The benefits of behavioral finance in the investment planning process

Investment advisors who stay active across their client base in times of market volatility are more likely to add new clients from a variety of sources.

Clients and prospects want to know that their advisor is looking out for them, even when the advice they are delivering is to stay the course or focus on the long term.

Laying a foundation for communications based on behavioral finance allows advisors to better set expectations early on in client relationships, while also offering an opportunity to maintain an open dialogue when markets become turbulent.

When properly employed, behavioral finance allows advisors to pursue the twin goals of helping investors feel less financial stress while making better decisions in pursuit of their long-term goals.

A recent study found those advisors who employed behavioral finance in their approach:

  1. Gained a better understanding of clients’ risk appetite and kept them invested during the market turbulence in early 2020;
  2. Reported elevated client acquisition activity earlier in the year; and
  3. Developed deeper relations with clients.

As market volatility escalated, advisors increasingly turned to behavioral finance to help keep clients invested and focused on their long-term goals.

These are the key conclusions of a White Paper by Cerulli Associates, in partnership with Charles Schwab Investment Management, Inc., and the Investments & Wealth Institute: The Evolving Role of Behavioral Finance in 2020.    The Evolving Role of Behavioral Finance in 2020 | Schwab Funds

These findings will not be surprising to most investment advisors.  Nevertheless, the evidence supporting including elements of behavioral finance in the planning process is growing, and it is becoming more widely accepted.

It goes without saying, that advisors truly need to get to know their clients and use these insights to create personalised action plans to help them achieve their goals.  Clients prefer this too. 

Incorporating elements of behavioral finance in the planning process will help achieve this, benefiting both the client and advisor.

We all have behavioral biases and are prone to making poor decisions, investment related or otherwise. Therefore, it is important to understand our behavioral biases. From this perspective, behavioral finance can help us make better investment decisions.

For a further discussion on how investment decisions can be improved by employing behavior finance see this Kiwi Investor Blog Post, which includes access to a Behavioral Finance Toolkit.

Behavioral Biases

The following Table outlines the Top 5 behavioral biases identified by advisors in the Cerulli Associates study.

Recency biasBeing easily influenced by recent news events or experiences
Loss aversionOpting for less risk in portfolio than is recommended
Familiarity/home biasPreferring to invest in familiar (U.S. domiciled) companies
FramingMaking decisions based on the way the information is presented
Mental accountingSeparating wealth into different buckets based on financial goals

Not unexpectedly Recency bias was found by advisors to be the most common behavioral bias amongst clients this year.  This was also the most common behavioral bias in 2019, on both occasions 35% of Advisors indicated that Recency bias was a significant contributor to their clients’ decision making.

Loss aversion held the number two spot in both years.  The Paper provides a full list of Client behavioral biases identified, comparing 2020 results with those in 2019.

Clients are more than likely affected by several behavioral biases.

Source: Staib Financial Planning, LLC

Advisors can help clients improve their investment outcomes by influencing the behavioral bias in a positive way.  By way of example in the paper, Framing (easily influenced by recent events), “an advisor can emphasize how rebalancing a portfolio during an equity market decline allows investors to accumulate more shares of their favorite stock or funds at a reduced price.”

They conclude: “by embracing the principles of behavioral finance, advisors can nudge clients toward more constructive ways to think about their portfolios.”

Survey Results – the benefits of Behavioral Finance

The paper defines Behavioral finance as the study of the emotional and intellectual processes that combine to drive investors’ decision making, with the goal of helping clients optimize financial outcomes and emotional satisfaction.

As the White Paper outlines “Advisors must help investors create and maintain a mental framework to help ease their concerns about the fluctuations of the market. Behavioral finance can be a crucial element of advisors’ efforts to help investors overcome their emotional reactions in pursuit of their longterm financial goals.”

There has been an increase in advisors adopting the principles of behavioral finance in America, particularly in relation to client communications.

In 2020 81% of advisors indicated adopting the principles of behavioral finance, up from 71% in 2019.

The increase is likely in response by advisors to provide a “mental framework to deal with the adversity presented by increased uncertainty in the market and in life overall in 2020.”

Benefits of Behavioral Finance

Keeping clients invested was found to be a key benefit of incorporating behavioral finance in the advice process, 55% of advisors indicated this as a benefit, up from 30% in 2019.

