Behavioral finance can be described as “the intersection of behavioral psychology and finance that helps explain why people make irrational financial decisions.” In simpler terms, humans are emotional, which often leads us to make suboptimal decisions.
Classical theory assumes that all humans are rational and will make decisions based on a fixed set of inputs to maximize gains. This is not true in almost all cases, especially those involving emotional combinations such as divorce.
Behavioral finance theory states that our brains engage in two types of thinking. The first is our “quick mind,” which makes quick judgments, which is the subconscious mind, and uses emotion and intuition. Our “slow mind” is more logical, calculating, and uses conscious thoughts. Because we make thousands and thousands of decisions every day, our brain prefers the fast system. It will process as many decisions as possible as quickly as possible to be more efficient. The interaction between the two systems and our basic tendency to use our brain’s speed causes behavioral effects that lead to irrational decisions.
There are some behavioral biases that come up again and again in a client’s decision-making process during divorce proceedings. As professionals, it is important to first understand when emotions distort perception. Next, we need to know how to deal with these biases and use them for the benefit of our clients. The following three behavioral biases appear most often and can lead to opportunities for you to demonstrate additional value to your customers.
- Anchoring is the unconscious decision to place additional importance or importance on the first information received about a topic. This anchor does not have to be important, accurate, or even properly vetted information. Clients often have unrealistic opinions about the valuation of a home, business, or other asset because they heard a conversation or read something in the news that linked their thinking to a specific starting value.
It is important to recognize where the perceived value is coming from and whether it is based on logic and fact or is merely an anchor that drives the decision-making process. One way to combat fixation bias is to provide a timeline of events to document how ratings have changed over time. As the information changes, the value also changes. Also, when initially presenting the different normalization options, it may be wise to present the data in different forms or as a set of results. This helps individuals understand that ranges and other options are available, which helps eliminate the fixation bias for a fixed number.
- Loss aversion indicates that potential losses and losses are viewed more seriously than gains. This bias can help explain why no one often feels like a “winner” in a divorce case. Fair splits still result in a net emotional loss for both parties. This is doubly the case in custody battles, where any loss of time with children is seen as a negative rather than a way to spend uninterrupted family time.
Although difficult to overcome, one common technique for overcoming this bias is to change the context of the conversation. Focusing on the benefits of a particular course of action and emphasizing future positives can have a significant impact on a client’s emotional health. From a planning standpoint, loss aversion can be avoided by talking positives about future lifestyle goals (new home, vacations, funded college expenses, etc.). In addition, focusing on the process and the path forward can help put losses into perspective.
- The endowment effect explains how individuals value what they already own higher than what they do not already possess. This can be observed in a number of ways, most commonly in the family’s home or work. Although the true market value of a home may be as high as $500,000, it will inevitably have a higher sentimental value for the property owner.
This is highly related to the present bias, whereby things in the near future have more value. On the surface, a house you can sleep in offers more present value than a pension or retirement account would be worth in 20 years. Knowing how different parties to a divorce value assets can be helpful. When evaluating how assets will be divided, knowing the impact of the endowment can lead to more realistic ideas for finding common ground between the parties.
As you can see, rational thoughts and decisions rarely exist in real life. Understanding how emotions relate to finances and the divorce process is integral to providing value to clients. Please contact our team at Marcum Wealth To help your clients build a financial plan and help them overcome behavioral biases.
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