What FAs need to know about behavioral science in finance

Behavioral science studies how people react to each other and their environment. As a field of study, it’s lags behind geology in and chemistry in longevity (it emerged in the 1980s), but may be more practical.  Financial advisors know that investors’ actions are caused by a variety of sources, from the news, their family values, to other fears. Behavioral science as applied to the field of finance helps explain how and why investors react to the market and each other.  Importantly, behavioral science has moved into exploring how to motivate people to change their behavior towards positive goals.

Financial theory holds that people, as investors, will be rational thinkers, moving towards wealth maximization.  Yet, often, investors, as people, make irrational choices. Behavioral science explains why investors make bad choices. It also studies how to encourage better choices. Examining the commonly experienced elements of behavioral finance in terms of irrational investors may help financial advisors to alert their clients as to when they are straying from logic.

There are three key elements to behavioral finance that most advisors experience regularly in working with their clients. These are: 1) that investors make most of their decisions based on rules of thumb or short cuts; 2) that investors filter information through a collection of narratives and anecdotes; and 3) the market is inefficient because of these limitations and non-rational decisions.  Understanding that clients will repeatedly make these mistakes can help financial advisors predict problems ahead of time. Some advisors may even use education about behavioral finance to assist clients in understanding how a financial advisor may help guide the client towards more rational choices.

Another crucial element of behavioral finance that investment advisors experience regularly is that of the limits of decision making by an investor due to the investor’s need to make a decision. This concept, called bounded rationality, holds that when an investor makes a decision, they are limited in their rationality by the need to make a satisfactory decision (in time, to appease people) rather than an optimal decision.  In other words, investors take short-cuts in making decisions based on time constraints or other elements that render those decisions less than optimal. Understanding the urge to take short-cuts may be useful for both investor as well as advisor.

A second element of behavioral finance that investment advisors experience is that investors have a distorted view of loss. Investors who are overly focused on negative effects of losses when compared to their gains take a short term view on investment choices. Those “myopic loss” investors focus too much on short term volatility in the market, and as a result make less than optimal choices. Or, the myopic loss investors may be too reactive to the market and make too many moves.

Finally, advisors may experience clients who engage in what behavioral finance refers to as anchoring. This phenomenon occurs when an investors clings to a benchmark or level regardless of whether it is appropriate for them. This may be that investors view a company that was previously thought to be successful but has had management problems or massive litigation as a “safe investment” despite news reports to the contrary. This could also occur where investors think a certain return percentage is preferable or necessary (causing them to choose riskier stocks). This could also occur where investors are committed to a number needed for retirement that is too low or too high for them.