Architecture of Financial Decision-Making
Modern economic theory assumes people reach decisions about money through a rational decision making process devoid of emotion and including consideration of all factors and available information. In reality, people are not nearly so rational in making such decisions.
Richard Thaler, Professor of Behavioral Science and Economics at the University of Chicago, Booth School of Business, asked this question; “How much would you pay to eliminate the risk of dying from a disease if you had an affliction with a 1 in 1,000 chance of killing you?” The answer was around the range of $5,000. A second question of the same group was asked: “How much would you charge to take part in a study where we exposed you to the same disease in question one?” The answers were two or three orders of magnitude larger at $500,000 or $5,000,000. Economic modeling would tell an economist the answers should be the same when a rational decision making process is used. So what happened? Emotions happened. Fear happened. Cognitive processes involved in making a decision were dramatically shaped by human emotions and fear.
The study of Behavioral Finance tells us humans often become irrational in the face of the social, cognitive, and emotional factors that affect psychological functioning during the decision making process. Our application of Behavioral Finance relaxes the traditional assumptions of financial economics by incorporating the observable human departures from rationality into conflict resolution, negotiation coaching, guidance of the decision making process, and successful client relationships. We are building the Architecture of Financial Decision-Making.
Why is Behavioral Finance Important?
Declines in portfolio values, home values, and escalating unemployment have induced a fear of the unknown that is unparalleled in recent history. Unemployed and underemployed workers are in danger of losing their homes and their piece of the American dream. Workers are accessing their 401(k) to make ends meet and wondering what affect this will have on their future retirement security. Many have lost faith in the financial markets and belief systems have been shaken to an extent not seen in most lifetimes. This fear has urged Americans to re-evaluate their attitudes towards risk, debt, and spending.
Experience and Neuroscience tell us people take ownership of financial decisions to a much greater extent when the decision is reached with the support of their advisors and not based 100% upon advice from a trusted advisor. Building ownership of the outcome is facilitated with the client’s involvement in the decision making process. We believe self determination is a vital part to every financial decision-making process and endeavor to build the Architecture necessary to facilitate it.
A process driven by numbers, formulas, codes and technical jargon leaves much to be desired for individuals and families faced with life changing financial decisions. Some clients can be comforted by repetitive modeling and projections and some can quiet their fears by listening to a trusted expert. We believe effective and rewarding client relationships require the comfort of factual data, trust in the expert, and a personal relationship re-enforced by the advisor’s ability to recognize and address the cognitive and emotional barriers a client faces in decision making. If too much focus is given to the strategies, solutions, and implementation while ignoring the client needs, wants, and wishes; we risk the relevance of the advisory process and its ability to reflect the client’s unique degree of reality.