The purpose of the wealth management industry is to increase the value of your portfolio. Add a new focus to the industry's mission: your head.
How an investor thinks and feels — not just about money but also about nearly every human experience — is increasingly marketed as something that can be monetized, for the benefit of both clients and advisors. And the means for doing so are multiplying.
Think of an artificial intelligence-powered algorithm that decides a client is skittish about large-sum charitable giving but open to creating a private foundation. Or of a robo-advisor whose programming determines how you feel about risk and therefore how much equity you should own. What about a paper credential showing that an advisor has completed a training course on the biases — in layman's language, beliefs — that get in our way of making the most of our money? Or a "storytelling" approach that reframes an investor's life experiences and financial choices to create a plausible vision of better outcomes?
Tools addressing the emotional and cognitive components of saving and spending increasingly make their way into investors' financial lives, signaling how behavioral finance is becoming a commodity for wealth managers.
The branch of economics explores the ways in which humans aren't completely rational in financial decisions large and small. For example, a client with loss-aversion bias can fall into the trap of waiting for a truly losing fund to bounce back instead of just dumping it, taking the loss and putting money into a better bet. An investor convinced that he knows more about small-cap stocks than he really does, thanks to the welter of online commentary and insights, can throw dollars after bad companies thanks to his overconfidence bias. A client who can't resist spending his bonus today, rather than putting it into a retirement plan, is afflicted with a present bias that makes delayed gratification tough.
Embedding those insights, and hundreds more, into automated tools and in-person approaches that advisors use to interact with clients can help stymie the all-too-human responses that prevent many investors from amassing greater wealth.
It's an exercise that must continually be repeated. Asked if investors learned from past mistakes, such as the tech stock bubble that burst more than two decades ago, leaving many investors in the red, Richard Thaler, a professor of behavioral science and economics at the University of Chicago and Nobel laureate for is contributions to the field, said in an interview with Morningstar last June, that "there doesn't seem to be any evidence that we do learn."
That's where advisors can add value. Thaler said that "a good financial advisor is part economist, part psychologist," and concluded that "understanding the psychology of the client is essential to being a good advisor."
From childhood memories to "finish lines," advisors can learn a lot about how their clients think about money.
Research by Arizent, the parent company of Financial Planning,
Meir Statman, professor of finance at Santa Clara University in Santa Clara, California:
FP: How has behavioral finance evolved?
MS: We have had two generations of behavioral finance. In the first (one, in the 1980s), people are irrational and interested only in maximizing their wealth — a rational want. In the second, people are still are mostly or entirely interested in maximizing their wealth, but they are neither a rational nor irrational — they are generally "normal," smart and knowledgeable, but sometimes, they are "normal," stupid and ignorant.
The first generation talked about emotions as being errors — as if emotions are not useful. I use the lottery as an example. In first-generation thinking, people who buy lottery tickets do so because they don't know math and statistics and they don't know the odds. And I always ask, suppose that I see you about to buy a lottery ticket and I tell you that the odds are not one in 100 million as you thought, but one in 200 million. Is that going to deter you from buying your lottery ticket? No. What people buy is a dream. It's like what people buy when they go to the movie — fiction. You would not call somebody stupid for going to the movies.
Emotions are useful for us. It is a matter of figuring out what is it that people want before you declare them stupid. Some people like (stock) trading the same way that some people like to play video games. They're not going to start a Google, and if the lottery ticket costs, say, $1, and it affords them some sort of psychic kick that you know they can keep the dream alive, isn't the purchase a rational decision? I've seen some lists of 200 cognitive errors, which are a cognitive error themselves. That is what happens when people judge the wisdom of a choice by the outcome.
FP: How should advisors talk to clients?
MS: You don't have to be a psychiatrist or a psychologist. You just have to be thinking about things as a good friend does and say, 'What is it that you are doing?' Then you can see if somebody is exceedingly optimistic and thinking, 'this idea is going to make me rich!' You can then say, 'Well, you know, slow down a bit and think about what can happen on the downside. If somebody comes and says, 'I just know that the stock market is going to go down, and I've been right before,' then you can guide them without insulting them.
