Monday, 21 October 2019

Behavioral Finance

Behavioral Finance

knowledge of behavioral finance can be useful to financial planners and counselors trying to understand their clients’ financial goals, objectives, and behavior patterns (Chatterjee & Goetz, 2015). For example, going back to the discussion of Ben and Colleen, a financial planner who works with this couple should understand that Ben and Colleen’s perception of their finances and financial well-being are just as important for them as the objective measures of these characteristics. In psychology, this is known as anchoring (Tversky & Kahneman, 1974). Findings from a study by Ariely, Loewenstein, and Pelec (2003) would suggest that most individuals do not know how much money they need to maintain a standard of living that would maximize their utility either in the current period or in the future. Therefore, in many cases, well-intentioned people such as Ben and Colleen may use sub-optimal reference points from which they are anchored, particularly when this anchoring was based on observing their friends, relatives, and acquaintances determine their optimal financial needs. Irrespective of how the broader market is performing, Ben and Colleen’s financial expectations and financial satisfaction may be anchored to the expectations and satisfaction of their friends, acquaintances, and their life experiences.

Additionally, the works of Richard Thaler (winner of the 2017 Nobel Prize in Economics) and other behavioral economists find that investors suffer from what is known as myopic loss aversion (Benartzi & Thaler, 1995). Myopic loss aversion is defined as a tendency of investors to compare the performances of their investment portfolios from the perspective of avoiding a possible loss rather than from the perspective of potential gains. This behavior is based on the amount of risk they perceive having taken within their investments. Other studies indicate that investors who frequently checked the performances of their portfolios were also more likely to sell off their securities after experiencing a market drop. This runs counter to the rational investment notion of buying securities when prices fall and selling the securities when prices rise. Loss aversion can also explain the decision of Ben and Colleen to sell their investment portfolio soon after the markets fell in 2008. As a result of this tendency, many individual investors tend to exit the market after it has fallen and denied their portfolios an opportunity to recover when the market subsequently rebounds.

Some knowledge of behavioral finance can help in improving counselors’ understanding of their clients’ financial behaviors when providing them financial advice. Ben and Colleen’s perception of financial preparedness, like that of most people, will be shaped by their unique cognitive biases, financial attitudes, and their previous experiences with money and wealth. This chapter defines and discusses key concepts in behavioral finance as they relate to the financial planning process. The discussions in this chapter revolve around the integration of some of these key behavioral finance-based concepts within the advisors’ counseling and communication techniques, and how these techniques can be useful in improving the quality of advice planners provide to their clients.

What Is Behavioral Finance?

Behavioral finance can be defined as an interdisciplinary area that utilizes components of economics, finance, and psychology to examine the implications and outcomes of financial decisions made by individual investors and traders in the market. These individuals are often constrained by their emotional biases and cognitive abilities to rationally process sophisticated financial information (Mullainathan & Thaler, 2000). The findings from the area of behavioral finance indicate that many of the financial decisions made by people are better understood when the assumption of rational decisionmaking by all parties involved in the decision is dropped.

In a perfect world, all individuals are expected to be rational in their financial decision-making. And neoclassical economics assumes that these optimal decisions are made after individuals have carefully weighed the costs and benefits of the expected outcomes (Becker, 2013). The rational choice theory also assumes that people have stable and consistent intertemporal preferences and their decisions are based on an underlying desire to maximize their utility. However, numerous studies conducted by Amos Tversky and Daniel Kahneman challenged this assumption of rational human behavior. These authors found that people do not always make rational decisions. In fact, peoples’ decisions depend on the context of the situation and the framing of the choices when decisions are presented to them. 

The authors found that people tend to be more risk-averse when they have to make a financial decision in the domain of gains and are more risk-taking when they are faced with a potential loss-making scenario. The authors also found that people disliked taking a loss more than they liked an equivalent amount of gain; this finding provided the foundation for what became known as prospect theory (Kahneman & Tversky, 1979). The authors also found that people were more likely to make impulsive decisions, which are often riskier and possibly financially more harmful when they are facing a loss-related scenario. As a result of this fear of loss, many investors hold on to their loss-making stocks a lot longer than they hold on to their profitable stocks; this is known as the disposition effect (Shefrin, 2001).

This fear of loss and the unknown also manifests in peoples’ decisions to resist change and drives peoples’ preference for the status quo. The status quo bias is also known as mental inertia (Kahneman, Knesch, & Thaler, 1991; Samuelson & Zeckhauser, 1988). Extant literature finds that status quo bias can prevent people from changing their financial behaviors. Ariely and Wortenbroch (2002) found in one study that individuals continue to show a preference for the status quo bias when they have to make important decisions, the outcome of which is not known ahead of time. Ariely and Wortenbroch argue that this aversion to the unknown is also the reason why people procrastinate when they have to act on important financial decisions.

The process of financial planning involves numerous meetings and communications between financial planners and their clients. Scholars of behavioral finance describe this type of communication, which forms a big part of the client-planner relationship, at two levels (Evans, 2008; Kahneman & Klein, 2009). Benartzi (2013) differentiates the two levels as reflective and intuitive decision-making. The intuitive decision-making process is quick, impulsive, and less thoughtful than the reflective decision-making process. The reflective decision-making process is slower but more thoughtful and rational.

