In doing research for one of my book chapters, I uncovered some great information about behavioral finance. For my purposes, this science explains the ways in which emotion affects financial markets along with other mediums such as saving and spending. I realized while reading that a deep enough understanding of this stuff could lend itself directly to becoming a better financial planner. So much of what a planner does each day is specific to their clients. Rather than arming ourselves with just blanket financial advice, we try to understand the individual circumstances which each client grapples with. This allows for more client-specific solutions. A cookie-cutter financial planning practice will only grow so much until it can’t fully meet the increased demands of clients. This is why I choose to call myself a “wealth manager” as opposed to a “financial planner,” even though financial planning is part of what I do every day. I think the former title indicates an increased awareness of a client’s overall financial situation.
The big revelation I had about behavioral finance is simply that much of the financial planning theory I’ve read in textbooks is based in behavioral finance but with much better packaging. For example, I learned in the CFP (Certified Financial Planner) program that clients have both “internal” and “external” attributes. Some of the internal attributes include:
These are opposed to “external” attributes such as:
The latter are factors which we can’t influence. We could probably include religion and politics into these client-specific factors but I’ve been taught to avoid such topics for reasons of sensitivity. What’s interesting about the majority of economic and financial planning theory is that it assumes people act rationally, and with the intention of bettering themselves. For example, it should be a given that clients will try to buy stocks when prices are low and sell them when prices are high. Yet, many investors do exactly the opposite. Similarly, one should invest more of their portfolio in stocks (rather than bonds) at younger ages because they can better withstand volatility. However, often the exact opposite happens. Behavioral finance does a good job of explaining the irrational psychology which most of us fall prey to.
Daniel Kahneman is an authority on behavioral finance which rejects most standard economic theories. He has come up with his own advice based on his expected realities. Here are a few of them:
•ignore wall street analysts or do the opposite of what they say
•use money you can afford to lose when picking your own stocks
•don’t compare your returns to a benchmark—just try to make money.
The goal of Kahneman’s advice is to help investors keep emotion out of their financial decision-making and became betters investors as a result. His advice anticipates emotion and tries to be proactive about avoiding it.
Something else I found quite interesting is the preoccupation of some behavioral finance theories with the concept of arbitrage (capturing differences in price resulting from the simultaneous purchase and sale of various securities). This practice shows, often with crystal clarity, how incompetent and predictable investors are by constantly leaving money on the table for other investors to take. Yes, markets are fairly efficient, but plenty of people are still profiting nicely off the remaining inefficiencies.
Behavioral finance can also shed some light on everyday financial practices such as spending and saving. Like we said above, it’s not fair to assume that people strive towards what they should do. People tend to spend money on things they shouldn’t at times they shouldn’t and tend to save less than they should, too late in life, and through the wrong savings vehicles. This is explained by the fact that normal psychology patterns and good returns in the market are often inversely correlated.
Just some food for thought. I welcome any questions or comments.
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