Let’s face it, the financial services industry loves analytics. We produce mountains of data and delight in presenting it to clients in new and creative ways. Finance is, after all, a highly analytic field, so it is hardly surprising that we focus our time and energy on numbers. This is the paradigm that is often used to develop and deliver financial advice, but a growing body of evidence suggests that the financial decisions made by most individuals may have less to do with analytics and more to do with behavior and emotions. How do we as advisors strike the appropriate balance between analytics and emotions, and what can the field of behavioral finance teach us that may help our clients to make better financial decisions?
Behavioral finance is a field of study that combines the disciplines of psychology and finance to provide explanations for why people sometimes make irrational financial decisions. While it is often used to explain investor behavior, it contains some very practical lessons that may be applied to retirement planning.
One fundamental lesson for advisors is how best to communicate with clients. While it is appealing to focus on analytics and “take emotion out of decision making”, the study of behavioral finances suggests that accommodating human emotion and behavior yields better decision making results. In this same vein, we must recognize that analytic capabilities may be replaced over time with knowledge that is rooted in life experience. Our presentation skills should be flexible and our material appropriate for the target audience.
Individuals can benefit from the study of behavioral finance by identifying and improving upon how they make financial decisions. Research suggests many people fail to save enough money for retirement, make less than optimal investment decisions, and spend accumulated assets too quickly.
For example, retirement plan participants may be influenced by how a decision is presented (framing). Research suggests that participation in employer sponsored retirement plans dramatically increases when employees are automatically enrolled in the plan (opting out rather than opting in). Further, once enrolled, participants save far more on average if the employee’s savings rate is automatically increased gradually over time. These relatively minor changes have helped to counter the natural human tendencies of procrastination and placing a higher value on current consumption than on future consumption.
Inertia or procrastination may also explain certain suboptimal investment decisions, such as failing to adjust the investment mix of stocks and bonds to accommodate changes in age, risk propensity or market conditions. These may be mitigated through the use of target date retirement funds, automatic portfolio rebalancing and regular portfolio review meetings. More difficult to address is the tendency of some investors to place an extremely high level of confidence in their own investment decisions, beliefs and opinions. Investors with too much confidence in their own investment skills often buy and sell positions frequently, which can have a negative impact on their returns. Research shows that those who buy and sell often are at a disadvantage versus those investors that trade less frequently. Having an investment policy statement and systems in place to properly diversify among various asset classes can help mitigate poor decision making based on overconfidence.
As discussed in our prior blog posts, spending accumulated assets too quickly may be avoided by developing and maintaining a dynamic retirement budget and income plan. The Systematic Withdrawal Approach, Time Based Segmentation Approach and Essential Versus Discretionary Approach all place parameters around portfolio distributions, which help guard against overspending. When combined with income from a pension or annuity, the risk of spending too much money too quickly may be further mitigated.
As financial advisors, we are not expected to become experts in cognitive behavioral or psychological theory, nor should client interventions become part of our practice model. There are, however, many eminently practical applications of behavioral finance such as properly framing decisions of current savings versus future consumption and setting appropriate parameters around investment and retirement income strategies that should be considered. Recognizing and properly applying concepts from behavioral finance may greatly enhance client communication and decision making.
John Male, CFP®
The Gassman Financial Group
G&G Planning Concepts, Inc.
The Retirement Maven™
9 East 40th Street, Suite 1500
New York, NY 10016
Tel: 212-221-7067 Ext. 17