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Understanding Behavioral Aspects of Financial Planning and Investing

People often view financial planning and investing as overwhelming, intimidating, and scary, especially if they must tackle these tasks on their own. They are fearful of making costly mistakes that could influence their well-being. Their fear often stems from a lack of background, education, or experience to help them cope with the financial side of living.

The world of financial planning and investing can be highly complex and difficult. What should investors do?

Make Decisions Based on Your Goals and Determine the Appropriate Path to Get There

Investors sometimes find themselves in a similar position as Alice in Lewis Carroll’s Alice’s Adventures in Wonderland who, when coming to a fork in the road, asks the Cheshire Cat:

Alice: “Would you tell me, please, which way I ought to go from here?”
Cat: “That depends a good deal on where you want to get to.”
Alice: “I don’t much care where.”
Cat: “Then it doesn’t matter which way you go.”

Unlike Alice, investors should make decisions based on their goals and then determine the appropriate path to get there. Advisors should assist individuals in developing a financial plan that incorporates a client’s values, needs, and wants to reach their financial goals.

Assuming investors have well-defined goals, they can take one of two major paths to achieve them. One is to acquire the knowledge needed to do one’s own financial planning and investing. According to Benjamin Franklin, “An investment in knowledge pays the best interest.” Nothing is likely to pay off more than gaining a financial education and engaging in the necessary research, study, and analysis before making any financial decisions. Otherwise, the result could be regrettable.

Successful Financial Planning and Investing are Many More Than Crunching Numbers

Another is to use the services of an investment professional such as a certified financial planner or adviser who already has the requisite knowledge, skills, and abilities to conduct these important tasks. Both options involve trade-offs, but each offers the potential for long-term success.

Successful financial planning and investing are many more than crunching numbers, listening to popular opinion, and understanding the latest market trends. As much as people need to know about financial markets and investments, they also need to know about themselves. A large part of investing involves investor behavior. Emotional processes, mental mistakes, and individual personality complicate investment decisions.

As we all know as markets go up, people enter the market. When markets go down people redeem their investments occasionally at a great loss. As markets go up you are being exposed to the greatest market risk, after markets go down you are exposed to the greatest market opportunity.

Despite logic, investors often allow the greed and fear of others to affect their decisions and react with blind emotion instead of calculated reason. In fact, emotions explain asset pricing bubbles.

Investor behavior usually deviates from logic and reason as explained by Daniel Kahneman (2002) in his Nobel Prize-winning thesis who established a cognitive basis for common human errors that arise from what he defined as human biases.

The prominent and renowned financial planners Yeske and Buie said famously  “Financial planning clients are as prone to behavioral bias as anyone and advisers must work to mitigate these tendencies.” Consequently, appropriate financial planning policies can play a powerful role in keeping clients committed to a consistent and disciplined course of action and in avoiding such biases. Ignoring or failing to grasp this concept can have a detrimental influence on achieving our life goals.

Our purpose is to examine some behavioral aspects of financial planning and investing. We begin by differentiating between traditional or standard finance and behavioral finance and stressing the importance of understanding investor psychology. We then focus on how behavioral biases, emotions, and systematic cognitive errors can affect investment decisions. We conclude with a few observations about how understanding investor behavior can help improve decision-making processes.

The Role of the Financial Planner in Mitigating this Risk

Many financial planners and advisers now incorporate the insights gained from behavioral finance in working with their clients. They are becoming increasingly aware that personality traits, demographic and socioeconomic factors, household characteristics, cognitive and emotional biases, and even religion can affect financial decisions.

Being an effective financial planner requires understanding investor psychology. Data we found out, are no match for human emotions. One of the greatest services a financial adviser can provide to clients in understanding their life goals and keeping them on track in all market scenarios.

Financial Planners should lay the groundwork of the plan during calm times. That is, they should discuss what individual investing strategies should be followed in the event of turbulent markets. This imposes a disciplined approach instead of an emotional reaction if that situation presents itself. Financial Planners should support what they are recommending with facts and evidence instead of merely stating their opinions and beliefs.

Understanding fundamental human tendencies can help financial planners and advisers recognize behaviors that may interfere with their clients achieving their long-term goals. People typically do not have investment problems; instead, investments have people problems.

Although planners cannot prevent all behavioral biases, professionals can advise clients on how to reduce their influence during the financial planning process.

An important strategy is to invest aligned with the client’s life goals, understand the client’s needs, capacity and tolerance to exposure to risk and determine an appropriate asset allocation strategy, and rebalance the client’s portfolio every year.

About the Author
Dan Dobry was the founder of the Union of Financial Planners in Israel (UFPI), served as the first Chairman and President of UFPI. Dan was the Global Council Representative for Israel for the Global Community (FPSB) from 2012 - 2018 and from January 2019 is a member of the Committee for Standards and Qualifications for the European Union (SQC).
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