6 Behavioral Finance Principles Advisors Need to Know

People exhibit several common tendencies when making financial decisions

Neuroeconomics: the study of how people make financial decisions. Neuroeconomics: the study of how people make financial decisions.

Most people don’t make very good decisions about their own financial assets, as studies of the human brain have found.

A new white paper from First Clearing and Cannon Financial Institute looks at some of the basic principles of neuroeconomics, the study of how people make financial decisions, and how advisors can use those principles to improve client service and communication.

The paper, titled “The Silent Value: Advice for the 21st Century,” suggests that people with competent financial advisors do better than do-it-yourselfers and that the role of financial advisor may very well be more significant now than ever before.

“The latest research says that we humans don’t make financial decisions as logically as we used to believe,” said author Linda Eaton, executive vice president and performance improvement specialist for Cannon, in a press release. “It tells us that clients tend to slip into patterns of thinking that can cloud their judgment, ultimately impacting not only their investments but their lives.

“This means there’s a key opportunity at hand,” she continued. “At a time when more and more investors are trying to manage their own finances, advisors can provide a critical service that can’t be obtained elsewhere. By applying basic ‘brain-science’ principles, they can take their practices to a new level, deepening their relationships and increasing their value to clients.”

The paper points out the six tendencies that many people exhibit when making decisions about their finances and their futures.

These common tendencies demonstrate the advantages to having professional guidance to manage wealth, said Bill Coppel, chief client growth officer for First Clearing, in a press release.

“In our digital world, clients have access to a lot of information,” he said. “But advisors who understand a few brain-science principles offer much more than products and market data. They can relieve the anxiety of making financial choices, help clients clarify their true aspirations and relate those aspirations to their bigger financial picture.

Here is a closer look at the six common investor tendencies:

Emotional Decision-Making

1. Emotional Decision-Making

The white paper points to research finding that “the more important any decision is to a person, and the more complex a decision becomes, the more strongly it is lodged in the emotional regions of the human brain.” The study states that any high degree of emotion impairs the ability to make good decisions.

Instead of counteracting with logic, the white paper suggests acknowledging and dealing with the emotions first.

“Moving gently, making smaller, more gradual changes in a portfolio can often be more effective than trying to force a major change with which a client is uncomfortable, no matter how financially appropriate it may be,” writes Eaton in the study.

Loss Aversion

2. Loss Aversion

As the paper states, modern brain research has determined that “when the action involves money (or actually anything perceived as an asset), avoiding loss is a far more powerful instinct than pursuing gain.”

The tendency for loss aversion can have effects beyond a client’s fear of loss. The paper states this can also relate to the majority of advisors who “dramatically scale back their prospecting efforts as soon as their practice will support them.”

“Although most would cite that they just don’t have time to prospect now that they have actual clients to take care of, we know that this is more of an excuse to avoid something they perceive as unpleasant than it is an accurate assessment of the demands on their time,” writes Eaton in the paper. As the baby boomer generation moves into retirement, the paper suggests there is a risk of once-profitable practices fading away if practices focus only on current clients and not on seeking out new clients.

Mental Accounting

3. Mental Accounting

The third brain-related pattern, mental accounting, refers to “the tendency people have to put their assets in different mental compartments that don’t interact with each other,” according to the paper.

Because it can be difficult for people to grasp their entire financial picture as a whole, an advisor can help clients see the whole picture and use all their assets to achieve their goals.

Mental accounting can also explain why so many clients have multiple advisory relationships, the paper states.

Selective Attention

4. Selective Attention

Eaton writes in the paper that “a lot of the time, we don’t even see what’s really out there in the world. Instead, we see what we’re looking for and what we expect.” The paper suggests that advisors can use this idea of selective attention to construct client expectations and the client experience – from who greets clients on their first visit, to how quickly their concerns are addressed, to whether they’re invited to a client appreciation event.

Because a client’s opinion about an advisor’s service often depends less on the performance of the portfolio than it does on the performance of the advisor, the paper states that “clients who are given a vision of excellent service and then experience what they’ve been led to expect tend to be tremendously loyal.”

Framing

5. Framing

How something is communicated can have more impact on a person’s decision-making than what is communicated, the study found.  

The paper suggests that advisors should focus their recommendations as closely as possible to the client’s specific personal situation instead of presenting a solution to a client in terms of the investment itself or the markets.

Familiarity Bias

6. Familiarity Bias

“Human beings are creatures of habit, and we tend to repeat the same behaviors over and over again,” Eaton writes in the paper.

To illustrate this, the paper points to a recent study conducted by Dreyfus that showed the average American investor has more than 75% of their money in U.S.-based stocks. However, at the turn of the 21st century, the U.S. represented about 50% of global market capitalization, and by 2012, it had fallen below 38% and continues to trend down.

“Without some external impetus, many advisors just don’t keep up with the range of opportunities open to their clients," the paper says. "Few advisors deviate from their reliable old habits in other areas, too – like client service, technology, even what they read for research.”

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