Behavioral Finance in Practice: Closing the “Behavior Gap”

If you are a regular reader of the New York Times‘s Bucks blog, there’s a good chance you have seen Carl Richards‘s simple-yet-elegant, black-and-white napkin sketches. He has a particular knack for taking behavioral concepts — say, fear and greed, or overconfidence — and translating them into visual images. He likes to explore, and poke fun at, the relationship we all have to money and expose how emotions often have a role to play.

Richards is a certified financial planner, author of the best-selling book The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money, and now also a “financial artist.” He spoke at the Wealth Management 2013 conference.

So what exactly is the behavior gap? It’s what happens when we let emotion get in the way of smart financial decisions. In other words, it’s the distance between what we should do and what we actually do.

Here are some of the key take-aways, in Richards’s words, from his presentation:

• We need to get more comfortable talking about money. “It’s not just about spreadsheets and calculators. We’re taught never to talk about sex, politics, religion, and money in polite company. But in reality, sex, politics, and religion are often part of our conversations. We still have a ways to go on money.”
• We all bring baggage to conversations about money. Don’t jump to premature conclusions. Richards told a story that he also related in a New York Times piece: “My wife mentioned that her friend had recently redone her kitchen. As she explained all of the renovations, I started doing mental arithmetic that quickly added up to big dollars, dollars we couldn’t afford. Instead of engaging in a fun conversation about why my wife liked the kitchen and what she thought was cool about it, I responded with my typical ‘We can’t afford that.’ Of course when she heard my response, my wife gave me a confused look and said, ‘What are you talking about?’ What I took as code for, ‘I want a new kitchen,’ was just my wife talking about something she enjoyed.” Sound familiar?
• Asking “why?” is really important. “We spend a lot of time doing things (such as investing), but seldom stop to ask ourselves: Why are we doing this? It gets to the root of why things become so emotional.”
• Money isn’t about spreadsheets. It’s about our values and goals.
• There’s an awful lot of “noise” out there. “It’s important to be informed, but the line between informed and anxious is very thin, and most of us have crossed it. What does ‘informed’ really mean? What information is helpful and what is just making you anxious?”
• It’s OK to be scared.
• Embrace simplicity. “Simplicity is a really fascinating problem. In professional services, we all think complexity is a sign of intellectual gift and in some areas we think complexity is a selling tool. What we are hearing from clients is: ‘Please, please, please make this simple.’ We confuse ignorant and simplistic with elegantly simple.” Oliver Wendell Holmes, Jr. once said: “I would not give a fig for the simplicity this side of complexity, but I would give my life for the simplicity on the other side of complexity.” (For more on topic of simplicity, see the recent Saturday essay in the Wall Street Journal: “When Simplicity Is the Solution.”)
• Make planning/wealth management a process.
• Trust = Love. “I used to always say ‘trust,’ but I’m not going to be scared anymore of saying ‘love.’ Love is the ultimate financial planning spreadsheet. Love is the ultimate wealth management calculator. If we love people, we’ll do the right thing. If one by one by one we start treating people the way we should be treated as an industry, we will slowly change it. That will be a remarkable experience. If your adviser loves you, guess what? They don’t steal money from you. You don’t worry about whether you have a fiduciary duty or not, you just act as if you do.”
• Focus on what matters. Visualize a Venn diagram. The left circle is “Things that matter.” The right circle is “Things you can control.” The shaded overlapping area is “What you should focus on.”According to Richards, “We spend so much time worried about things that either don’t matter or that we have no control over. If we can instead, for ourselves, and then for our clients, start getting clear about those things that we have control over and that also matter, I think we can make a huge impact financially, but more importantly, on people’s lives.”

For more on the role of emotions, see “Sentimental Journey: Can Professional Investors Harness the Power of Emotions to Make Better Decisions?” from CFA Institute Magazine‘s March/April 2013 issue. Also, Shane Parrish of the Farnam Street blog has put together a very helpful “Behavioral Economics Reading List.”

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Photo credit: ©iStockphoto.com/DrAfter123