For Financial Planning Success Consider the Impact of Behavioral Finance
Behavioral finance is a relatively new field that seeks to combine psychological theory with conventional economics to provide explanations for why people fail to make optimal investment decisions. While financial planners know the core concepts behind investment advice, including asset allocation and modern portfolio theory, we also know that emotions have a LOT to do with financial decision-making. The success or failure of a financial plan is driven by a variety of possible influences. Factors like the right rate of savings, good investment selection, and careful risk management are all important and commonly recognized as elements of a high quality plan. But what can sabotage a plan? The obvious answers, like not saving enough or poor diversification of course apply. In spite of these apparent risks, financial planning can be like an iceberg, where much of the danger sits below the waterline. It is the hidden aspects of our own decisions that represent a great risk to the success of a financial plan, yet many of us remain unaware of the common flaws in financial decision making that tend to undermine even the best laid plans.
Importance of decision making
When making a financial plan the decisions we make today have consequences that can last for years, decades, or even generations. For many, the 2008 financial crisis left its mark on investor psyches because it was unexpected, sudden and dramatic. Despite the slow and steady recovery we saw, the financial crisis likely influenced decisions by making investors more risk-averse than they were before. Loss aversion results when people are more sensitive to possible losses than they are excited by potential gains and has kept investors more focused on how they could lose in the short term, rather than on how they could gain if they stay invested for the long term.
Smart decisions vs. instinctive reactions
Economics Nobel Prize winner Daniel Kahneman’s 2011 best seller “Thinking, Fast and Slow” provides a blueprint of these cutting-edge tips for improving your financial decision-making. Here are a few noteworthy examples to consider in your planning process.
Overconfidence is common and can put your plan at risk. It’s ok to be optimistic, but it’s dangerous to assume the future will look the same as the past and that what worked before will work again. Circumstances change, sometimes unexpectedly, and it can pay to prepare for possibilities - no matter how remote you think they are.
We feel the sting of losses more than the joy of gains, meaning that short term portfolio volatility can cause reactionary decisions that aren’t good for our long-term goals. Reviewing your accounts on a daily basis, particularly during periods of uncertainty, triggers our natural instinct to make decisions based on fear. If you have a good plan (and a good planning team) it makes sense to check accounts infrequently and keep your eye on the long-term.
Avoid “confirmation” of what you see the world. Limiting planning conversations to people that agree with your own way of thinking about finances makes it less likely that you consider new evidence and make fact-based decisions. Good financial planners will often challenge preconceived notions around finances and long-term goals, and this in turn can result in better decision-making.
Addressing the human side of the planning equation is a great step toward improving the odds of your financial plan succeeding. Lessons learned from behavioral finance can help keep you and your plan on track. Behavioral financial advice does not replace financial planning—it simply increases the effectiveness of your financial plan by improving decision-making behavior by recognizing emotions. When investors recognize the behaviors that distort their decisions, they may be better positioned to realize improved portfolio performance by taking advantage of long-term equity returns. Understanding the investor biases that are most common in today’s markets can be an important step toward improving your portfolio performance.