It really is the role of advisors to know that well-being comes from money and that that underlies everything, but it also comes from family. It comes from work, it comes from health, it comes from friends. And instead of looking at 'what's your attitude toward risk', advisors should look at what matters to you — what goes on in your family. Let's talk about those things that are painful to you.
Every family has its own pain, and if you are a wise advisor and you solicit these things and you share perhaps your own history, because every family has them, then you find that you can help (clients) increase their well-being, even if they don't increase their wealth.
FP: How do advisors mess up with clients?
MS: They might present themselves as smart, and their clients as stupid. And that is not smart. It's really important to use humility and first admit that you are subject to biases and then say, 'my advantage is that I learned about these and I can guide you as a teacher guides students.' You don't want to convey, 'let me teach you about those cognitive errors, you stupid client of mine.'
FP: Are detailed psychological profiles of clients useful?
MS: I don't think they're really useful. The big five you probably know (conscientiousness, extroversion, agreeableness, openness and neuroticism), so these might be useful. Conscientiousness, for example, is strongly associated with self control. Self control is a wonderful thing.
FP: What is the most misunderstood concept in behavioral finance?
MS: Loss aversion. Loss aversion is not an error — it's what people do, and sometimes it is smart and sometimes it is not as smart. And confirmation bias: people hate to confront evidence that is inconsistent with their wishes and ideas and so on. And so how do you get people to confront facts as they are? You have to be careful not to confuse good outcomes as good decisions and bad outcomes with that decision.
Dan Egan, vice president of behavioral finance and investing at Betterment:
FP: How should advisors deal with changing client behavior?
DE: One of the areas we've seen that has had a golden age and is still doing a lot of interesting stuff is asset managers and 401(k)s, which are obviously the biggest and most democratic savings instrument most Americans have. There's been a lot of very interesting research on how tweaking plan parameters, with things like defaults and auto escalation and employer matches, can influence people's behaviors. There's a lot you can do in the system around the person, rather than asking them to change their behavior first.
Also, and we've not seen this dramatically, but there's starting to be some use of gamification in positive ways.
And there have been a few places that have started to really play around with pricing schemes that both incentivize and reward behavioral patterns for how you get charged for services based upon how you act.
FP: Are behavioral finance credentials for advisors worth it?
DE: I think are, but it's a little bit like a second-year med student: first you learn a lot of conceptual, historical truths about things. This struggle is not to show that people will make decisions in irrational ways; it's to show them how you are going to help them make better decisions. Those programs make you aware of the patterns and how malleable we are. But I don't think you end up being a good doctor who is able to help people improve their decision-making and who knows what the cure is. You're just more aware of exactly what problems are.
The growing and varying areas of study are rising in adoption across the industry, long after pioneers first dispelled the myth that investing is just about numbers.
FP: Do psychological profiles of clients have value?
DE: People are individuals who even change over time. It's important to view them not as being a fixed element. If somebody came in and had very weak legs, their personal trainer wouldn't say, 'cool. We're going to avoid leg exercises.' They'd be like, OK, that's one of the elements that we actually need to change and focus on.
There's a lot of it that's quite silly, that feels a little bit like Cosmo quiz. And that's based on the idea that you can ask questions and people answer those questions differently, without tying it back to being able to give different advice or better advice or help clients make better decisions. That said, I do think it allows you to have a scaffold, with a set of questions. It's not so much a diagnostic test as it is a really useful way for us to scaffold a conversation about what you know and what you don't and what you're comfortable with. A psychological profile is more about giving a really good structure to the conversation about your relationship with money.
FP: Do the same biases affect wealthy and not-rich investors alike?
