Behavioral Finance 101 With Michael Finke

What is Behavioral Finance?

Traditional theories pertaining to personal savings, the efficiency of markets, and other aspects of personal finance explain what people should do with their money. However,  traditional economic theories don’t always do a good job of explaining how people actually behave. Why would that be the case? Professor of Wealth Management and Wealth Management Certified Professional® (WMCP®) Program Director, Michael Finke, PhD, CFP® tells us the answer can be found by understanding behavioral finance theories.

According to Finke, individuals tend to make mistakes, some of which they do over and over again. This phenomenon is known as “predictable irrationality.” For example, when markets fall as they did during the March 2020 COVID crash, investors will predictably sell stocks after they have fallen in value because many overreact to investment losses. Finance theory suggests that investors should instead buy stocks in order to rebalance.

Another example is the difficulty many people have with resisting the temptation to spend from more liquid savings. Finke states, “We all have this temptation. I’m a professor and I understand financial planning, but when my checking account gets too big, more boxes tend to show up from Amazon for some reason.” By acknowledging that a client may struggle with saving, a financial advisor can help clients save in such a way that they don’t have to struggle with temptation. They can advise clients to set aside the maximum amount for their 401k, place money in a brokerage account, set up automatic transfers of money so the client’s checking account doesn’t accumulate too much money, and more.

How Behavioral Finance Knowledge Can Help Advisors

Awareness of these behavioral phenomena allows advisors to adjust their planning strategies to help clients meet their goals. Another such phenomenon is the tendency to overweight small losses. Known as Prospect Theory, a concept discovered by Daniel Kahneman and Amos Tversky in the late 1970s, this phenomenon refers to a non-equivalency in people’s responses to gains and losses. According to Finke, “Gains tend to make people a little bit happy, while losses, even little ones, tend to make people irrationally upset.”

As such, clients tend to be exceedingly loss averse. Finke mentions several ways advisors can combat people’s irrationality towards losses by not giving quarterly performance updates or reframing information in a manner that does not elicit an emotional response.

Knowing behavioral biases allows financial advisors to predict how their clients may act in a certain scenario and help them achieve their long-term financial goals. However, not all people are the same. According to Finke, factors of a person’s personality can greatly impact how they will approach saving situations.

The Impact of Optimism

One such factor is optimism. According to Finke, optimists are more likely to save for retirement and make sound investing decisions when doing so. Part of the reasoning behind this is “dispositional optimism.” As Finke explains it, dispositional optimists are likely to expect the best outcome and plan accordingly. As such, these optimists believe they will live to see their eighties and nineties and make it a goal to maintain a high quality of life.

Optimists are more likely to live to see advanced age because they place a greater value on the future. Dispositional optimists will exercise, eat right, and plan well to make sure they live to their eighties and have the financial security to enjoy them.

Additional benefits of optimism occur when managing money. The average person takes a suboptimal amount of risk with their investments, typically electing for lower risk than may be optimal given their long-term goals. However, since optimists view losses as a temporary setback and believe the best outcome is still within their grasp, optimists will tend to take more risk and react less to losses.

For those who aren’t naturally optimistic, financial advisors can use framing to shed a more positive light on future goals. Pessimism can harm an individual’s motivation to take the necessary steps to plan for the future. After all, a pessimist might say, “What’s the use? The markets are stacked against me and I’ll never be able to save enough to have a comfortable retirement.” However, by hiring an impartial advisor who takes the emotional aspect out of planning, pessimists can mitigate their tendencies that work against long-term financial success.

This difference in viewpoint explains how people can generally have the same goals for retirement and some fall tremendously short while others wind up attaining their goals. Typically, people hope to maintain the same quality of life and ability to spend in retirement as they do in their working years. However, optimists tend to meet this goal more often than pessimists. This isn’t to say that optimists will always retire well and pessimists will not. But a positive outlook can certainly help.

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