Behavioral Finance

Why Does My Client Do That?

In recent months, Dr. Robert Simon and Justin A. Reckers, CFP®, CDFA, AIF® have discussed the emerging field of Behavioral Finance as it applies to reaching settlement in divorce proceedings.  What has emerged is a practical and pragmatic way of conceptualizing the social, cognitive, and emotional factors that influence financial decisions during a divorce.  The field of Behavioral Finance has developed in recent years with a goal of understanding and explaining how human emotions and cognitive errors influence the movement of stock markets.  While the field of Behavioral Finance was originally promulgated by those interested in increasing their profits in the markets; analysis of the principles of this field show there is a broad applicability to a variety of every day settings and decisions.

Dr. Simon and Justin A. Reckers, CFP®, CDFA, AIF® believe the analysis and use of Behavioral Finance concepts and principles will help divorce practitioners to better understand how emotions and cognitive processes affect decision making around financial issues of those involved in divorce proceedings. This will allow practitioners to recognize their client’s barriers to settlement, giving them the ability to be proactive in facilitating a settlement.  They are interested specifically in cognitive barriers such as decision making and behavioral biases, biases in probability and belief, and social biases that cause deviation in judgment of particular situations. Merging the disciplines of Psychology and Finance is teaching how human decision making processes differ from traditional economic assumptions in the face of emotion.

To further illustrate the concept of Behavioral Finance, consider The Endowment Effect. This is a familiar barrier to decision making in divorce proceedings.  The Endowment Effect happens when people demand more to give up an object they currently own than they would be willing to pay to acquire it. It is a bias toward an asset where ownership rights have already been established when compared to an identical item that is not yet owned. For example, the client’s aversion to change or loss of security they associate with the family residence can lead to the bias towards keeping the home in spite of that decision being ill advised. Being aware of this bias in your client, why it is caused, and ways to work through it can help avoid the pitfalls that tunnel vision carries for your client’s future financial success.

There are a number of other roadblocks that have been identified by Behavioral Finance theorists. Selective Thinking, Anchoring and Status Quo Bias are a few common in divorce proceedings. The common thread in these examples is they have their roots in the human psyche’s aversion to and fear of loss and change.

Dr. Simon and Justin A. Reckers, CFP®, CDFA, AIF® are working together using the tools of Behavioral Finance to help clients and their advisors recognize the roles of these cognitive barriers, overcome the roadblocks they create, and facilitate movement toward settlement during divorce proceedings.

Cognitive

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Cognitive and Emotional Barriers to Financial Decision Making Process

and Emotional Barriers to Financial Decision Making Process
Confirmation Bias: The tendency to search for or interpret information in a way that confirms one’s
preconceptions. Also seen as “selective perception”, the tendency for expectations to affect perception, or
“selective thinking”
Ambiguity Effect: The avoidance of options for which missing information makes the probability seem
“unknown”.
Endowment Effect: When people demand much more to give up an object they currently own than they
would be willing to pay to acquire it. It is a bias toward an asset where ownership rights have already been
established when compared to a seemingly identical item that is not yet owned.
Focusing Effect: Prediction bias occurring when people place too much importance on one aspect of an
event causing an error in accurately predicting the outcome.
Anchoring: The tendency to rely too heavily, or “anchor,” on a past reference or on one trait or piece of
information when making decisions.
Framing Effect: Drawing different conclusions based on how data is presented. Includes the tendency
to ignore that a solution exists, because the source is seen as an “enemy” or “inferior” or the “mental
accounting” of assets as belonging to current income, current wealth or future income.
Hyperbolic Discounting: The tendency for people to have a stronger preference for immediate payoffs
relative to later payoffs even where immediate receipts are smaller than later payouts.
Status Quo Bias: The tendency for people to like things to stay relatively the same because the
disadvantages of change loom larger than the advantages.
Self-fulfilling Prophecy: The tendency to engage in behaviors that elicit results which will (consciously
or not) confirm our beliefs.
Bandwagon Effect: The tendency to do or believe things because many other people do or believe the
same.

Confirmation Bias: The tendency to search for or interpret information in a way that confirms one’s preconceptions. Also see as “selective perception”, the tendency for expectations to affect perception, or “selective thinking”.

Ambiguity Effect: The avoidance of options for which missing information makes the probability seem “unknown”.

Endowment Effect: When people demand much more to give up an object they currently own than they would be willing to pay to acquire it. It is a bias toward an asset where ownership rights have already been established when compared to a seemingly identical item that is not yet owned.

Focusing Effect: Prediction bias occurring when people place too much importance on one aspect of an event causing an error in accurately predicting the outcome.

Anchoring: The tendency to rely too heavily, or “anchor,” on a past reference or on one trait or piece of information when making decisions.

Framing Effect: Drawing different conclusions based on how data is presented. Includes the tendency to ignore that a solution exists, because the source is seen as an “enemy” or “inferior” or the “mental accounting” of assets as belonging to current income, current wealth or future income.

Hyperbolic Discounting: The tendency for people to have a stronger preference for immediate payoffs relative to later payoffs even where immediate receipts are smaller than later payouts.

Status Quo Bias: The tendency for people to like things to stay relatively the same because the disadvantages of change loom larger than the advantages.

Self-fulfilling Prophecy: The tendency to engage in behaviors that elicit results which will (consciously or not) confirm our beliefs.

Bandwagon Effect: The tendency to do or believe things because many other people do or believe the same.

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Justin A. Reckers CFP®, CDFA™, AIF®

Pacific Divorce Management Managing Director and Financial Planner

Robert A. Simon, Ph.D.

Forensic and Clinical Psychology and Pacific Divorce Management Affiliate

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Our firm does not provide legal or tax advice. Be sure to consult with your own tax and legal advisors before taking any action that would have tax consequences. The information provided herein is obtained from sources believed to be reliable; but no representation or warranty is made as to its accuracy or completeness.