Pandemic Payoff - The Time For Behavioral Finance Is Now

Jun 1, 2020 2:37:00 PM / by Fusion Family Wealth

 

Charles Paikert, New York
Regular FWR correspondent Charles Paikert takes a look at the world of behavioral finance, a topic that we have examined before. The turbulent financial and economic situation has thrown a sharp spotlight on this discipline.Behavioral finance, the stepchild of behavioral economics, appears to have found its moment.

Clients are less likely to panic during times of crisis such as the coronavirus-fueled market plunge in March, say wealth managers using behavioral finance techniques.

“The current crisis puts the value of providing clients with the behavioral finance approach under the spotlight,” says Jonathan Blau, CEO of Fusion Family Wealth in Long Island, New York. “We’re not getting panic calls. Instead of having to talk people off the edge of the cliff, we’re able to use our time more efficiently, like making tax trades or rebalancing portfolios.”

The COVID-19 pandemic has underscored the need for implementing behavioral finance practices, says Paul Pagnato, CEO of Reston, Virginia-based wealth management firm PagnatoKarp.

“We’ve already had the dialog with clients about how fast things can change and what that means,” Pagnato says. “They know that what people call 100-year floods can come every three years. They’re prepared.”

Indeed, the coronavirus presents a unique challenge for advisors, says Daniel Crosby, chief behavioral officer at Brinker Capital in Atlanta and author of The Behavioral Investor.

“The pandemic threatens both the health and wealth of all of us,” Crosby says. “Fear has been pervasive…and the toll the pandemic has taken is dramatic. It’s the perfect time for financial professionals to demonstrate the value that they add outside of strictly giving financial advice.”

Academic origins

Where does behavioral finance come in?

The field grew out of the work of Nobel Prize winner Daniel Kahneman, the Israeli-American psychologist and economist who, with Amos Tversky, Richard Thaler and others, established a cognitive basis for common human error that arise from biases that people are not aware they have.

Kahneman’s empirical research was groundbreaking, challenging the widespread assumption by economists – and asset managers – of human rationality when it came to making decisions. Thinking Fast and Slow, Kahneman’s
best-selling book, summarized his findings in everyday language for a general audience.

The role of bias

The concepts of understanding the role of biases in making decisions about money and life choices has been increasingly embraced by wealth managers and psychologists specializing in the field.

“Advisors need to know what motivates people,” says psychologist and financial behavior specialist Szifra Birke, principal of Birke Consulting, who has worked with a number of wealth management firms. “They need to understand their clients, be good listeners and have emotional awareness. Clients can make emotional decisions and not be aware of their impact. Advisors need to be the steady hand and not let clients’ irrational behavior take over.”

Client’s behavioral problems are driven by feelings and thinking that aren’t well controlled, according to Jim Grubman, who specializes in working with wealthy families as head of Family Wealth Consulting. Moreover, both clients and advisors themselves are over confident that they can predict the future.

“The best firms have learned communication skills for listening and explaining in ways that help the client avoid panic, decision fatigue and reactivity,” Grubman says.

What wealth managers shouldn’t do is “throw massive amounts of detailed explanation at the client,” he adds. “Jargon, data and troves of charts make clients tune out just when they need to focus and calm down.”

Paying attention

Indeed, behavioral finance specialists stress the need for effective communication.
“You have to know what language to speak to each client,” says Jay Mooreland, head of the Behavioral Finance Network. “Advisors may think they are impressing a client by using technical terms like standard deviation, but if the client is a social bee instead of an analytical one, they may be thinking ‘Why is the advisor talking over my head?’”

Advisors also need to learn to be attentive to clients’ moods, says Crosby.

“Psychologists have documented a tendency called the ‘affect heuristic’ which leads [people] to see their financial decisions through the lens of whatever mood they are in,” he explains. “A fearful client tends to see risk everywhere, whereas an exuberant person might be unaware of risks that are staring them in the face.”

Scratching the clients’ itch

When it comes to investing, a common bias is the desire to simply do something in a time of crisis – even when dramatic action may be ill advised. So while advising clients to stay the course during a market upheaval may be prudent, it’s hard to execute behaviorally.

Brinker Capital tries to offer clients “a middle ground” that satisfies a desire for action without capitulating by offering “replacement behaviors” such as rebalancing, tax-loss harvesting or bidding for a high-quality company that may be selling at a steep discount.

California-based wealth management firm Aspiriant also seeks ways to help clients who want do something, anything, “scratch their itch,” says chief client officer Thomas Tracy. “We understand that there’s an emotional component,” says Tracy, “and we suggest actions like buying defensive stocks or paying down debt.”

Framing and familiarity

Aspiriant gives every client an “investment framing statement” that shifts the investing focus from “what’s going on today to a long-term perspective,” he says.
“We want to set realistic expectations and get them out of the here-and-now by providing information about other historical periods,” Tracy explains. “If a client is more emotional, we want to talk them away from going to cash and remind them that a market decline is not the same as a permanent loss.”

Many investors also tend to confuse familiarity with safety, behavioral experts say.
“This can lead investors to over-allocate in domestic stocks, over-invest in real estate and to generally take insufficient risk,” says Crosby.

Fusion Family Wealth’s Blau agrees. “Certainty and return are inversely related,” he says. “More of one means less of the other.”

Proof of concept

Behavioral finance has been particularly effective during the pandemic because of its emphasis on guarding against emotional reactivity, according to Blau.

“Successful investors continuously act on a plan,” he says. “Failed investors react to current events and markets.”

Training clients to understand their psychological framework and how it relates to markets is critical, says Phillip Toews, CEO of Toews Corp, a New York-based RIA.

“Behavioral coaching teaches clients what works fiscally and emotionally,” says Toews, who also heads the Investing Behavioral Institute.

“You have to put in the time,” he says. “It’s the difference between watching a professional tennis player hit a backhand shot and then trying it yourself and practicing hitting a backhand shot with a coach and then trying it in a game. Clients need help building their neural pathways to invest effectively.”

That training has paid off during the pandemic, according to Toews.

“If a client has gone from being reactive to proactive and buys into the plan, then instead of explaining the need not to be emotional during the crisis, they’re marching right along with you,” he explains. Applying behavioral finance techniques means that the coronavirus can be seen as a particular catalyst for disruption, not an unprecedented one, says Grubman.

Clients who see the pandemic as unique and calamitous are more likely to react with “much more severe decision-making than those who see it as disruptive but not unlike many other disruptions,” he notes.

And while the COVID-19 crisis has highlighted the value of behavioral finance, its principles can benefit advisors in good times as well as bad.

“Clients feel better connected and are more loyal,” says Birke. “It’s not just another transaction for them.”

Using behavioral finance has helped his firm retain clients and enhance its brand in the marketplace according to Pagnato.

“We’re not losing clients because of the markets,” he says. “Keeping clients means recurring revenues and loyal clients means referrals. We’re also retaining employees who know the value of our approach and that enhances the firms’ culture. If it wasn’t for behavioral finance, I don’t think we’re capable of doing that.”

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