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How to battle irrational financial behavior

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A basic principle of economics is that people are rational and make decisions that maximize their utility.

It’s common sense: Why would they do otherwise?

That assumption facilitates economic models but reality proves otherwise. People can and will do irrational things with their finances.

Behavioral economics (also called behavioral finance) addresses these irrational aspects. David Zuckerman, CFP, CIMA, principal with Zuckerman Capital Management LLC in Los Angeles has been studying behavioral economics for about 10 years. Although his college major was traditional economics, he found that the longer he worked as a financial advisor, the more inconstancies he spotted between clients’ behavior and what traditional economics posited they would do.

“The further I got into my career, the more I realized that people are not rational and that many of the biases embedded in the human psyche drive people to irrational decisions,” he says. “I wanted to delve a bit deeper into that and find out more about why there’s such a disconnect between reality, where people do not make rational decisions, and the traditional economic theory that holds that people always act rationally.”

Behavioral finance isn’t just an interesting academic subject — it has useful implications for understanding retirees’ behavior and how their decision-making processes can help or hurt their finances. Because retirees can’t hit the financial reset button as easily as younger people, it might not be possible for older clients to recover from their self-imposed mistakes. Here’s what you need to know to keep retired clients on track.

The big biases

William “Marty” Martin, Psy.D. with The Planning Center Inc. in Chicago says advisors need to be aware of several key behavioral finance themes with their retired clients. First, everyone makes cognitive errors when they make decisions largely because of the amount and now speed of data in our daily lives. Recognizing the categories of cognitive errors enables clients to catch themselves while making these errors and later prevent most of the errors. In addition, financial advisors are subject to the same cognitive errors as their clients, he adds.

Read on to learn what the advisors interviewed for this article believe are specific biases worth monitoring.

Back when human beings were hunter-gatherers, the instinct to herd and stay with large groups of people and follow their actions made a lot of sense. It still does.1.      Herding.

Back when human beings were hunter-gatherers, the instinct to herd and stay with large groups of people and follow their actions made a lot of sense. There was safety in numbers and herding increased the odds of survival. But that history doesn’t translate well to personal finance decisions, Zuckerman cautions: “The instinct to herd can wreak havoc on investment returns. Warren Buffet’s mantra — ‘Be fearful when others are greedy, and be greedy when others are fearful’ — is something that clients with the instinct to herd will often find meaningful.”

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Clients’ emotional decisions give financial advisors angst

When clients anchor, they incorporate irrelevant information into their financial decisions. 2. Anchoring.

When clients anchor, they incorporate irrelevant information into their financial decisions. Philip Weiss, CFA, CPA, chief investment analyst with Baltimore-Washington Financial Advisors Inc. in Columbia, Maryland, gives the example of a client who expresses interest in a stock that previously traded at $100 and now trades at $60. The client points out that the price is down 40 percent, which makes it a bargain. Not necessarily, Weiss points out: “That $100 doesn’t mean that that was really a reflection of value or anything else; that’s just what the market paid for it then. That didn’t mean that it was worth it.”

Anchoring can also interfere with rational decisions to sell depreciated assets, whether it’s a home — “It used to be worth $x and I won’t sell for less than that” — or stocks. Weiss cites the price history of numerous stocks that hit historical highs and took years to subsequently revisit those highs, assuming they ever did. Microsoft’s price, for instance, peaked in December 1999 and still hasn’t regained that valuation. Advisors need to recognize when clients are locking on to a reference point by anchoring or the clients might set inappropriate reference values.

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The advisor as therapist …

Everyone likes to make correct, well-informed financial decisions. 3.      Confirmation bias.

Everyone likes to make correct, well-informed decisions. Consequently, we seek out information that supports our decisions and downplay or overlook contrary opinions. Think of the last time you bought a new car or made another major purchase — you probably sought out positive post-purchase reviews to reinforce your purchase.

This tendency to seek confirmation also occurs with negative opinions. For example, The Conference Board’s measure of U.S. consumers’ confidence fell from a revised 97.8 in January 2016 to 92.2 in February, the lowest level in seven months. At the same time, though, the U.S. unemployment rate in the United States was recorded at 4.9 percent for February 2016, unchanged from January and at its lowest level since April 2008, and other indicators also showed modest economic growth.

