Introducing the marriage of traditional finance, psychology, and neuroscience.
By: Chris Merchant, CFP® BFA®
According to a study by DALBAR, Inc., the S&P 500 had a return of 7.20 percent over the past 20 years, while the average stock investor had a return of 5.29 percent over the same period. The Barclays Bond Index had a return of 4.60 percent, while the average bond investor had a return of 0.44 percent1.
Why do investors perform so poorly compared to unmanaged indexes?
We have known about the disconnect between traditional finance thinking and the reality of investing for some time. Traditional finance states that investors will make unbiased, rational choices based on risk tolerance (risk vs. return trade-off). Reality, however, has shown that people are often biased and irrational in their decision-making.
In addition, humans are more loss-averse than they are risk-averse. The human brain is hardwired to avoid danger, real or perceived, and that process can override our rational thinking, causing us to make emotionally driven decisions.
As a result, we often let emotions (e.g., greed or fear), or biases (e.g., loss aversion, recency bias or fear of missing out) influence us, causing us to make bad investment decisions. The average person underperforms the S&P 500 or Barclays Bond Index over any given timeframe not because of poor investment selections, but because of poor investment decisions.
Behavioral finance blends the studies of traditional finance, psychology and neuroscience. Its aim is to help us better understand how emotions and biases can negatively influence investment decisions, then help us learn how to avoid those negative effects.
After hearing about behavioral finance in industry news, I became interested in the possibilities it offered. I have long considered myself to be a coach to my clients. I believe that the value I provide extends beyond investment selection to helping my clients make high-stakes financial decisions.
A recent study by Vanguard confirmed my belief by showing that advice from a financial advisor is worth around 3 percent in net returns. 1.50 percent, or half of the total contribution from a financial advisor, comes from behavioral coaching. So, half the value a good advisor brings to the table comes from helping clients manage their behavior and make better financial decisions.
After seeing the ways in which behavioral finance could help me better advise my clients, I enrolled in our industry’s training certification program, Behavioral Financial Advisor™. Over the last year, I have traveled back and forth from Philadelphia for classroom instruction, shared projects and extensive coursework. I completed the program with a written exam and a continuing education requirement, successfully obtaining my BFA® designation in June.
As a firm, we have begun to implement concepts of behavioral coaching into our management style, and we have received great feedback thus far. We even taught a class on the subject at Trilogy by Lake Frederick in August. The combination of the BFA® certification with my previously obtained advanced designation, CFP® (Traditional Finance), has enhanced our service offerings, allowing us to better serve you. If you have any questions about the discipline of behavioral finance and how it can benefit you, please contact us.