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By Steve Lowrie, CFA
Special to the Financial Independence Hub
As a personal financial advisor, I am often asked about “the secret” to attaining financial freedom. Not to go all metaphysical on you, but to improve your long-term outcomes, try looking inward. After all, you are among the few drivers you have much control over. One great way to sharpen your financial acumen is by combining behavioural finance with an evidence-based perspective. Together, these disciplines offer reams of insights on how tending to your own best practices is often the best-kept secret to enjoying wealth management success.
Finding your Behavioural Finance focus
Here’s how The Behavioral Investor author Daniel Crosby describes behavioural finance:
“Emotional centers of the brain that helped guide primitive behavior like avoiding attack are now shown by brain scans to be involved in processing information about financial risks. These brain areas are found in mammals the world over and are blunt instruments designed for quick reaction, not precise thinking. Rapid, decisive action may save a squirrel from an owl, but it certainly doesn’t help investors. In fact, a large body of research suggests that investors profit most when they do the least.”
As early as the 1970s, Nobel laureate Daniel Kahneman was a driving force behind the formation of behavioural finance (along with Nobel laureate Richard Thaler and the late Amos Tversky). In his landmark book, “Thinking, Fast and Slow”, Kahneman describes this same quick vs. precise thinking as System 1 vs. System 2 thinking:
“System 1 [thinking] operates automatically and quickly, with little or no effort and no sense of voluntary control. System 2 [thinking] allocates attention to the effortful mental activities that demand it, including complex computations.”
Long before the term “behavioural finance” was a thing, wise academics and practitioners alike were suggesting investors are best off avoiding their fast-thinking instincts in favor of slower-thinking resolve. As billionaire Warren Buffett said decades ago:
“Success in investing doesn’t correlate with I.Q. … Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
Buffett is correct. And yet, from what I see every day, fast, reactionary thinking continues to dominate most investors’ actions. What else could explain the never-ending parade of people chasing after FOMO (fear of missing out) investment trends instead of following the simple investing strategies, an evidence-based mindset prescribes?
Your brain’s take on Wealth Management
What’s actually going on in our heads when we allow our instincts and emotions to overcome our higher reasoning? Wall Street Journal columnist Jason Zweig’s “Your Money & Your Brain” takes us on a fascinating tour inside the mechanics in our own heads.
For example, Zweig warns us:
“…the amygdala [in your brain] can flood your body with fear signals before you are consciously aware of being afraid … [and] the nucleus accumbens in your reflexive brain becomes intensely aroused when you anticipate a financial gain.”
In this related piece, “It’s the Little Things That Can Color an Investor’s Outlook,” Zweig describes how even seeing the same financial numbers in red vs. a neutral color can unwittingly change our feelings about the data. Additional “insidious influences” include whether we’re hungry or full, sleepy or awake, or experiencing a cloudy or sunny day.
These sorts of overcharged emotions and unconscious biases can steer you wrong when you’re deciding whether to buy, sell, or hold your investments. They can also knock you off course from your holistic financial planning.
Nudging your way to Cost Savings
By adding academic rigor to our thinking, behavioural finance improves our ability to identify and manage our behavioural weaknesses. We can then apply that knowledge toward not reacting to the quick tricks our brain plays on us. Better still, we can learn how to play tricks right back on our brain: turning otherwise adverse instincts to our advantage.
Nobel laureate Richard Thaler is another huge figure in the field of behavioural finance. His best-seller, Nudge, teaches us how to do just that. Thaler describes:
“A nudge, as we will use the term, is any aspect of the choice architecture that alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives. To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting the fruit at eye level [in a buffet] counts as a nudge. Banning junk food does not.”
Thaler describes a financial example of nudging: In the U.S., when employees independently choose when and how much to contribute to their employer’s retirement plan, participation and savings rates tend to be chronically low. More recently, many employers have started “nudging” employees by auto-enrolling them in the plan and increasing their contribution rates annually. Under this model, employees can freely opt out if they DON’T want to participate, but if they simply “go with the flow,” they automatically become better at saving and investing for their retirement.
As an individual investor, there are countless ways you can use similar behavioural nudges to improve your own financial outcomes. For example, you could have a portion of your monthly paycheque auto-deposited and invested in your RRSP or TFSA before natural tendencies kick in and you end up spending it all instead.
Marrying an Evidence-Based Approach to Wealth Management with Holistic Financial Planning
By recognizing and understanding the basics of behavioural finance, you can fight those financial urges and focus on an evidence-based approach to wealth management.
Are you ready to change your financial behaviour, uncover cost savings, and significantly improve your chance of reaching those long-term financial goals? Check out this Forbes article: Need to Beat Your Bad Money Habits? A Behavior Change Expert Explains How.
One key point is to not just focus on investing, but to also take a hard look at how you can increase your savings. Because if you don’t have any money to invest, it doesn’t really matter whether you would be any good at investing it. This CNBC article by financial psychologist Dr. Brad Klontz describes how to use financial psychology to crush those savings goals.
Looking at the data alone is not enough to change your financial perspective. Your personal financial advisor should be looking at your unique financial needs and balancing that with an evidence-based approach to investing. By embracing holistic financial planning, you can approach your wealth management in a measured way, specific to your situation.
Building your Wealth through Behavioural Finance
As The Behavioral Investor author Daniel Crosby has observed,
“Animals use their brains to look out on the world, but it is a unique human capability to look within.”
If you’d like to achieve your long-term financial goals and think a combination of behavioural finance, evidence-based investing, and holistic financial planning would be right for you, reach out and let’s talk!
Steve Lowrie holds the CFA designation and has 25 years of experience dealing with individual investors. Before creating Lowrie Financial in 2009, he worked at various Bay Street brokerage firms both as an advisor and in management. “I help investors ignore the Wall and Bay Street hype and hysteria, and focus on what’s best for themselves.” This blog originally appeared on his site on Nov. 22, 2021 and is republished here with permission.
