From the May 2011 issue of Investment Advisor • Subscribe!

May 1, 2011

Advisors Beware: The Downside of Behavioral Finance

A superficial understanding of behavioral finance can be counterproductive

Behavioral finance is very much in vogue these days, and many advisors across the nation are looking to find out more about it and to apply its principles in their practice. Yet some believe that the financial world’s rush to embrace behavioral finance may be a little too much too soon, and could actually prove to be counterintuitive or futile for financial advisors.

Justin Reckers, director of financial planning at Pacific Wealth Management in San Diego, says that financial advisors really have to make an effort to understand what behavioral finance is. They need to understand how psychology interacts with economic theory, and they need to realize that the goal of proper applied behavioral finance is to create more educated and better-equipped investors who can recognize the mental roadblocks they may have, and how these may be inhibiting their overall goal of saving and proper financial planning. If advisors do not keep that very fundamental tenet in mind, Reckers believes they risk falling prey to misusing behavioral finance or using it in a limited fashion.

As behavioral finance has become a greater part of the mainstream financial forum, Reckers is most concerned that advisors may rely on financial products that are either being billed by the firms producing them as capable of dealing with particular investor biases or fears, or are a reflection – albeit unwitting – of what an advisor believes is the right fix for a particular fear or bias.

While financial institutions have been making use of behavioral finance for years, it is only recently that they have started to make it a part of the retail side of their business, Reckers says. There’s a danger in this if advisors and their clients concentrate on financial products that firms may produce as a consequence of implementing behavioral finance principles on their end, he says, since “proper behavioral finance needs to be used in client relationships in order to make people aware of their behavior.” Anything else, Reckers says, would be more of a quick-fix solution to a deep-set issue.

“Rather than products, self-determination is the most important part of applied behavioral finance,” he says. “It is about building a decision-making process to get people to make their own decisions. As a financial advisor, my goal is to figure out where a client wants to go and what is driving their behavior. Specific products are not the answer.”

It’s only natural – particularly in volatile times – to want to assuage client fears in the most immediate way possible, says Chip Workman, lead advisor for the Asset Advisory Group in Cincinnati. And if there are financial products capable of taking care of those fears, then it’s an easy fix. But even if there’s merit in the products themselves and they can take care of a client’s near-term fears, using them would mean succumbing to only a product-driven solution that doesn’t employ behavioral finance properly and to its fullest potential, Workman says.

“Behavioral finance is a wonderful science and tool, and when used correctly, provides a great opportunity to further the relationship between clients’ emotions and their money and saving goals,” he says, “but using it properly also means having to confront some painful truths about oneself. Advisors face a tremendous challenge in using behavioral finance properly, but they have to make sure that neither they nor their clients are chasing the fear of the moment with a particular product. Advisors have to determine whether products fit into the long-term goal of their clients – this is the only way in which you’ll see behavioral finance being used properly.”

The proper implementation of behavioral finance calls for working closely with clients, even on a day-to-day basis if necessary. Constant interaction between advisors and their clients is necessary, and as a result, advisors should be able to get clients to a place in which they can make their own decisions, Reckers says. This means that an advisor needs to not only get people to trust themselves (“there is neuroscience behind the fact that people will not make their own decisions if there is a person of authority in the picture,” he says), but also get rid of his or her own biases and ensure they don’t interfere with a particular client’s financial goals.

“As an advisor, you have to be aware of your own biases, you need to get past them and look past yourself and build better decision-making processes both for yourself and for your client,” he says.

In a proper application of behavioral finance, a financial advisor needs to identify and meet the needs of a client’s behavior, says Ted McLyman, Augusta, Ga.-based financial management firm Apexx Financial, who heads up the firm’s behavioral finance group. The client should not have to change their behavior to mirror the behavior of the financial advisor, which is why every advisor must be as aware of their behavioral biases as their clients are of theirs.

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