What is Behavioral Finance (BeFi)?
Behavioral Finance was initially presented in the late 1970s as a way of better understanding the influences on financial markets. At that time, experts relied upon the “efficient markets theory” which was based on an elegant idea that stock values applied all information and correlated perfectly with per capita consumption. Under this hypothesis, all stocks would trade at fair market value on the exchanges. However, over time it became clear that this theory failed to explain a recurrent trend of excess volatility among stock prices. The Nobel prize-winning work of economists Schiller and Fama, plus the groundbreaking research performed by psychologists Kahneman (also a Nobel laureate) and Tversky, suggested an answer: irrational human behavior.
From that time on, investor behavior was accepted as an unavoidable factor in influencing modern financial theories. For financial advisors, this study of human behavior as it relates to key decisions and biases around financial investments, is what we call Behavioral Finance (for more information, read our blog).
Why Should Advisors Embrace Behavioral Finance?
Financial advice is a growing industry, expected to show a 15.4% increase in jobs by 2031, and much of that is due to the fact that it's constantly evolving. As advisors seek ways to add value and better serve client demands, addressing client behaviors, biases and emotions has been rapidly gaining traction. In 2021, the CFP Board added a new category titled “Psychology of Financial Planning” to its CFP Exam and continuing education criteria.
Understanding what drives client behavior allows advisors a greater opportunity to improve their clients’ financial lives. Studying and embracing behavioral finance concepts provides advisors with a greater understanding of why and how a client may react to certain recommendations. As financial planners often experience, the act of setting up an effective financial plan is only one part of the equation. When clients fail to implement tailored strategies that are directly in sync with long term goals, something else is afoot. An advisor trained in behavioral finance can perceive client challenges and begin an open dialogue around tackling some of these negative or conflicting behaviors.
Some of the benefits to embracing behavioral finance may include:
- Greater trust between advisor and client
- Deeper, emotionally rich relationships
- Improved client retention
- More referrals
- Greater share of wallet
Leveraging behavioral finance in your practice has another huge benefit: it keeps clients on track. Advisors want their clients to succeed in meeting their financial goals. In fact, many advisors cite ‘helping people meet their financial goals’ as one of the top reasons they select this career. But a client’s financial outlook is affected by unexpected life events just as much as it is affected by more predictable (though not necessarily logical) human emotions and decision-making.
Advisors skilled in the art of behavioral finance recognize that most clients will make decisions that are influenced by emotions, biases and cognitive errors. Advisors can proactively meet client needs by giving them advice that resonates with and addresses their biggest concerns. Exploring any negative patterns or biases allows attuned advisors insight into what drives their particular client’s behaviors. Even when a recommendation is in a client’s best interest, these biases can prevent clients from following the advice. A plan that ignores the human element could be doomed to fail if it unknowingly requires clients to act in ways that are uncomfortable or require a significant change in behavior.
Appealing to both logic and emotion is vital to coaching clients through their financial plan and any subsequent course corrections. By giving clients a safe and trusted space to share their thoughts or motivations can uncover challenges that would have gone otherwise unheard. Advisors who understand this can tailor the conversation to best support their client, providing the right amount of listening, logic, and emotional guidance in executing on their financial plan.
Behavioral Finance is Increasing in Popularity and Understanding
COVID created an environment where advisors suddenly had to apply behavioral finance concepts almost daily- even if it was a previously untapped skill. The pandemic accelerated demand for a more “human” advisor – one versed in financial knowledge and a greater understanding of what clients might be feeling on a regular basis. Putting this into practice sparked increasing demand for this level of client understanding in the long run:
- A recent Schwab BeFi Barometer survey found that 81% of advisors are incorporating behavioral finance into client communications.
- Professors and researchers are creating collegiate programs to teach the art of financial planning – not just the concepts of bias, but also the tools to navigate client conversations that may improve behaviors with this information in mind.
- Embracing behavioral finance could become a stronger competitive advantage for financial planners over robo-advisors and other less-personal financial advice tools.
- Advisor technologies continue to evolve at a rapid pace and are now including elements that address behavioral finance-related solutions for clients.
Want to learn how you can provide incredible value to your clients through behavioral coaching and applied behavioral finance techniques? Start here with Orion’s Chief Behavioral Officer, Dr. Daniel Crosby’s, covering the drivers of human behavior and how to keep clients invested.
0350-OAT-2/7/2023