In conversation with
Dr. Daniel Crosby

Psychologist Dr. Daniel Crosby is Chief Behavioral Officer at Orion Advisor Solutions, a firm that provides technology solutions for wealth managers. An expert in behavioral finance, Dr. Crosby has written two best-selling books, Personal Benchmark: Integrating Behavioral Finance and Investment Management, and The Laws of Wealth. His latest book, The Behavioral Investor, is a comprehensive look at the neurology, physiology, and psychology of sound financial decision-making. We sat down with him to discuss the elements of behavioral finance, how it can help advisors understand their clients, and the role of curiosity in advising.

Flourish: Please briefly explain what behavioral finance is and how it differs from traditional finance. 

Dr. Daniel Crosby: I describe behavioral finance as finance that accounts for the messiness of human nature. Traditional economic models are modeled on an assumption of human rationality and a presumption of utility maximization, which is a fancy way of saying that economists traditionally expected that people would always act in their best interest and try to maximize the benefits they receive from buying a good or a service. In short, in the world of money and commerce, people would act rationally, like unemotional machines. But psychologists observed that, for a variety of reasons and in many ways that form patterns, people don’t always behave rationally. When these observations are applied to the world of finance and investments we get behavioral finance, which deals with financial decision-making as it intersects with the messy, weird, and wonderful way we are all human.

Flourish: Can you describe some of the ways we are irrational in how we deal with money?
Daniel: In The Behavioral Investor I looked at about 200 ways people can make poor decisions and distilled those into four broad categories of biases that affect our thinking about investing and money: 

1. The first involves ego, which really means overconfidence. Most of us, and especially men, think we're smarter, better, faster, and stronger than the next person. Overconfidence can lead to several problems when investing. When we’re overconfident, we believe ourselves to be more prescient about the future than we actually are, which makes us think we have the ability to identify investment winners and losers. It also makes us more confident in our luck than we should be, which makes us underestimate risk. 
   
   2. The second broad area of bias involves emotion. Research has shown that we are programmed so that our likes and dislikes are shaped in milliseconds, much before we are consciously aware of what is happening. As a result, our brains create a “logical” explanation for our preferences after the original, emotion-based reason has been set. If we go with what we like and what feels right when investing, we may be allowing emotion to play too big a role. 
   
   3. Third, we have a bias toward conservatism, or a proneness to the status quo. One form of that is manifested in the way we stick with things that are familiar. People in the Northeast, for example, tend to overweight financial stocks in their portfolios because they are more familiar with the financial companies that dominate the local economy — just as Midwesterners tend to overweight agricultural and manufacturing-related companies and Californians tend to overweight technology. Another form of conservatism is loss avoidance. Behavioral finance research has shown that the loss of, say, $100 is more painful than the joy of finding $100. As a result, people will go to great lengths to avoid loss when investing, often clinging to money-losing investments rather than selling. 
   
   4. Finally, there is attention. We are attracted to the flashy and tend to ignore the mundane. Did you know, for example, that five times as many people die from taking selfies each year than die from shark attacks? That’s because shark attacks make network news while people who get run over while taking selfies when distracted or drunk receive no attention at all. When investing, we often are drawn to what’s hot or what’s in the news, rather than pay attention to things not making headlines.

Flourish: How can understanding behavioral finance help advisors help their clients? 
Daniel: A few years ago, Merrill Lynch looked at all the ways in which advisors add value and found that the behavioral and relationship pieces added more dollars-and-cents value than the technical aspects. Yet having an advisor understand that people don’t always act rationally when dealing with money isn’t just a one-time thing — nor is explaining to a client that their thinking and reactions may be more emotional than they realize. I'm a big advocate for embedding behavioral finance principles and technology throughout the advisor/client journey. 

We know from the literature that people forget about 90% of what they learn within three days if it's not reiterated or personalized for them. So simply knowing about a behavioral finance bias, for instance, or having an advisor teach a client about it turns out to be a weak predictor of how a client will behave. For that reason, behavioral finance insights should be baked into the entire advisor/client relationship. 

Flourish: From our work, we’ve found that cash is a particularly emotion-fraught asset for investors. Why is that?  
Daniel: If you remember Maslow’s hierarchy of needs from college psychology, at the base of human needs are things including food, water, and a safe place to live. Cash serves a similar foundational need in people’s financial lives. It represents safety, security, and certainty. Having cash socked away for a rainy day can free people to make better behavioral decisions with the rest of their money, especially if cash is earmarked as being in a safety bucket.

Of course, one of the behavioral biases that encourages people to hold onto cash, the conservatism bias, also tends to keep them locked into the cash investments they already have, even if their current vehicle earns them substantially less than an equally safe alternative vehicle. One way for an advisor to encourage people to change is to make the change small or incremental. So, instead of suggesting moving a large amount of cash to something new, suggest a small move as a trial. To use a baseball metaphor, sometimes bunting a single is more powerful than slamming a home run. 

Flourish: Imagine a scenario: An advisor has a client that is consistently earning good returns in their investment account. They have a mortgage at 3.5%. Now they want to take money out of the portfolio or out of a cash account to pay off their mortgage and be debt free. How can an advisor approach a conversation with the client that takes the role of emotions into consideration?
Daniel: To start, you always want to understand the why. Let’s say an advisor begins with the understanding that they should reconsider because from a mathematical perspective that’s suboptimal when you have a 3.5% mortgage and cash will get you around 5% today. Why would you do that? If the advisor makes the mathematical case for taking a different path and the client pushes back, that’s where I think we need to be careful. Resistance always has purpose and often it’s that an emotional need isn’t being addressed.

If you begin to ask questions and are curious instead of judgmental, you may learn, for example, that their parents lost their house to foreclosure when they were a child and that this has been their dream to sort of tick that box and have it off sort of the mental clipboard. I think we need to assume a stance of curiosity then make an informed decision from there. It’s only after that client has been able to articulate the emotion behind that resistance that you’ll be able to give the right advice.

Flourish: What new corners of behavioral finance are you planning to explore next? And what can you tell us about your upcoming book?
Daniel: The upcoming book is called The Soul of Wealth and explores where I see the things going with behavioral finance. The growth and the trajectory of behavioral finance has largely mirrored the growth and the trajectory of psychology more broadly. You have Freud early in the game studying brokenness: what makes you sad, what makes you lose your mind, what makes you depressed, anxious, etc. It's not until the 1990s when you get the positive psychology movement that says, "Hey, we know what makes people sad and broken. What about if we studied what makes people flourish? What about if we studied what makes a great leader, or a great parent, or a great instructor?" It has only been about 35 years that we've had a concentrated effort around studying human potential, human flourishing, and human greatness.

Behavioral finance took a similar path, starting out with looking at all the silly ways people blow their money and make dumb decisions. There's a place for that, absolutely. It's only as we understand our brokenness that we can manage the risks that attend that fallibility.

The future of behavioral finance, and what The Soul of Wealth is all about, is money and meaning. How can we use money to buy happiness? How can we use money to bless other people's lives? How can we make our life meaningful and what's the role of money in a life well lived? This next iteration of behavioral finance is one that I think will privilege growth, happiness, and meaning.

This interview has been edited and condensed for clarity. This material is provided for informational purposes only. The views and opinions expressed in this interview are those of the individual being interviewed and do not necessarily reflect the views or opinions of Flourish. The inclusion of any external party in this interview does not constitute an endorsement or recommendation by Flourish. The information provided is not intended as financial, investment, or legal advice and should not be relied upon as such.