June 20, 2011

Emotion, Intuition Key to Advisor Use of Behavioral Finance

A new white paper from Allianz shows how emotion and intuition affect clients' attitudes and actions

More and more financial advisors today are on the lookout for practical ways in which to apply the principles of behavioral finance into their practices, but coming up with options that are easy to implement is not that simple.

Shlomo Benartzi, Chief Behavioral Economist, Allianz Global Investors’ Center for Behavioral Finance“The demand for solutions is almost unmanageable,” says UCLA professor Shlomo Benartzi, an expert in behavioral finance and chief behavioral economist of the Allianz Global Investors’ Center for Behavioral Finance. “In responding to the needs of our clients, our main problem is prioritizing and deciding what we should address first.”

Since it was launched in 2010, Allianz’s Center for Behavioral Finance has engaged in many discussions with financial advisors in order to get a sense of the problems that advisors are facing vis-à-vis their clients in the post financial crisis era, and what sorts of tools or solutions would help them address these problems and better serve their clients. Recently, the Center released a white paper that Benartzi says is “Step One” in what will be a long process designed to help advisors incorporate behavioral finance theories and techniques in their practices.

The paper, entitled “Behavioral Finance in Action,” focuses on emotion and intuition, both of which play a key role in peoples’ decision making processes, particularly after the financial crisis, Benartzi says. The white paper offers academic insights that financial advisors can use tohelp their clients discriminate between wise intuitions, which can help them achieve better results in their financial planning, and the kinds of common, erroneous judgments that only serve to hold them back from their goals.

Understanding the impediments that investors face is the first step in coming up with solutions, and the paper identified four of these that impact the advisor/client relationship: Investor paralysis (the psychological fallout from the financial crisis has caused investors to leave record amounts of cash on the sidelines); lack of investor discipline (most investors often buy high and sell low); a crisis of trust (the recent financial crisis has had a lasting impact on the bond of trust between financial advisors and their clients) and the disinclination to save (inadequate savings is a chronic problem, not just for retirement, but for other contingencies as well).

All these challenges, Benartzi says, are products of the intuitive mind and can be addressed in simple and applicable ways that an advisor can easily follow. These solutions – which form a part of The Center’s Behavioral Toolbox -- also engage the rational mind, which can counteract the more impulsive and sometimes irrational decisions that the intuitive mind makes.

To address the issue of investor paralysis, for example, the white paper recommends the “Invest More Tomorrow Strategy,” whereby advisors invite clients to begin investing at a specific time in the future and to agree on the size and frequency of subsequent investments. Advisors can also help rein in their clients’ lack of investment discipline by encouraging them to pre-commit to a rational investment plan that includes decisions on what actions to take in advance of large market movements.

“Most people do not stick to their investment goals so we have developed a commitment contract where people will sign in advance about certain market situations that can come up, and this will help them stick to their goals,” Benartzi says. “By signing the contract, a person will actually be signing on to their goal. Having a plan for every possible scenario would make people sleep better and feel more secure.”

The white paper also outlines several ways in which advisors can strengthen their relationships with their clients and regain their trust. This is a key element of the process, since many people have felt a deep sense of betrayal by their advisors in the aftermath of the financial crisis. Advisors have a greater chance of regaining and maintaining their clients’ trust if they demonstrate their competence on a regular basis and show that they have empathy for their clients even in the toughest of times, Benartzi says.

Finally, the Center’s Behavioral Time Machine, which is currently in development, seeks to bolster savings rates by connecting individuals with their future selves. Using age-progression software, this tool allows people to see images of themselves 30 years in the future and has been proven in studies to be effective at increasing savings rates.

“We’re spending quite a bit of time and money on this and we hope that we’ll have it soon,” Benartzi says. “When you age people, you don’t want to scare them, you want them to have a realistic image of their future. Most existing software packages that age people make them look more like fire victims than anything else, but there’s a far greater chance of people saving more if they feel moreconfident about themselves in the future.”

The Allianz Center’s overarching goal is to translate academic behavioral finance theory into action that advisors can use. “We offer a template that advisors can, in a sense, just copy, if they like, in a quick way. Whatever we have done and continue to do is very applicable,” Benartzi says. “But coming up with applicable solutions is a long process and not something that can be done over coffee.”

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