Ideal Situations for Behavioral Finance

Applied behavioral finance can foster self-determination with your clients.

by Justin A. Reckers and Robert A. Simon

Originally published by November 18th 2010.

Financial advisors have a myriad of daily client interactions ranging from initial consultations to retirement planning and estate planning. Some of these interactions are underscored by losses clients have experienced such as the loss of a job, a loved one or even a way of life. Other client interactions are impacted by fear such as fear of the unknown, fear of financial reversal or fear of an uncertain future. Still other interactions are complicated by conflict in family or business relationships. The one common factor all of these challenging interactions have is that financial safety and security is an underlying motivator for the conversation. Each of these interactions with clients offers financial advisors an opportunity to promote good decision-making processes and ultimately be a problem solver and even a peacemaker.

Roughly 50% of marriages end in divorce. The end of a marriage brings about strong emotions and complex financial situations. Divorce is the largest financial transaction of most lives. The settlement will, in part, determine financial well-being for many years to come. It is critical it be soundly structured. For many, divorce is the most emotionally chaotic time in their lives. Anger, pain, fear, and guilt along with concerns around power and control all have their roles to play. Financial professionals initially came into the complex world of divorce in the role of being expert witnesses and even “hired guns” to provide expert testimony in court around the value of an asset or appropriate rate of return. These professionals have their place in a divorce process but it is not their role to encourage high quality decision-making. Nor is it their role to concern themselves with what is good or bad for a client.

In family court, litigation focuses on two major issues: child custody and money (property, assets). A large number of financial disputes that make their way into family court can be mitigated or resolved outside of court given the motivation, desire and commitment of both parties and a good peacemaker. Recharacterizing many of the “disputes” in divorce as decision making problems can help couples reach more mutually beneficial settlements and preserve valuable emotional and financial resources. We attribute success directly to our ability to invent financial solutions advantageous to both clients. We expand the pie before dividing it. Skill at inventing options is one of the most useful assets a peacemaker or negotiator can have.

Financial advisors are ideal peacemakers in the context of divorce because they can be a true neutral party. No other professional involved in the divorce litigation has that opportunity. “Collaborative divorce” has the concept of a financial neutral at its core and involves a financial planner trained in the intricacies of divorce and experienced as a neutral party and peacemaker. The neutral financial professional works equally with both parties to gather data, brainstorm options and analyze the short and long term consequences of each option. It is more effective for the parties to think of themselves as partners in an important, side-by-side search for an agreement that is advantageous to both parties. Clients can then transition successfully into their new financial reality with a game plan for financial independence.

Probate disputes can be especially damaging to families. Siblings fight over money with each other. Step parents break wills to take assets intended for children. These can be some of the most difficult transitions in the wake of a loss. The interests of the parties simply are not meeting in these situations. The first and most obvious opportunity for advisors to positively affect this situation is to encourage good planning by clients to avoid there being anything to fight over. In the event a dispute does arise, the advisor can again act as a neutral party.

Emotional involvement on one side of an issue makes it difficult to achieve the detachment necessary to remain neutral and to create wise ways of meeting the interests of both sides. Shortsighted self-concern leads a party to develop only one-sided solutions. Getting to the bottom of the emotional issues, concerns, needs and fears is a powerful means of uncovering the true difference in interests and beliefs and may offer chances for compromise. It is possible for an item to be high benefit to one party, yet low cost to the other side. This difference can allow for agreement if it is clearly articulated and presented. The kinds of differences that best lend themselves to compromise are differences in interests, in the value placed on time, in forecasts, and in aversion to risk. Uncovering these differences is the first step in an advisor’s role shepherding the parties to a mutually beneficial compromise. Observations from behavioral finance can be instrumental in recognizing and evaluating differences in the value placed on time and aversion to risk.

The cloud of emotions that obscures underlying interests is illustrated well in a classic argument over sharing an orange. The story unfolds with two children fighting over an orange, each trying to get more than their half share. The best outcome to the children was to cut the orange in half and try to determine which side was larger and obtain that side for themselves. Mom did the best she could to cut the orange perfectly in half so neither child would feel they had gotten the smaller piece. No matter how much attention she paid there would still be one side larger than the other. This put the two children at odds. In order for one child to gain a larger share the other would have to lose. What they failed to recognize was the interest of the other. If time was spent to remove emotional roadblocks and uncover the interests underlying the negotiation it would have been obvious that the argument was un-necessary. The first child was interested in using the orange to make juice and the other wanted to bake a cake. If they had removed the emotion from the negotiation and talked about interests they would have seen the opportunity to expend the pie to be divided and quickly find a mutually beneficial compromise giving the baker the entire orange peel and the juicer the entire center giving them both 100%, instead of the 51% they so desperately sought in their argument.

Next month we will begin detailing specific client situations in need of intervention using principles of applied behavioral finance starting with financial disputes between couples. Each case will give advisors a practical example of how they can help clients recognize when they have a decision-making problem rather than a dispute. 

Justin A. Reckers, CFP, CDFA, AIF is director of financial planning at Pacific Wealth Management and managing director of Pacific Divorce Management, LLC, in San Diego.

Robert A. Simon, Ph.D. is a forensic psychologist, trial consultant, expert witness, and alternative dispute resolution specialist based in Del Mar, Calif.