The benefit of developing a better understanding of client’s comfort level with risk also grew in 2020, from 20% in 2019 to 44% in 2020 (probably not surprisingly given events in March and April of this year).

In 2019, the benefits of incorporating behavioral finance most cited by advisors was: strengthening relationships (50%), improving decisions (49%), and better managing client expectations (45%).  These benefits also scored highly in 2020. 

The paper provides a full list of the benefits of incorporating behavioral finance, comparing the results of 2020 with 2019.

To summarise, the results highlighted the dual role of behavioral finance in client relationships as:

  1. serving as a framework for deeper engagement to strengthen communications and prioritize goals during good times; and
  2. to help minimize clients’ instinctual adverse reactions during periods of acute volatility.

The paper then focused on two areas:

  • Growing the client base
  • Deepening client connections

Behavioral Finance Advisors experienced greater growth of their client base in 2020

In 2020 55% of advisor respondents indicated they had added new clients since the first quarter of 2020.  4% indicated they had experienced net client losses.

However, the results differed materially between advisors who adopted elements of behavioral finance compared to those who do not.

“Two-thirds (66%) of behavioral finance users reported adding to their client base, compared to just 36% of advisors who are not incorporating behavioral finance in their practices.”

The source of these new clients?:

  • “Approximately two-thirds of new clients were sourced from other advisors with whom clients had become dissatisfied, or as an outcome of investors seeking to consolidate their accounts and maintain fewer advisor relationships. This is frequently attributable to satisfied clients referring friends and family who are discontented with their current advisory relationship.”
  • “The other third of new client relationships was attributable to the conversion of formerly selfdirected investors who found the current conditions an opportune time to seek professional advice for the first time.“

Therefore, “behavioral finance adherents are more likely to not only educate clients regarding the potential for volatility, but also to urge clients to expect it. This scenario reinforces many of the key benefits of leveraging behavioral finance in advisory relationships, especially with regard to managing expectations and remaining invested during periods of volatility.”

Behavioral Finance Advisors develop deeper connections with their client base

Cerulli’s research has found that the level of an advisor’s proactive communication during periods of market volatility is the most reliable indicator of the degree to which the advisor will add new clients during the period.

In the study that they undertook, for example, they found that 72% of those advisors who employed elements of behavioral finance and increased their outgoing calls added new clients, compared to 42% of non-users of behavioral finance.

They conclude “The unifying element in these results is that proactive personal communication was valued by investors and was especially effective for advisors who have made behavioral finance a part of their client engagement strategy.“

A key point here, is that “Instead of having to pivot from touting their investment returns to focusing on explaining volatility, behavioral finance users were able to frame current conditions as expected developments within the context of the long-term plans they had previously developed and discussed.”

From this perspective, it is important to understand what type of communications clients and prospects prefer.

It goes without saying, that advisors truly need to get to know their clients and use these insights to create personalized action plans to help them achieve their goals.

Clients prefer this too. 

Incorporating elements of behavioral finance in the planning process will deliver this, benefiting both the client and advisor. 

Please read my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Behavioral Biases

Recency biasBeing easily influenced by recent news events or experiences
Loss aversionOpting for less risk in portfolio than is recommended
Familiarity/home biasPreferring to invest in familiar (U.S. domiciled) companies
FramingMaking decisions based on the way the information is presented
Mental accountingSeparating wealth into different buckets based on financial goals
Confirmation biasSeeking information that reinforces existing perceptions
AnchoringFocusing on a specific reference point when making decisions
HerdingFollowing the crowd or latest investment trends
Endowment effectAssigning a greater value to investments or assets already owned
Inertia/status quoFailing to take action or avoiding changes to a portfolio
Selective memoryRecalling only positive experiences or outcomes
Regret aversionFearing to take action due to previous mistakes or regret avoidance
Availability biasBasing decisions only on readily available information
OverconfidenceBeing overly confident in one’s own ability
Self-controlSpending excessively today at expense of the future

Sources: Cerulli Associates, in partnership with Charles Schwab Investment Management, Inc., and the Investments & Wealth Institute. Analyst Note: Advisors were asked, “To what degree do you believe the following biases may be affecting your clients’ investment decision making?”

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