From the outset, behavioral finance has focused on documenting the irrational financial behavior of human beings, and even today, says Daniel Crosby, founder and president of Atlanta-based behavioral finance consulting firm, IncBlot, the science is still largely centered on highlighting the mistakes people make with respect to financial planning.
Crosby believes that people — financial advisors and the general investing public — have begun to tire of the seemingly endless litany of flaws (“I have counted 117 well-documented irrationalities or behavioral biases,” he said.) that behavioral finance has highlighted and are ready for something else.
“We’re at a point where behavioral finance needs to go in a new direction, one that answers the questions ‘so what’ and ‘now what,’” he said.
Crosby set up IncBlot to try to answer those questions and to be a part of what he believes is the important and necessary transition of behavioral finance from theory to practice — a change that will allow financial practitioners to use the science in a more meaningful, useful and realistic manner.
He firmly believes that behavioral finance needs to stop uncovering new ways in which human behavior can spoil proper and logical financial planning, and instead focus on whittling the already existent body of knowledge down to a decent and workable universe that will enable greater practicality.
“Today, we know that there are 117 ways to mess things up, and that’s all fine, but what are the two or three big pillars that account for the majority of these biases?” he asked. “Winnowing that knowledge down to […] a manageable universe of the ways in which we make mistakes will make it that much easier for everyone, particularly for financial advisors, who’ll find it easier to incorporate behavioral finance at every step of the investing process,” he said.
More importantly, though, Crosby believes that behavioral finance must seek to cast both investing and investors in a more positive light than it has done up to now, and that the science needs to evolve in such a way so that it highlights the more positive aspects of human financial behavior.
“Over the last 15 to 20 years, we’ve seen a movement in clinical psychology to study positive psychology, and that’s what we need in behavioral finance,” he said. “We have to speak to the other side of the coin, as it were, to make investors aware of the good things that they do and to draw attention to the positive hallmarks of investor performance.”
To make sure that that happens effectively, advisors should get clients to focus entirely on themselves and their lifetime goals in order to simplify the investment process. Advisors need to help their clients set up personal benchmarks and focus only on them; only then will they be able to help them both exhibit and feel encouraged by the more positive aspects of their investment behavior.
“There are thousands of pieces of economic data out there, and what happens is that people focus on those and how they are likely to impact their financial performance,” Crosby said. “People worry about the performance of the Cypriot economy, to give a recent example, but the reality is that the performance of the Cypriot economy is really not that germane to their lives or to their situation.”
When investors react to a large, external event like a downturn of the economy of Cyprus, they will definitely exhibit the negative behaviors chronicled by behavioral finance, but if advisors can get their clients to look instead at the benchmarks they have set up to accomplish in their own personal financial agenda — sending a child to college, for example — then they will be able to get them to see positive financial behavior that will ultimately encourage them more for the future, Crosby said.
“We know that people will be loss averse, for example, because behavioral finance has documented this very well. It is not enough for an advisor to tell their clients that they are loss averse because this is like saying ‘stop eating cookies’ without offering any alternative,” he said.
Crosby is currently working with several advisory firms to come up with programs that will help their clients focus on working toward and achieving personal benchmarks in order to highlight more positive behavioral tendencies that will ultimately help them be better investors.