Behavioural finance – your financial adviser’s friend

You might think that good financial decision-making should be based on credible data and reasoning – and you would be right. But you might also think that it is possible to leave emotion out of this process – and you would be wrong. Today’s financial advisers are increasingly relying on behavioural finance tools to support their clients and help them navigate the choppy waters of the financial markets more serenely.

For a long time, prevailing theory held that financial agents, particularly investors, were rational beings who would always make the optimal decision. This belief in unlimited rationality notably gave rise to the efficient market hypothesis, which assumes that an efficient market is, theoretically, one in which the price of each asset perfectly incorporates all the information available about that asset, and that there are therefore never any errors when it comes to valuation. That view is now a thing of the past. The impact of emotions on financial decision-making is now widely recognised and documented. myLIFE has been illustrating the benefits of behavioural finance for a number of years, with financial advisers now increasingly incorporating this reality into their service philosophy.

The majority of investors who come to speak with an advisor expect to discuss solutions and strategies to adopt depending on the state of the market. They are much less likely, however, to open up about their financial problems and anxieties. But it should come as no surprise to hear that your financial adviser is taking a growing interest in our emotional relationship with money. Far from being an inappropriate act of intrusiveness, it is instead a sign of the care your adviser is taking to guarantee the quality of the service they mean to deliver. In order to provide a client with the support they need, an adviser must be able to identify the behavioural biases to which the client is most susceptible.

Behavioural finance has highlighted the importance of taking into account the emotional rollercoaster that investors experience in times of market turbulence. It has shown that fear and overconfidence can lead individuals to make irrational and impulsive decisions that have a detrimental effect on the performance of their investments. Beyond their individual impact, these cognitive, emotional and collective imitation errors have a significant influence on the dynamics of financial markets and lead to price distortions.

A realistic view of the financial decision-making process

For better or worse, money matters generate strong emotions that have an impact on our decisions. And contrary to what traditional finance has long claimed, this is not simply noise in the system – random, isolated errors that are better off being ignored. These cognitive biases are a recurring phenomenon, always following the same patterns, and their impact on financial decisions can be anticipated. Behavioural finance has shown that it is not only possible to describe and classify them, but also to find ways of countering their effects.

The line between traditional and behavioural finance is becoming increasingly blurred, with attempts now being made to integrate the psychological elements of finance in order to obtain a more realistic picture of the financial decision-making process.

Today, instead of pitting traditional finance against behavioural finance, we are seeking to integrate psychological elements into our thinking in order to obtain a more realistic picture of the financial decision-making process. According to a survey of more than 300 financial professionals that was carried out in 2020 by the statistics platform Statista, the use of behavioural finance to support clients is popular with professionals due to the following three advantages in particular:

• • clients are more likely to stick to a long-term investment vision (55%), which helps to avoid the massive sale of assets during periods of high market volatility.
  • clients remain more loyal to their advisers (48%) thanks to a closer relationship and greater level of trust.
  • clients’ expectations are easier to manage (40%) thanks to the ability to communicate more comprehensively and effectively.

In short, making use of behavioural finance gives your financial adviser the means to better understand your errors of judgement when it comes to money, as well as the poor decisions that can occur as a result – with the ability to help you move beyond the emotional and towards optimal decision-making as described in classical theory. It goes without saying that this would in turn give you more confidence in them to support you in any future decisions you make. Based on the results of the survey carried out by Statista, here is a more detailed list of the advantages a financial adviser can look forward to when they make use of behavioural finance tools.

Six reasons to incorporate behavioural finance into your range of services

1. Manage expectations better through effective communication

A financial adviser who draws on the discoveries of behavioural finance is fully aware that their clients are emotional beings, not robots. They will not blame their clients for their cognitive biases; instead, they will work with their clients to help them recognise those biases. From an anxious client to one prone to overconfidence, the adviser will adapt their approach to help each client identify and understand the specific psychological and emotional biases that are influencing their decision-making. The adviser’s goal? To enable their clients to make more rational choices that are based on more realistic expectations. The adviser’s ability to incorporate this emotional aspect will help to create a climate of confidence while improving the quality of communication with their clients.

2. Foster a long-term outlook, even in the face of turbulence

In times of high stock market volatility, emotions run high and decisions are often made on impulse. Financial professionals who adopt the tools of behavioural finance are better equipped to guide their clients through periods of stock market turbulence. They can more easily put in place decision-making frameworks that mitigate their clients’ cognitive biases and improve the rationality of their decisions. An effective strategy in this regard is to adopt an approach that is based on clients’ objectives. Instead of focusing solely on market movements, this approach emphasises the alignment of investment decisions with longer-term financial objectives that have been agreed upon with the client.

In addition to their legal obligation to assess an investor’s risk profile in relation to their financial capacity, a good adviser will also ask an investor about their emotional capacity to cope with risk.

3. Take into account a client’s degree of emotional comfort in the face of risk

In addition to their objective financial capacity to bear risk, investors all have a varying emotional capacity to deal with risk. Taking this into account will increase an investor’s degree of psychological comfort and greatly enhance the quality of communication between a financial adviser and their client. In addition to their legal obligation to assess an investor’s risk profile in relation to their financial capacity, a good adviser will therefore also ask an investor about their emotional capacity to cope with risk.

For example, you can be an experienced investor but still be very anxious about sudden market movements, with experience quickly giving way to emotion and irrational decisions. When it comes to accepting risk, rather than just accepting an assertion a client makes when they have a clear head, it can be useful for a financial adviser who has the right tools to put clients through an emotional stress test to better assess how they (over)react. There is sometimes a big gap between the way we imagine ourselves reacting in a given situation and the way we actually behave when that situation arises.

4. Reinforce investor loyalty

A financial adviser who makes use of behavioural finance knows that investor preferences are not fixed and are instead subject to change, particularly with age. Thanks to the quality of communication they will have been able to establish by taking into account the emotional characteristics of their clients, they will be better equipped to anticipate these potential changes in preferences and quicker to propose that they be reflected in the structure of their clients’ portfolios. Being a good behavioural adviser means having a base of reference for each client. Understanding their concerns, objectives and fears is a starting point from which the professional can guide their clients and detect signs of irrationality in their behaviour. This long-term approach creates a lasting and trustworthy relationship.

5. Provide personalised support based on more clearly defined priorities

A financial adviser who incorporates behavioural finance into their approach seeks to better understand their clients’ values in order to establish investment priorities for each client accordingly. While investment performance and the strategies for achieving it remain highly important, they are no longer at the heart of the relationship. In addition to quantitative data, advisers will build the support they provide around a narrative that incorporates their clients’ emotions, prejudices and life goals. In line with a client’s values and aspirations, this narrative helps to reduce their anxiety about their investment choices, helping them make calmer – and, more often than not, better – decisions.

6. Attract new clients

Financial advisers who integrate their clients’ values and non-financial concerns into their financial plans have an advantage over competitors who are singularly focused on the purely technical expertise of their business. A personalised, listening-based approach is a distinguishing factor that helps to win over investors and strengthen their loyalty.

At a time when the banking world is going increasingly virtual and there are more products on offer than ever before, it is important for financial advisers to be able to stand out from the crowd by offering more personalised services to their wealthy clients – who are, incidentally, the first to benefit from an approach which, thanks to the tools of behavioural finance, takes better account of their preferences and encourages high-quality, long-term support.