Behavioral Finance and Investment Planning

In 1998, scholars Daniel Read and Barbara van Leeuwen asked participants to select an apple or piece of chocolate prior to engaging in the experiment. After making their choice, the participants were asked whether they wanted the apple or chocolate for next week’s experiment.

The experiment was a sham. The actual experiment was the snack. When faced with the choice of an apple or chocolate, nearly ¾ chose the chocolate. When asked what snack they wanted next week, preferences reversed completely: Three out of four participants chose the apple. 

Resisting temptation is difficult in the present, but it’s easier to control out temptation when we’re not faced with rejecting sugar, fat, and cocoa in the present. At a recent Society of Actuaries meeting––the worlds' experts on health and longevity––members exited a session and immediately faced a snack table filled with apples and donuts. Nobody touched the apples.

We are far better at planning for the future than we are at making decisions in the present that are consistent with our future goals. We imagine that in the future our ability to resist temptations will be far greater than it is today. Of course, when the future becomes the present we often fail to make the choices we hoped to make.

Most of us go through life giving little thought to how our financial decisions affect our long-run financial goals. We simply live our lives and eventually the future arrives and we find ourselves far from the outcomes we may have wanted if we had actually developed a plan. In fact, the mere act of sitting down with a financial advisor to identify goals may be the first time clients devote any conscious effort to defining their future. 

Behavioral finance suggests that imagining the future has significant and unexpected benefits. Presenting workers with an estimate of their retirement income rather than a lump sum statement forces them to imagine how well they will live in retirement. They develop what economists refer to as imagination capital when they are confronted with the consequences of their savings decisions. Other experiments found that showing workers an artificially aged photo of themselves, as a retiree, motivated them to save more as well.

In the new Wealth Management Certified Professional® (WMCP®) curriculum, we emphasize the importance of goal-based investment planning. What is goal-based investment planning? Instead of focusing on an investment account, the advisor begins with an investment goal and then builds a savings, investment, and account plan that gives the client the best chance of meeting the goal.

Goal-based investing has two important advantages over account-based investing. The first is technical.  Knowing the spending flexibility of the client with respect to the goal allows the advisor to create a portfolio recommendation that more closely matches the amount of risk a client is willing to accept. It also allows an advisor to manage cash flows to reduce goal volatility, and to select the right type of account to maximize after-tax investment performance.

The second benefit is behavioral. Assigning an investment plan to a goal forces the client to imagine the goal, and the consequences of not meeting the goal. Building imagination capital through goal-based investing ties the client emotionally to the goal. If they don’t develop a savings plan, then they will fail to meet the goal that a client expect to reach. 

Envisioning and ultimately owning a goal takes two behavioral finance principles that normally result in  bad investor behavior and uses them to the client’s advantage. The first is the endowment effect. Once we own something, we tend to place a far greater value on it. Many clients refuse to sell an inherited business or antique because the mere ownership causes them to value it more––despite the fact that they would never actually buy the antique or the business for a fair market value.

But once we own a goal, we do everything we can to make sure that the goal doesn’t slip away. If we don’t save enough, we risk losing out on the goal that we now own. This creates a strong negative emotional response that motivates us to save more. Once you get a client to imagine and own a goal, it become far easier to manage their behavior to stay on the right path to reach that goal.

The second behavioral finance principal that can be manipulated for the power of good through goal-based planning is loss aversion. By attaching ourselves to a goal, we fear its loss. Athletes who set even arbitrary goals can be emotionally devastated by failing to meet that goal. But they may be only somewhat excited about exceeding the goal. Once a threshold is set, whether it be a marathon time or a retirement savings amount, it is human nature to meet it and be disappointed if we don’t meet the goal.

Investing in the highest level of academic accreditation

Sound investment planning means recognizing client behavior and building strategies that use behavioral finance principles to create better investing results. In the WMCP® program at The American College, we incorporate behavioral finance throughout the curriculum. Whether it is optimal portfolio rebalancing, selecting financial products, or tax loss harvesting, the WMCP® helps advisors recognize behavioral barriers and create plan that help clients meet financial goals.