Behavioral Finance 2.0 - Financial Psychology

Journal of Financial Planning: May 2017

 

Bradley T. Klontz, Psy.D., CFP®, is a co-founder of the Financial Psychology Institute™, an associate professor of practice at Creighton University Heider College of Business, a managing principal at Your Mental Wealth Advisors™, and an author/editor of several books.

Edward J. Horwitz, Ph.D., CFP®, ChFC®, FBS, CLU®, CSA, is the Mutual of Omaha Endowed Executive Director in Risk Management, and an associate professor of practice at Creighton University Heider College of Business.

The financial planning profession has a growing interest in blending psychology theory and techniques with financial planning. The most recent edition of CFP Board’s Financial Planning Competency Handbook illustrates this integration with new chapters on financial therapy, behavioral finance, and marriage and family therapy applications to financial planning. The Journal has also recognized the benefits of this trend, as evidenced by the 2016 Montgomery-Warschauer Award given to Sarah Asebedo and Martin Seay for their psychology and financial planning integration article “From Functioning to Flourishing: Applying Positive Psychology to Financial Planning” published in the November 2015 issue.

Where We’ve Been

Early efforts to integrate psychology with finance focused on behavioral finance. Behavioral finance is built on the premise that human beings don’t always act in their best financial interests. Practicing financial planners, who frequently witness clients act against their own interests, intuitively understand this.

Whether it’s buying high and selling low, holding on to poor investments to avoid feelings of regret, selling a winning investment to experience feelings of pride, or refusing to diversify a concentrated position, poor investment decisions are ubiquitous. The field of behavioral finance has identified a host of cognitive biases explaining and predicting these types of behaviors. This includes constructs such as status quo bias, mental accounting, overconfidence, the disposition effect, and others.

Behavioral finance has historically been broadly defined as the application of psychology to finance. However, a closer look at the behavioral finance research reveals what is more accurately described as the application of a particular field of psychology to finance. In essence, behavioral finance is the application of cognitive psychology to finance (see the 2016 book Facilitating Financial Health: Tools for Financial Planners, Coaches, and Therapists by Bradley T. Klontz, Rick Kahler, and Ted Klontz for more).

The American Psychological Association defines cognitive psychology as “the study of higher mental processes such as attention, language use, memory, perception, problem solving, and thinking.” In its application of cognitive psychology to finance, behavioral finance has provided valuable information regarding common cognitive biases and thinking errors and how they impact financial decisions.

Where We Are

Our knowledge about behavioral finance has grown from laboratory research and analyzing large datasets. The bulk of behavioral finance research has been conducted by economists and finance professors—not financial planning practitioners. The studies are typically designed, conducted, and analyzed by researchers who have limited—if any—direct experience working with clients. This has led to a significant disconnect between research and practice, which is a common schism in many fields. While behavioral finance concepts can be quite fascinating, aside from a basic understanding of natural human tendencies, most planners are at a loss regarding how to apply this information to help their clients.

Consider a hallmark of behavioral finance research findings on the disposition effect first identified in 1985 by economists and finance professors Hersh Shefrin and Meir Statman in the Journal of Finance article, “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence.” Based on an analysis of aggregate stock and mutual fund trades over a several-year period, they observed that in an effort to seek pride and avoid regret, investors had a tendency to sell shares that had appreciated in value and hold onto shares that had lost value. These behaviors run counter to what would be expected if individuals were acting in their best financial interests.

This observation by Shefrin and Statman helps explain the cognitive underpinnings of a self-destructive financial tendency. However, where such behavioral finance research provides tremendous value in understanding human behavior and motivation, it fails to offer strategies to intervene on a client’s cognitive biases. In many cases, this type of research is conducted by theoreticians and statisticians who have never sat in front of a client, nor tried to shape a client’s behavior. As such, application discussions are often an afterthought.

Current Limitations

Behavioral finance research begs questions such as: “How do I convince my client to sell a losing position when her pride won’t let her admit defeat?” “What should I do when my client is exhibiting a bias towards the status quo?” “How should I tactfully address my client’s overconfidence in his prediction of future market directions?” Aside from macro-finance interventions, such as automatic 401(k) enrollment, behavioral finance provides little theory or few techniques to help shape the financial beliefs and behaviors of individuals, couples, or families.

Another limitation of much of the current behavioral finance literature is that it focuses on the findings of cognitive psychology. Behavioral finance just scratches the surface of what psychology has to offer the planning profession, potentially ignoring other fields of psychology, many of which may be more useful to practicing financial planners. These include social psychology, personality psychology, multicultural psychology, positive psychology, family psychology, and developmental psychology. The broader integration of psychology into the world of personal finance has been termed “financial psychology” by Klontz, Kahler, and Klontz.

Financial Psychology

Financial psychology can be seen as akin to clinical psychology, which “integrates science, theory, and practice to understand, predict, and alleviate maladjustment, disability, and discomfort as well as promote human adaptation, adjustment, and personality development,” according to the American Psychological Association. Applied clinical psychology draws from the entire body of psychological theory and research to apply findings to alleviate maladjustment and promote adaptation in individuals and groups.

Similarly, financial psychology draws from behavioral finance and other areas of psychology to help alleviate financial stress and promote healthy financial behaviors. Financial psychology focuses on using psychological research and theory to create micro-based techniques to help shape idiosyncratic financial beliefs and behaviors to improve financial health. These efforts go beyond cognitive biases into the realm of a client’s idiosyncratic beliefs, such as money scripts and financial behaviors like resisting financial advice, overspending, financial enabling, and financial anxiety.

Making It Relevant

To make behavioral finance more relevant to planners, an expansion into more practice-oriented fields of psychology is needed. For example, how does a client’s upbringing impact their financial beliefs and behaviors? Once problems are identified, how can a planner help a client? Techniques adapted from schools of psychotherapy can be helpful, such as cognitive-behavioral therapy, motivational interviewing, solution-focused therapy, or positive psychology. These areas of psychology are perhaps most useful for financial planners who want to help clients identify, challenge, and change cognitive biases.

To be useful to financial planners, the findings of behavioral finance need to be viewed from the broader context of financial psychology. Behavioral finance has identified our common, in-born cognitive biases, which when left unhindered, can have a detrimental impact on our financial outcomes. It’s also important to take into account a client’s unique personality, developmental history, social, cultural and gender influences, and family dynamics, and how these have shaped their idiosyncratic beliefs and behaviors.

With our broadening understanding of client psychology, the financial planning field continues to benefit from practice-oriented solutions to equip planners to better understand, assess, intervene, and shape clients’ financial beliefs and behaviors to improve their financial health and overall well-being.

Topic
General Financial Planning Principles