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‘Role of financial advisor is to help client identify goals’

Tanya Thomas Mumbai | Updated on January 16, 2018 Published on October 24, 2016

Sarah



The up-and-coming field of behavioural finance combines psychology and economics to help people make more rational financial decisions. In an interview with BusinessLine, Sarah Newcomb, Behavioural Economist, Morningstar Inc, explains how financial advisors can use these tweaks or ‘nudges’ to make savers savvier. Excerpts:

Can you take us through how behavioural finance works?

I work in the intersection of psychology and financial decision-making, so I’m very interested how we think and feel about money that affects the choices we make. A lot of behavioural finance focuses on nudges or small tweaks that we can make to our choice architecture that help us make decisions that align with our long-term goals.

One of the biggest changes in regulation that has come out of behavioural science in the US is that a lot of companies are now making enrollment in the employer-sponsored retirement programme where rather than having to check a little box that says, “Yes, enroll me,” now we take advantage of our natural laziness and you will have to check a box that says, “No, I don’t want to be enrolled.” So, you still have complete freedom on whether or not you’re enrolled but if you don’t bother to do anything, then you’re going to be enrolled. So, we’ve seen some improvement in savings rate because of this. What I’m focusing is on helping people become better decision-makers, or elements of psychology that financial advisors can use when talking to clients to help them set goals and overcome some of the emotional barriers to good money management.



Can you give an example of how financial advisors can gain from this?

One of the biggest barriers we found in behavioural science that keeps us from making good financial decisions is that we discount the future. When something is closer and immediate, we see those costs and benefits as disproportionately large as opposed to our mental picture of the costs or benefits of something in 10 years. So, we repeatedly, in academic studies, take small immediate rewards over large rewards later.

One thing that shows promise is using psychological distance to our advantage. We’ve seen that when people have a closer relationship with your future self, you make better financial decisions. One of the things you can do is age-progress your face, it puts clarity and detail in your own picture of you. It’s like a little brain hack that makes your future more real and the consequence of your saving or not saving feel more real. Another thing that financial advisors can do for clients is to get them to put a lot more detail into the mental picture of their lives in the future.

Why do you think defining financial goals can be tricky for savers?

One study in behavioural economist Shlomo Benartzi’s book on retiring successfully was about asking people to define their financial goals — it could be retiring comfortably, leaving a legacy for their children, or the ability to cover all their healthcare costs in their old age. And then they were handed a list of the 10-12 typical goals that people save for. The study found that statistically, a lot of people failed to identify their highest priority goals. So, when they used this master list, it helped them better identify their goals. And this was after they were given time to really think about it. Financial advisors can help us identify our goals. Prioritising is always difficult. You may think it’s important to leave a legacy of wealth to your children and pay for your health in old age, but you must also figure out that if you have to choose between the two, which one is more important to you.

What can regulators learn from behavioural finance studies?

For those creating policy, the important thing is to make sure that the incentives of people selling financial products must align with the incentives of people buying financial products. In the US, for instance, we are seeing regulations tighten to ensure that advisors sell products that are in the client’s best interest. If a client has a portfolio allocation that is fine to begin with, and there is a new product that the advisor is selling him, and if the only advantage of the new product is that he is paid to sell it, then you’re adding risk and transaction costs and higher fees to a portfolio that is already fine.

Published on October 24, 2016
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