Advisors specialize in knowing every facet of their clients’ financial lives. Will they need to delve into their mental processes and emotional states as well?
Absolutely says Dan Egan, Betterment’s director of behavioral finance. With automated software digitizing many menial tasks — like rebalancing portfolios and utilizing tax-loss harvesting — the advisors’ value will hinge on dealing with complex human relationships, he says.
A foundation in behavioral finance could prove advantageous, Egan says. “That’s a skill set that I would be investing in right now,” he says, “so I could leverage technology, but also be able to add the necessary human element.”
Betterment has already incorporated behavioral finance elements into its client platform, he says. For instance, the firm now employs visual cues to indicate whether a client is doing enough to reach their goals, or if they need to save more.
“We use color to draw people’s attention to whether or not they’re on track,” Egan says. Betterment displays financial information in green when a client is meeting savings goals, but those same numbers show up in bright orange if not, he says.
“We’re not going to show everything in black and white, so people never have an emotional reaction,” Egan says. “Let’s use behavioral biases so that people have the right emotional response.”
Egan, along with assistant professor Victor Ricciardi and investment advisor Michael Pompian, shared their thoughts on the future of behavioral finance during a Financial Planning webinar Monday.
COGNITIVE VS. EMOTIONAL BIASES
Although advisors are becoming savvier to behavioral approaches, some just don’t know where to start.
Articles from the Journal of Financial Planning says Ricciardi, assistant professor of financial management at Goucher College in Baltimore, are a good resource. They're free and address basic biases with detailed descriptions and offer tools to help deal with them.
“Think about the degree of comfort that you have,” Ricciardi says. “If you have no background, then take a more moderate, conservative approach.”
There are two basic types of behavioral biases, cognitive and emotional, says Michael Pompian, founder and CIO of Sunpointe Investments. Cognitive biases produce “followers” or “independents” depending on the risk tolerance levels, while emotional biases lead to “preservers” or “accumulators.”
Advisors should moderate the portfolios of clients with cognitive biases and adapt to those with emotional biases, Pompian says.
“Generally speaking, advisors should try to moderate or change cognitive biases because they’re easier to work with than emotional biases,” he says. “Emotional biases are not as easy to correct so generally they’ll need to be adapted.”
Exhibiting overconfidence and trading too much, or losing risk tolerance, are some of the more obvious signs of a money disorder, Ricciardi says.
“Learn about certain biases and try to help improve their behavior,” says Ricciardi, who is coeditor of the 2014 book, Investor Behavior: The Psychology of Financial Planning and Investing. “The next piece is to start thinking like a financial coach. Essentially you will learn how to assess those biases.”
And, don’t forget to look in the mirror, he says.
“Advisors tend to suffer from biases as well,” Ricciardi says. Learning to identify the biases will help advisors as well as the clients overcome them, he says.
Just how much financial therapy will play a role in planning in the coming years is an emerging issue, says Ricciardi.
“Some planners are already giving clients referrals to financial therapists,” he says. Some planners meet with financial therapists and have a 'kumbaya session' with people who have severe money disorders, he says.
Clients often have positive or negative financial turning points that influence behavior later in life, Ricciardi says. “Clients can then develop money scripts, or money beliefs,” Ricciardi say. “If those experiences are negative and severe enough, clients can develop money disorders, like hoarding, for example.”
Financial counselors are going to specialize with these disorders in the coming years, he says.
“It’s just such a new field,” Ricciardi says.