The behavioral advantage

Insights from behavioral finance give advisors powerful tools to add value for their clients—and to their practice

Key takeaways

  • Your clients may have emotional and irrational reactions to unsettled markets—and that’s normal.

  • These reactions often are fueled by behavioral biases that influence the decisions we make.

  • Advisors can play a valuable role in educating clients about these biases.

  • Understanding behavioral biases helps clients spot and address them.

  • Incorporating behavioral finance concepts into the planning process can strengthen the advisor/client relationship.

The stock market turned turbulent in 2020 after a decade of steady gains. Financial advisors are on the front lines during times like these: helping clients avoid making irrational, counterproductive decisions so they stay on track for their most important goals.

When coaching clients through challenging markets, it helps to understand the root causes of their reactions. The science of behavioral finance provides valuable insights. Research in behavioral finance aims to explain the ways certain emotional and mental biases can directly influence decisions around money.

In the following five-part series, we’ll explore some of the most common biases advisors see in their clients. We’ll also discuss strategies advisors can use to help their clients understand these impulses and avoid them—and to build stronger relationships in the process.

Understanding behavioral finance

For decades, data-driven concepts like modern portfolio theory and the efficient market hypothesis have guided advisors’ work with clients. These ideas remain essential. But it’s clear that the financial markets are not always efficient, in part because investors don’t always act rationally.

The field of behavioral finance has found deep-rooted biases that drive investors to make decisions that often are contrary to their best interest. Many investors may not be aware of the innate impulses affecting their decisions. Some biases, such as loss aversion and overconfidence, are driven by powerful, hard-wired emotions. Other biases are cognitive—mental mistakes caused by the way our brains process information. Both kinds can cause critical mistakes that endanger long-term goals, such as selling out of equities after a steep decline or clinging to a concentrated employer-stock position out of familiarity.

Advisors have opportunities to work with their clients to identify and address counterproductive behaviors in real time. This process becomes especially important in challenging markets, when clients may be more likely to make decisions that harm long-term results.

The advantage for advisors

The value of incorporating behavioral finance into an advisory practice surpasses portfolio performance. A survey of more than 300 advisors highlights a range of benefits.

The BeFi Barometer 2020 study, conducted by Cerulli Associates, was sponsored by Charles Schwab Investment Management in collaboration with the Investments & Wealth Institute. It found that advisors who use behavioral finance in their practices benefit from stronger trust with clients and a better ability to manage expectations.1 Additionally, when advisors understand their clients’ biases, they can incorporate the principles of behavioral finance into their portfolio construction processes. For example, this may mean taking a more specialized approach to asset allocation or rebalancing strategies to better match a client’s risk tolerance and goals.

That work can result in better client outcomes and stronger, longer-lasting relationships—and can help differentiate advisors in a competitive and fast-changing industry.

You don’t need a degree in behavioral psychology to help your clients identify and overcome their biases. And you don’t need to do it alone: we can offer the education and guidance you need to successfully implement behavioral finance in your practice. In the articles that follow, we’ll take a closer look at some of the most common—and potentially harmful—behavioral biases.

 

Omar Aguilar

Omar Aguilar, Ph.D.
Senior Vice President,
Chief Investment Officer, Passive Equity and Multi-Asset Strategies
Charles Schwab Investment Management, Inc.

About the author

Omar Aguilar

Omar Aguilar, Ph.D.

Senior Vice President, Chief Investment Officer of Passive Equity and Multi-Asset Strategies