by Billy Funderburk, CFP®, MBA
Traditional financial advice is based upon the Nobel Prize winning economic theory called modern portfolio theory. This theory, much like traditional economic theory, assumes a “rational economic man” or rational economic actor. In reality, people frequently behave irrationally with respect to their financial decisions in life. Behavioral financial advice begins with this idea and works to aid people in making more rational decisions in their financial lives. In short, behavioral financial advice attempts to bridge the gap between financial advice and successful financial outcomes in our lives.
There are three components to behavioral financial advice. The first is psychology and behavior. The second is traditional finance and economics. And the third is neuroscience, which involves the study of the brain itself.
The first component, psychology and behavior refer to research that has determined that we all have biases, heuristic elements (mental shortcuts) and also suffer from framing effects which influence our ability to make rational decisions. This results in behavior which can derail the best laid financial plans.
The second component, traditional finance and economics is still needed to help you to create a financial plan, to build and diversify your portfolio of investments, and to help you understand the effects that the economy will have on your portfolio over time.
The third component, neuroscience, is the newest of these research areas. Neuroscience has learned that our brain “wiring” can cause us to misinterpret signals that we received from our environment and react in ways that damage our financial lives. Our “wiring” can also cause us to have emotional reactions and to act on those emotional reactions, also causing harm to our financial lives.
Behavioral financial advice uses various tools to deal with all three of these components. When done well, behavioral financial advice can greatly increase the likelihood that you will make great financial decisions and achieve your financial goals.
Note: Concepts derived from the course, "Behavioral Financial Advice and Your Clients" by Think2Perform Inc.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.