DE: People are people, regardless of how many commas they have. Some people are super 'keeping up with the Joneses.' They're very materialistic. Even though they make lots of money or have lots of money, spending is still an issue. There is a freedom from grocery bill stress that high net worth people have. And they don't have to spend as many thought cycles throughout the course of the day thinking about how to optimize their money and their budget. But I've seen people who have tens of millions of dollars, and they stress about it just as much as somebody who has $5,000. They make similar mistakes. They get caught up in similar fads. They want to beat their brother-in- law's returns so that they can talk about it at Thanksgiving.
FP: Should non-optimal behaviors be engaged, or avoided?
DE: If you can design systems around people that reward good behavior and discourage or bypass bad behavior, that's going to be the most effective outcome. What you're doing there is avoiding their behavior. You're not actually engaging with it. You're bypassing or doing the runaround.
So in 401(k) plans where they auto escalate your savings, one of the most common problems people have is lifestyle creep. You start out not making a lot of money, then you start making more money, and instead of dedicating a significant proportion of each raise to savings, you spend more money.
You can try to have them set a budget. It's effortful. People hate this. Or you can just say, whenever you get a raise, we're going to take 50% of it and chuck it into your 401(k) and nobody complains when you do that. But it's not like some hardship.
So in terms of effectiveness using behavioral design, a system and changing the system is always going to be the most effective. You should always be transparent and upfront about that. It should never be hidden or sneaky.
This is how we see that there are better outcomes. Put yourself in other people's shoes and think about doing this to people who you really care about. It makes you more thoughtful in designing the system.
Colleen Jaconetti, senior investment analyst at Vanguard:
FP: What does Vanguard do for advisors on the behavioral finance front?
CJ: I'm part of a team that develops research to help advisors improve investor outcomes. So we create research and thought leadership around helping advisors implement things with asset allocation, low-cost rebalancing and withdrawals. And then the other big piece of work is really around the behavioral coaching. These things are not always easy to do, even by seasoned investment professionals, because it seems at times to be counterintuitive. And that's where the behavioral coaching piece comes in, and it's really helping people help your clients stick to a plan.
We're trying to help advisors articulate the value that they add to the relationship and give them ideas of ways to explain things, because behavior coaching is somewhat hard to explain at times. How do you explain to a client that when they called you in the middle of the global financial crisis that you decided to not abandon your 80% stock-bond allocation and go to 100% bonds or all cash. You actually added a lot of value in hindsight?
FP: Do advisors have biases?
CJ: I think everybody has natural biases. I'll give an example. Seven years ago, my father passed away. And my mother was getting along on her life insurance, and then the market went down, down, down. I literally said, 'Mom, just put your statement down, before (you) have a heart attack.' I knew that over the long run, the best thing to do is not get out of your balanced portfolio and go all cash, even though that was what every fiber in her body was pushing her to do.
So I just think that advisors aren't different than other people, right? But they might know a little more to pull back when they might want to do something that might not be in their best interest.
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FP: What is the most under-recognized bias?
CJ: Recency bias is a strong one. A lot of people remember the recent past. I just had a conversation about this yesterday: One of the hardest things for us to work with clients on is why they should follow a total return approach to spending in retirement.
So that means spending from their income or capital appreciation, as opposed to an income-only approach. Say a client saves and sacrifices a whole lot to get $1 million. And once they retire, they say, I just want to live off the income. Sometimes, that is a really hard bias to keep people from because it's actually better for them to spend from the capital appreciation on their portfolio and meaningfully overweight dividend-paying stocks.
That's one of the strongest investment implementation biases that we frequently fight against. You have the opportunity to really show people some of these alternative histories or help better show things that may have gone one way or another had they not had behavioral coaching. So that makes sense. I feel like the use of technology and effectively communicating the value of behavioral coaching has helped.
FP: Why should an investor think of an advisor as having a default empathetic compass?
CJ: So you're paying them for an expectation. You're paying a fee to help me reach my goals. And if you're not treating me with empathy and respect for my goals and feelings — say I call you and I'm really upset about what's going on in the market— you're going to get fired. People have higher expectations now for all the services they're paying for. There is a level of professionalism expected.
