How I Apply Behavioral Finance to Achieve Better Client Outcomes

allan rothI’m fascinated with the field of behavioral economics and have taught the subject for nearly 20 years. But theory must be applied to be useful. Here’s how I apply behavioral finance to help clients to think differently about their investing.

Behavioral finance recognizes that we are not rational, mathematical animals; we are emotional beings. We often deviate from traditional economics, which says we are unbiased by emotion and have consistent and coherent preferences when it comes to wealth and security. In fact, the weighting of those two preferences is predictably irrational. Wealth has a higher preference in a bull market while security rules the day in a bear market. Morningstar’s Mind The Gap Study shows investors’ poor market timing caused them to underperform by nearly 1.7% annually over the past decade. I review that Morningstar study with clients, making sure that they recognize this applies to them as well as investment advisors.

Prospect theory and recency bias

Clients must make a critical decision selecting an allocation between risky assets such as stocks and low-risk assets such as bonds and cash. More importantly, they must commit to stick with the allocation they select. In my experience, clients typically want to take on more risk than they need to, especially in a bull market. I look at the client’s need to take risk rather than relying on their willingness to take risk, which is poorly measured in a risk-profile questionnaire.

It’s one thing to ask a client how they would feel if their stock portfolio lost 50% or more; such a question elicits an idealized response. Though they might say they would buy more stocks to rebalance, few actually do. That’s because prospect theory demonstrates that we experience roughly twice as much pain from losing money as pleasure from making the same amount of money. Did they (or you) rebalance in the 33 days ending March 23, 2020 when stocks lost 35% as the pandemic hit?