Psychoanalysis Has Met Investing. What Does It Mean For Advisors?

Psychoanalysis Has Met Investing. What Does It Mean For Advisors? Behavioral finance is the study of why investors think and do what they do about money and investing

By Greg Salsbury

Even if you are only an occasional reader of trade publications, you cant have escaped one of the hottest buzz-phrases in our industry: “Behavioral Finance.” The term refers to the colliding of psychology and financial theory to form a burgeoning new field of study.

You may be surprised to know the 2002 Nobel Prize winner in economics, Dr. Daniel Kahneman, is not an economist, but a psychologist. In a nutshell, behavioral finance, or behavioral economics, is the study of why investors think and do what they do about money and investing. The unflattering results show that investors can be irrational, emotional and, at times, dysfunctional.

Forget about simple fear and greed, or conservative and aggressive. Psychologists have given us a new vocabulary for describing investor behavior. Enter the brave new world of “myopic loss aversion,” “mental accounting,” “regret syndrome,” “cognitive dissonance” and “attachment bias.” One expert even provides a formula for understanding investors, explaining that “Losses hurt 2.25 times more than gains satisfy.”

There is no doubt the experts are on to something. They correctly question illogic such as: what compels people to drive 30 minutes to use a $1 coupon; wash their car to save $10, but never dream of washing a neighbors car for $10; why missing a train by one minute is so much more painful than missing it by half an hour; or why the same person who would never buy the most expensive orange juice at the grocery store has no trouble plopping down $5 for a venti, half-caf, breve latte.

But lets suppose, as a student of the game, youve done your homework and pored over the works of Hersh Shefrin in “Beyond Greed and Fear” or the extensive research of Dr. Shlomo Benartzi and Dr. Meir Statman. Or to get a more down-to-earth understanding, youve read the more layperson-friendly “Investment Madness,” by Dr. John Nofsinger.

If you have, then youve probably reacted as a patient who has finally been given, after years of suffering, the clinical definition of his ailment. And your reaction was likely something like this: “Yep, thats exactly what Ive got! So, what does it mean doc?” In other words, the whole behavioral finance craze probably has left you with one lingering questionSo what?

So, what do these great explanations of human and investor behavior mean for the typical investor? This question is where behavioral finance literature seems to leave us hanging. So, consider this article the 60-second “Cliff Notes” version of how you can use behavioral finance to help your clients avoid some of the most common financial missteps.

(1) Dont try this alone.

Understanding investment products is a complicated science. Applying these financial products to the investing process becomes art, particularly when investor behavior, emotions and biases come into play. Research shows that left to their own devices, investors make a multitude of mistakes.

They dont properly allocate assets. They borrow against 401(k)s. They overload their portfolios in a given sector or company, often with their own employers stock. They buy when they should sell, and sell when they should buy. They are overly influenced by the trend du jour.

The greatest lesson investors can take from behavioral finance is that they need the services of a financial professional. Just as the typical patient would be considered foolish to attempt brain surgery on himself, the typical investor is equally lost in this complicated world.

Help investors by illustrating how you can help them: establish goals; allocate assets; implement a long-term strategy; monitor progress; and, perhaps most importantly, provide an objective viewpoint to help investors overcome the fear and emotion that often drives investment decisions.

(2) What you dont see can help you.

The next time you meet with a client, ask how much he or she paid in taxes last year. You will find an amazing percentage of them have no clue. Dont be shocked if some proudly state, “I didnt pay any taxes. I got a refund!”

They believe this because the Internal Revenue Service engineered a model that is well suited for accumulating money without us ever missing itcollection in advance. The IRS collects its piece of our paychecks automatically, before we have a chance to spend it.

Collection in advance can help your clients become disciplined savers. An automatic investment plan allows clients to pay themselves first. Investments are treated as another part of their regular budget. Rather than spending extra income on impulse, an automatic investment plan forces investors to put more money away over the long run.

Additionally, you can show clients how an automatic investment plan and dollar-cost averaging, although not guaranteeing a profit or protecting against loss, can help reduce regret and volatility within a portfolio.