Imagine with me for a moment. Jade, a client, walks into your office holding an account statement. The statement identifies 10,000 shares of a stock – (DGE) – trading on the London exchange. You immediately recognize the stock as Diageo, a global spirits company. You’re a little puzzled, however, because Jade has clearly expressed great distaste for investments related to alcohol. Several family members have alcohol-based problems, and her father died from an alcohol-related disease. Yet, here she is in your office, with a statement showing ownership of Diageo stock. Not only that, she has just asked you to liquidate 25% of her portfolio so that she can purchase additional shares of DGE. You cannot help but wonder, “What’s going on?”
There is one more piece of information you should have. The DGE shares are from her mother’s portfolio, which Jade just inherited. Seems her father had worked for Diageo and while there, purchased the stock. Jade learned about the stock holding after her mother’s passing. Now, she seems to be violating her deeply-held anti-alcohol belief in favor of increasing her Diageo holdings. It just doesn’t make sense, and again you ask, “What is going on?”
Cognitive Dissonance and Selective Perception
What is going on here, is the manifestation of a behavioral finance bias. The particular bias is cognitive dissonance, which is a condition where someone experiences mental discomfort when newly acquired information conflicts with existing understanding. When in this imbalanced state, individuals will often make decisions that are inconsistent with their existing belief system, in order to resolve the dissonance.
Jade deeply loved her parents, and was especially close to her mother. As a result, the DGE shares are causing her to reassess her deeply held beliefs. If both her mother and father felt the DGE shares were good, then maybe she should change her beliefs and thereby, her actions. Jane is exhibiting an aspect of cognitive dissonance known as selective perception, by deciding in favor of the Diageo stock.
While professional financial planners are not therapists, one of the greatest services they can provide is to keep clients from making decisions that result in financial harm. This can be especially valuable when the client is experiencing significant emotional distress – like Jade.
Definition of Behavioral Finance
Behavioral finance can be defined as applying psychology to finance, and experience shows that many individuals carry one or more behavioral biases. These biases, when unchecked, can result in an individual consistently making harmful financial decisions. In fact, while you as a financial planner are working to act in the client’s best interest, the client is doing the opposite. The outcome is that much of your good work provides few, if any, positive results.
This, then, is the value in understanding behavioral finance concepts. It is not enough for a financial planning professional to have solid financial knowledge. A planner who is trying to do the best for clients should also have a working knowledge of the psychological aspects of client decision-making. This is not to say that financial planners should become licensed therapists. However, the way an individual thinks, feels, and makes decisions has a direct impact on their financial well-being. Think about assessing an investor’s risk tolerance. The usual questionnaire most likely cannot really identify how an individual will make investment decisions. Having at least a rudimentary knowledge of behavioral finance will help the planner recognize and better understand why a client may be making certain decisions. More importantly, this understanding will help the financial planner provide guidance to help the client start making better financial decisions.
Personal financial planners, like most professionals, seek to find ways to differentiate themselves in a crowded marketplace. In an environment where there are so many ways to get financial information and advice, what can a financial planner do to stand out? One positive solution is to begin mastering behavioral finance concepts and incorporate them into your practice. Doing so will help clients to better understand themselves and make more financially sound decisions. As a result, they will likely realize greater success in meeting their goals and objectives. They will also be happy with their financial planner, and happy clients tend to refer friends and family. Both you and your client will be successful, in part, because you invested the time to educate yourself about behavioral finance and its impact on clients. You will also have taken another step in promoting the value of working with a professional personal financial planner.