Beyond Wealth: Integrating Financial Planning and Investor Behavior

As financial advisors, our purpose is to increase the financial well-being of our clients. And, although I believe we add a great deal of value for our clients in helping set and implement long-term financial goals, reviewing insurances and risk management strategies, being tax-efficient in all aspects of investing and estate/gift transfer issues, helping with education funding strategies, attempting to constantly reduce portfolio expenses, etc., I think it is also our recognition of the psychological and emotional aspects related to money and investing that is valuable. Consider this:

  • Money is a significant source of stress and anxiety for many people.  We often provide emotional support and guidance to help clients navigate financial challenges and alleviate their worries.
  • We work with clients to set financial goals and create plans to achieve them. This involves understanding clients’ values, motivations, and aspirations, which has a psychological component.
  • Assessing a client’s risk tolerance is a critical part of financial planning. We understand each client’s psychological comfort levels with investment risk and recommend appropriate investment strategies accordingly.
  • Effective communication is essential in financial advisory relationships, as we must often explain complex financial or tax concepts in a way that is easily understood. Understanding a client’s learning style and preferences can be psychologically beneficial in this regard.
  • We often help clients manage stress related to financial setbacks, such as market downturns, unexpected expenses, or job loss, and can provide guidance and reassurance during these challenging times.

In many cases, and especially when the markets become increasingly unpredictable, our most valuable advice may simply be encouraging clients to follow good investment practices. This means keeping them from getting too swayed by momentary urges and making dramatic portfolio changes, usually based upon emotion, that they may regret later. Basically, our goal is to remove emotion and inject a bit of common sense when needed.

Using the Modern Portfolio Theory (MPT)

One of the foundational concepts that tries to quantify common sense is Modern Portfolio Theory (MPT), first discussed by Harry Markowitz when he was a doctoral candidate at the University of Chicago in 1952 (as an aside, I’m not sure how far we need to get from 1952 before we cannot continue to call something “modern”).  MPT takes the dynamics of individual portfolio decisions (e.g., how much in stocks, bonds, etc.) and generates a continuum of investment options based on risk-tolerance. Typically called the “efficient frontier,” the continuum offers up portfolio allocations that aim to maximize expected return given a level of risk or, putting it another way, the lowest possible risk for a given level of return. MPT evolved and eventually engulfed other theorems, including the Efficient Market Hypothesis, which essentially translates into: markets reflect all information, trade at fair value, and the aggregate participants are rational.

Putting these together creates the following building blocks:

  • Investors are rational.
  • Markets are efficient.
  • Investors must take on more risk to generate more return.
  • Diversification (the use of uncorrelated or less correlated assets) reduces the risk of the overall portfolio.
  • Investors should build portfolios according to mean-variance theory.

Now, although a lot of that is true over extended periods of time, MPT tends to break down in the shorter-term and becomes “Modern Portfolio Reality” in which:

  • Investors are not rational but could be considered “normal” (the definition of which is way beyond the scope of this missive).
  • Markets are not perfectly efficient.
  • Investors take on risk in the hopes of greater returns in areas not supported by fundamentals (e.g., tulip bulbs, Beanie Babies, cryptocurrencies, etc.).
  • Diversification breaks down when systematic risk alters correlations.
  • Investors design portfolios on the rules of behavioral theory.

This dichotomy has led to the increased study of what is called “behavioral finance.” Behavioral finance attempts to explain and increase our understanding of the emotions and reasoning patterns of investors (and markets) in decision making. It tries to overlay the human element on investment and financial decisions.

Arnold Wood, founder and former President & CEO at Martingale Asset Management, described behavioral finance as follows:

“It is the study of us. After all, we are human, and we are not always rational in the way equilibrium models would like us to be. Rather we play games that indulge self-interest. Financial markets are a real game, they are the arena of fear and greed. Our apprehensions and aspirations are acted out every day in the marketplace. So, perhaps, prices are not always rational, and efficiency may be a textbook hoax.”

Recognizing Our Decision-Making “Biases”

Research in psychology has documented a range of decision-making behaviors called biases. These biases can affect all types of decision making but have particular implications when it comes to money and investing. The most common of these biases are:

  • Overconfidence – Overconfident investors tend to overestimate their ability to identify successful investments. Feeling that they control more of the performance of an investment than they do, this could lead to a lack of proper diversification and/or excessive trading. Overconfidence may be fueled by another characteristic known as “Self-Attribution Bias.” This means that individuals faced with a positive outcome following an investment decision consider it a reflection of their ability and skill, while a negative outcome is attributed to bad luck or misfortune.
  • Loss Aversion – In general, investors are more sensitive to loss than to gain, in some research by a ratio of 2:1. Loss aversion occasionally leads to the “Sunk Cost Fallacy.” An example is when people try to avoid locking in a loss, instead, holding onto an investment hoping the price rises to at least “break-even.” By doing so, they do not have to admit they made an investment mistake.
  • Inertia (or Regret Avoidance) – Emotions can often sway investors from acting, even if they have committed to do so. The human desire to avoid regret drives this behavior, usually leading to the most convenient path, which is “wait and see,” and often inactivity (fear). We sometimes see this effect with clients who do not want to rebalance after a portion of their portfolio has done particularly well or poorly.
  • Framing – The way that something is presented (i.e., highlighting positive or negative aspects) translates to a different response even when the outcome is the same. One example of this is displaying beef that is 95% lean or 5% fat. Finance theory suggests we consider our portfolio in the aggregate, nevertheless, the eye often falls on individual investments. The focus is on the 5% fat. This narrowness tends to increase investor sensitivity to loss as compared to those individuals that are more comprehensive in their review.
  • Home Bias – Investors have been documented to prefer investing in familiar/home country assets, associating familiarity with lower risk. This could lead to a lack of proper diversification.
  • Recency Bias – Investors more prominently recall and emphasize recent events/performance over those in the near and distant past, assuming the current trend will continue.
  • Anchoring/Conservatism Bias – This is the tendency for investors to rely too heavily on an initial piece of information, despite new and/or contradictory information.
  • Herd Behavior – This is purchasing investments based on price momentum while ignoring basic economic principles. Do meme stocks ring a bell?

In summary, we often integrate psychological aspects into our work to help clients make informed and emotionally sound financial decisions.  Although our role is primarily focused on financial planning, investment management, and wealth-building, we often provide valuable support in managing the emotional aspects of a client’s financial life.

Open conversations with your financial advisory team create a foundation of trust and in a better understanding of your needs. We encourage you to speak to your advisor if you have any questions.

Wealthspire Advisors is the common brand and trade name used by Wealthspire Advisors LLC, Private Ocean, LLC, and ACG Advisory Services, LLC, separately registered investment advisers and subsidiary companies of NFP Corp.
Please Note: Limitations. The achievement of any professional designation, certification, degree, or license, recognition by publications, media, or other organizations, membership in any professional organization, or any amount of prior experience or success, should not be construed by a client or prospective client as a guarantee that he/she will experience a certain level of results or satisfaction if Wealthspire is engaged, or continues to be engaged, to provide investment advisory services.
Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, Certified Financial Planner™, and CFP® (with plaque design) in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
© 2024 Wealthspire Advisors
Dmitriy Katsnelson

About Dmitriy Katsnelson

Dmitriy serves as Deputy Chief Investment Officer and is based in our Potomac, Maryland office.

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Bill Schwartz

About Bill Schwartz, CPA, CFP®

Bill Schwartz is a managing director in our Potomac, Maryland office.

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