Nonetheless, some clients will focus on the negative number and ignore the positive result in an example of confirmation bias. “Clients who have become pessimistic gravitate toward news and information that confirms their pessimistic outlook,” says Zuckerman. “Without diversity of information, it is difficult to make well-informed investment decisions. In order to be helpful I will often point out data and perspective that is contrary to a (client’s) pessimistic outlook.”

See also …           

What “everybody knows” is not always right

 Clients lose physical flexibility as they age but they also experience reduced intellectual adaptability.

4. Inability to make changes.

Clients lose physical flexibility as they age but they also experience reduced intellectual adaptability.

Cicily Maton, CFP, CFT with The Planning Center Inc. has been studying behavioral finance and incorporating it in her work with clients since the early 2000s. She’s noticed with that it often becomes more difficult for aging clients to make changes. She shares a case in which she had been working with a client for about 12 years when the client and his wife expressed a desire to organize their finances more efficiently in case the husband died before the wife.

The changes involved consolidating and transferring several accounts that were at other firms to Maton’s firm, a step to which the client agreed; nonetheless, he wouldn’t complete the paperwork. “He said, ‘You’re right on,’ but he couldn’t get it done,” says Matson. “He couldn’t make the changes, he couldn’t sign the papers, let me think about that, let me do that next meeting.”

The client eventually signed the papers but only when his death appeared imminent. “He just didn’t have the energy and the willpower to go through with it even though he intellectually knew it was right,” she says. Maton took a lesson from the experience: If clients need to change their estate plan or some other aspect of their finances, do it while the client still has the cognitive ability to make the decision and the energy to carry it out, otherwise it’s not going to get done.

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The holistic approach to clients

Aging myths and their impact on your practice

Investopedia defines base rate bias as “the tendency for people to erroneously judge the likelihood of a situation by not taking into account all relevant data."5.      Base rate bias.

Investopedia defines base rate bias as “the tendency for people to erroneously judge the likelihood of a situation by not taking into account all relevant data and focusing more heavily on new information without acknowledging how the new information impacts the original assumptions.”

The bias manifests in investors’ tendency to dramatically overestimate the probability of future market declines after a sharp sell-off in stocks, says Zuckerman. History and statistics and history suggest that after a large sell-off in stocks, the likelihood of a further large drop is significantly lower than most investors estimate. “While the actual probability of future declines decreases as markets decline, investors often see the market in an opposite manner, feeling that a future decline is more likely as the market slides,” he explains. “This leads to conservatism bias whereby investors miss opportunities created by lower prices.”

How can you spot these biases? Keep reading …

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Five reasons not to panic over markets

Bracing for the next market crash

Clients usually don’t know that these biases are influencing their behavior. Advisers can help them set and achieve realistic goals.Spotting client biases

Clients usually don’t know that these biases are influencing their behavior. One strategy advisors can adopt is to have clients take profile tests that can identify their financial personalities and biases.

Zuckerman likes to combine these tools with conversations about how clients responded during stressful events. “I think that quantitative metrics are useful and I think that they are an essential starting point,” he says. “However, research has shown that answers to risk tolerance questionnaires do tend to vary based on market conditions. And, I think that, as a result, there’s no substitute for really finding out what types of emotions were being experienced during a precipitous decline in the market as well as what investment decisions, if any, those emotions translated to.”

Atlanta-based DNA Behavior offers a suite of behavioral profiles, including Financial DNA. The test measures clients’ “core, natural and instinctive behavior,” according to Leon Morales, vice president, relationship management integration. Learning their own profiles helps advisors recognize their personal biases as well as those of clients, he notes, which can improve communication and retention. He reports that the monthly fee for the online services ranges from $60 to $270, based on the selected features.

A formal profile is also a valuable aid for heading off potential problems, says Morales. Because our behavior is largely programmed by an early age, a client’s behavior is unlikely to change significantly just because he or she has retired. That can cause problems when the instinctive behaviors clash with the client’s new financial status as a retiree. If the client is a risk-taker, for example, it will be important to monitor the client’s portfolio to prevent him or her from making excessively aggressive investments that put the retirement plan at risk.

This article also appears in the May 2016 edition of Retirement Advisor magazine.

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