In the opening case, where Ben Sanford is averse to seeking the services of a financial planner, the Sanfords have seen a number of planners but have not yet committed. During these initial meetings with the respective planners, it is likely that the Sanfords (especially Ben because of his aversion to using financial planners), may have used an intuitive decision-making process to evaluate the financial planners and have not found anyone with whom they were able to commit to a long-term engagement. An intuitive decision-making process is less thoughtful and quick and is often influenced by the perceived biases and past experiences to which an individual may be anchored. According to Kahneman and Klein (2009), the two types of decision-making are reconciled initially where the reflective decision-making process agrees with the intuitive decision process until proven wrong.

One practical challenge to this two-system decision-making process is that the outcome of the decision is not known until later in the future. Since the outcome is not known it causes uncertainty, and in the absence of evidence to disprove, the reflective mind usually agrees with the decisions that the intuitive mind makes initially. If the outcome is found to be undesirable in the future, many individuals are left to regret the mistakes they made in their financial decisions at some later point in time.

Applications of Behavioral Finance In Understanding and Changing Clients’ Behavior

As discussed earlier, emotional and cognitive biases can constrain peoples’ abilities to make rational financial decisions. The intuitive decision-making system, which is our quick but emotional and impulsive decision-making system, relies on certain mental shortcuts to make quick decisions. These are known as heuristics (Kahneman, 2003). Heuristics rely on peoples’ biases developed from their life experiences, preferences, and perceptions. For example, it is not uncommon for planners to find their clients apply at least some form of heuristics or biases based on their attitudes toward finances when making important financial decisions. In extreme cases, decisions made by some clients are deeply emotional and could conflict with the financial planner’s recommendations. Later in the book, there will be further discussion on the theory behind heuristics and biases.

When clients make emotional but irrational decisions based on their preconceived notions and perceptions, it can be more challenging for financial planners to change their clients’ behavior. According to Klontz, Kahler, and Klontz (2008), financial planners need to have detailed discussions with their clients and gradually bring about changes to help reduce their clients’ stress during the transition process. Financial therapists believe that various counseling techniques can reduce clients’ biases and resistance to the changes recommended by financial planners (Goetz & Gale, 2014). Similarly, Thaler and Sunstein (2008) suggest that counselors can help their clients make better financial decisions by providing them with good recommendations and timely follow-up and feedback to help keep their clients on track toward achieving their financial goals.

Risk tolerance, risk Capacity, and Client risk perceptions

Financial risk tolerance can be defined as an individual’s willingness to take financial risks. People who are less worried when taking greater levels of risk within their portfolios are considered to have a high-risk tolerance, whereas people who are less willing to take financial risks within their portfolios are considered risk-averse. According to Ricciardi (2008), people’s perceptions of risk may not be the same as their risk tolerance. Risk capacity is a person’s ability to take a financial risk based on their financial resources (Cordell, 2002). Risk tolerance can be measured using psychometrically developed risk tolerance scales (e.g., Barsky, Juster, Kimball, & Shapiro, 1997; Grable & Lytton, 2003; Roszkowski & Davey, 2010). Financial advisors also have to measure their clients’ risk tolerance before they can provide portfolio recommendations to their clients. In practice, financial planners can obtain more risk-related information from clients using a standardized scale.

Financial planners can also discuss the risk and return characteristics of various asset classes before making financial recommendations in order to get a true sense of a client’s risk perception and risk capacity that may not be captured with a regular risk tolerance scale. Financial planners can further counsel their clients to correct their clients’ misperceptions of risk tolerance and help align their clients’ portfolios closer to their clients’ actual risk tolerance.

overconfidence Bias

On many occasions, clients’ expectations of their expected standard of living upon retirement do not align with the amount of money they have saved for this purpose. The number of wealthy individuals can accumulate over time is constrained by their levels of risk tolerance and their investment time horizons. Furthermore, many individuals do not have sufficient financial literacy to correctly assess their true financial situations. Individual investors frequently overestimate the amount of wealth they can accumulate across time. Consequently, many individual investors fail to follow normative investment principles and overestimate the securities selection and market timing abilities within their portfolios (Barber & Odean, 2002). Other studies have found that people overestimate their abilities to predict future returns (Bondt & Thaler, 1994; Heath & Tversky, 1991). The advent of social media and the internet have transformed the investment management industry over the past two decades. However, Barber and Odean (2000) find that increased access to and the availability of this very large amount of financial data have resulted in the unintended consequence of investor overconfidence and have resulted in substantial loss of wealth for investors who attempt to time the market (Barber & Odean, 2000).

Just as in the case of financial markets, people also underestimate the potential for loss from very low probability but financially burdensome adverse events that can otherwise be mitigated through insurance coverage (Eisner & Strotz, 1961). Conversely, Finkelstein and McGarry (2006) found that people who overestimated their probabilities of needing nursing care were more likely to purchase long-term care insurance. These errors can be linked to the average person’s inability to understand the true magnitude or probability of the potential risk of loss to which they could be exposed (De Bondt, 1998).

Financial literacy and Financial Capability

The concept of financial literacy includes financial planning–related knowledge and skills, people’s perceptions of knowledge about their finances, financial behavior, and financial education (Finke & Huston, 2014). Financial capability is closely related to financial literacy. Financial capability is defined as the individual’s capacity based on knowledge, skills, and access, to manage financial resources effectively (GAO, 2012). According to Nicolini, Cude, and Chatterjee (2013), making financial education available when consumers are making important, task-specific financial decisions may be the most efficient method of improving the quality of financial decisions that people make. Based on these studies, financial planners who educate their clients about the potential risks and returns of different investment choices are more likely to lead clients in making better financial decisions than planners who do not provide this type of task-specific financial education to their clients.

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