The change in attitude between planning and reality is similar to what happens when you set an alarm clock. You decide the most reasonable time to wake up the night before. Then, when morning arrives, you no longer believe that this time was all that reasonable. You hadn’t accounted for the variables that arose when your alarm went off, such as simply feeling too tired to get up.
Most clients see the wisdom of investing in risky assets. They work with an advisor to determine the right amount of risk in an investment portfolio and appear to understand that market volatility exists. However, this reasonable attitude toward risk often goes awry when markets crash. It can seem to an advisor that the client's attitude toward risk has completely changed when fear sets in and emotions begin driving investment decisions.
It's almost as if you have two brains: one that plans for the future and another that lives in the present. And the one that lives in the present is prone to making bad decisions.
Core components of the brain
In order to understand clients better, it can be helpful to understand how we use our brains to make financial decisions. Here is a brief rundown of some of the different areas of the brain and how they play a part in processing information:
- The cerebral cortex is where a vast amount of information processing takes place and it is divided into four main areas, called lobes.
- The frontal lobe is where a lot of information is calculated, compared, and processed. This is where we make most financial decisions.
- The prefrontal cortex is part of the frontal lobe where we engage in planning. When you’re working with clients, this is the main part of the brain that you’re engaging, in yourself and the client, as you help them plan and make financial decisions. The prefrontal cortex also helps us figure out if something is a good idea or not. It’s responsible in part for integrating the input from the various parts of the brain in order to determine the best course of action, like when to wake up in the morning.
- The limbic system is where emotion is processed, and memories are formed. When you get angry or sad, this is the area of the brain that helps you figure out how to respond.
How does the brain impact how we make financial decisions?
Psychologists have explored descriptive models to explain how we make decisions. Although not a perfect alignment with the cerebral cortex and the limbic system, these models highlight two systems that are often in conflict with one another.
For example, Nobel Laureate Daniel Kahneman has advanced what he calls “System 1” and “System 2” thinking.
System 1 responds instinctively, driven by emotion and without much time to process information. The intuitive response can be beneficial because the limbic system can process information much quicker than System 2. Unfortunately, System 1 tends to make mistakes because it often doesn't run its automatic, emotional response through the prefrontal cortex.
System 2 is slower and more deliberate, being driven by reasoning. As a result, System 2 tends to be more accurate and controlled. These two systems of thought tend to interact fairly well, where System 2 waits for a decision that System 1 isn’t equipped to address.
Some of these descriptive decision-making models focus on different versions of one’s self, for example, one’s short-run shelf and one’s long-run self. These selves differ in what time frame they put their emphasis, where one focuses on the here and now (the doer) and the other focuses on planning for the future (the planner). Other researchers describe these two versions of ourselves as our “current self” and our “future self,” and we tend to feel more connected to our current self than our future self. In fact, we’re more likely to view our future self as someone else than our own, present self.
How can the advisor meet the client in the middle?
Having an awareness of these models can be helpful in better understanding how clients process financial decisions. Elements in these models may come into play at various times and for different clients. Having a framework for how we make decisions allows us to recognize the players for who they are and how to respond to them.
Here are some useful strategies for helping the calculated thinker control the emotionally driven thinker:
The problem: Over-projection
It's important to recognize that the future self will often over-project how much control they'll have over their present self. It's easy to say that we'll get up when the alarm goes off in the morning, or that we'll rebalance back into stocks after the market has dropped 25 percent. But when we wake up in the morning or see our nest egg fall by a quarter, it's much harder to override our emotion with reason.
The solution: Incorporate rebalancing plans
Anticipate that we won't be able to control a client’s reaction to the unforeseen. If the client has to make active investing decisions when they are likely to be more emotional, they'll be prone to making bad choices. Instead, why not establish a rebalancing plan as part of an investment policy statement and then automatically rebalance when the market rises and falls. That way your client understands this up and down performance is normal and, because of this, there’s a set strategy in place when the stock market doesn’t go as planned.
The problem: Irrational withdrawals
What once felt like the perfect plan to a client, may not feel so perfect when there’s a hiccup in the stock market. This feeling of uncertainty, regarding investment portfolios, can cause clients to want to make a divestiture without considering the long-term effects.
The solution: Be a commitment device
Another strategy is to use what's known as a commitment device. Tax-sheltered accounts often penalize early withdrawals and can help clients view investments as untouchable. A less liquid account can serve as a lock box, or can at least make it more difficult for the emotional system to make a snap judgment. And since the advisor is not emotionally involved in a client's portfolio, advisors themselves can serve as a commitment device by developing a long-term investing strategy and guiding a client away from making bad investment decisions when emotions begin to overpower a client's rationale.
Becoming a more educated and effective wealth manager
Understanding the decision-making process and why people make the choices they do is at the core of behavioral finance. The article you’ve just read was adapted from the behavioral finance curriculum in the Wealth Management Certified Professional® (WMCP®) education program developed by The American College of Financial Services.
A team of investment researchers including Dr. Michael Finke, Dr. David Blanchett, head of retirement research at Morningstar, Dr. Wade Pfau, professor of retirement income at The American College of Financial Services, and dozens more, created the WMCP® to serve a global marketplace where mass-affluent and high-net-worth individuals seek advisors with a true understanding of their unique needs and goals.
Advisors with a WMCP® designation have deep knowledge of personal wealth and investment management, including portfolio theory, behavioral finance, mastery of investment tools, and advanced wealth management strategies.