mooreland, founder of The Behavioral Finance Network and a behavioral finance coach who sends out weekly coaching messages to his adviser clientele that often seeks to limit damage from ill-timed portfolio moves caused by scary financial headlines that spook investors.

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For coaching to be effective, it must be “proactive and deliver a consistent message,” says Mr. Mooreland.

“What we are trying to do is decouple the emotions from financial
decision-making. [As an adviser], you are trying to dictate the discussion. If
you don’t, the media will.”

But not every financial adviser is buying into the behavioral finance add-on, the CSIM survey found. Of those who said they’re not incorporating these concepts into their practices, 65% said it was because they have “difficulty translating behavioral theory into implementation.” Another 54% blamed a lack of software and tools.

“I am definitely a skeptic around the value of advisors marketing themselves as behavioral experts,” Michael Kitces, partner and director of wealth management at Pinnacle Advisory Group in Columbia, Md., told InvestmentNews via email. “Not that it’s bad to be a behavioral expert, but it’s not something clients are necessarily looking to buy.”

Research suggests clients still measure their financial advisers on performance. Mr. Kitces points to a 2019 Morningstar survey of individual investors that found that an adviser’s ability to help “control their emotions” ranked last in a list of 15 things client’s value.

Still, Omar Aguilar, chief investment officer of equities
and multi-asset strategies at CSIM, says advisory firms that add behavioral
finance to their offerings can “differentiate” themselves in a competitive
marketplace.

“It sounds counterintuitive, but understanding what clients’ biases and behaviors are is more important than returns,” Mr. Aguilar said. “The reason why behavioral finance is so relevant is because the use of these concepts allows advisers to build better and longer-lasting relationships.”

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As Ms. Spaziani puts it, the investment piece is the easiest piece of the puzzle. While we have little control over markets and the economy, what we can control is our behavior and “how we react” to stimuli and triggers.

“I view my job as trying to stop a client from making a silly decision,” said Mr. Spaziani, who felt so strongly about letting people know her practice was focused on more than just picking the right fund that she included the word “behavioral” in her firm’s name. “[In volatile markets], my clients aren’t saying to me, ‘Show me another spreadsheet.’ They’re calling me, saying, ‘Please help me understand why this is happening and what I need to do.’

“They’re starving for a different approach, someone to coach them, somebody who sees this as money therapy rather than a consultation about what mutual fund to buy,” Mr. Spaziani adds. To reinforce her message, she sends out monthly emails to clients that educate them on how behavioral biases impact their decision-making.

To help protect investors from themselves, Ryan Shuchman, partner at Cornerstone Financial Services in Southfield, Mich., uses a “fact-based” approach to bust biases.

Clients influenced by news headlines, for example, who fear that an ongoing trade war between China and the U.S. will cause a recession, are shown current economic data that prove otherwise. “We tell our clients we’re looking at the facts, the underlying fundamentals and economic data, and we are not seeing signs that a downturn is imminent,” Mr. Shuchman said.

Coaching clients on a continuous basis is part of Mr. Shuchman’s strategy.

“You want to make sure they their short-term impulsive decisions don’t get their retirement plans and accounts off track,” he said.

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The roots of modern-day behavioral finance date back to the late 1970s, when psychologists Daniel Kahneman, a Nobel Prize winner, and the late Amos Tversky peered into the psychology of decision-making and put behavioral finance on the radar. Their research showed that peoples’ investment decisions are influenced by irrational factors like cognitive biases.

Then Richard Thaler came along. A professor at the University of Chicago, he built on the psychologists’ work and won the Nobel Prize in Economic Sciences in 2017 for integrating economics and psychology. All three men are regarded as the founding fathers of behavioral finance.

But it was Mr. Thaler, through his research papers, speeches and best-selling books, who caught the attention of financial advisers and the investment community.

“Nudge,” which he co-wrote with Cass Sunstein in 2008, suggested that subtle interventions could steer people toward a desired action, such as saving for retirement. “Misbehaving: The Makings of Behavioral Economics” was released in 2015.  Mr. Thaler made the concepts digestible and relatable. Financial advisers finally understood that when it came to managing money, the way their clients were wired psychologically was sometimes an obstacle that needed to be overcome.

Gary Droz, managing director of MainLine Private Wealth in Wynnewood, Pa., said that listening to a speech by Mr. Thaler, nearly five years ago, “literally changed” his business.

“It hit a nerve with me,” said Mr. Droz. “I’ve been an adviser for 35 years and I used to always scratch my head about a lot of things my clients did. It all made sense after learning about behavioral finance.”

Mr. Droz immediately began attacking common behavioral biases that were holding clients back.

In dealing with loss aversion, Mr. Droz works tirelessly to teach clients not to panic during market swoons. He explains in “excruciating detail” how volatility works and how stocks have rebounded from past plunges, including the 2008 financial crisis. “We have trained clients to stand pat,” Mr. Droz said. “Unless you educate clients, they do stupid things out of panic.”

He’s dealing with investor inertia, too. Just as Mr. Thaler’s research showed 401(k) investors were less likely to sign up for a retirement savings plan on their own, and that auto-enroll was the only way to get them to participate, Mr. Droz has set up systems whereby his staff enrolls clients in accounts, and fills out forms and submits documents for them.

“We don’t give clients homework, because they won’t do it. We do it for them,” said Mr. Droz. “That is how behavioral finance permeates everything we do.”