Frontiers in Financial Psychology PDF

Frontiers in Financial Psychology Frontiers in Financial Psychology Members of the LexisNexis Group worldwide South Africa LexisNexis (Pty) Ltd www.lexisnexis.co.za JOHANNESBURG Building 8, Country Club Estate Office Park, 21 Woodlands Drive, Woodmead, 2191 CAPE TOWN TBE Waterfront, 3 Dock Road, V & A Waterfront, Cape Town, 8001 DURBAN TBE Umhlanga, Block A, Park Square, Centenary Boulevard, Umhlanga, 4319 Australia LexisNexis, CHATSWOOD, New South Wales Austria LexisNexis Verlag ARD Orac, VIENNA Benelux LexisNexis Benelux, AMSTERDAM Canada LexisNexis Canada, MARKHAM, Ontario China LexisNexis, BEIJING France LexisNexis, PARIS Germany LexisNexis Germany, MÜNSTER Hong Kong LexisNexis, HONG KONG India LexisNexis, NEW DELHI Italy Giuffrè Editore, MILAN Japan LexisNexis, TOKYO Korea LexisNexis, SEOUL Malaysia LexisNexis, KUALA LUMPUR New Zealand LexisNexis, WELLINGTON Poland LexisNexis Poland, WARSAW Singapore LexisNexis, SINGAPORE United Kingdom LexisNexis, LONDON United States LexisNexis, DAYTON, Ohio © 2023 ISBN Print: 978 1 776 17569 7 eBook: 978 1 776 175703 Copyright subsists in this work. No part of this work may be reproduced in any form or by any means without the publisher’s written permission. Any unauthorised reproduction of this work will constitute a copyright infringement and render the doer liable under both civil and criminal law. Whilst every effort has been made to ensure that the information published in this work is accurate, the editors, publishers and printers take no responsibility for any loss or damage suffered by any person as a result of the reliance upon the information contained therein. Editor: Kevna Jeram Technical Editor: Deena Nair Preface Welcome to the intriguing world of financial psychology. As you embark on this intellect- tual journey through the pages of “Frontiers in Financial Psychology”, it is my hope that you will develop a deeper understanding of human behaviour in relation to financial decision-making and the profound implications it holds for our financial well-being. The authors draw on their wealth of experience in practice and research to craft a col- lection of chapters that delve into the various factors that shape our financial choices. This book goes beyond the traditional boundaries to uncover some often-overlooked psychological factors that underlie our financial behaviours. Each chapter touches on a distinct facet of the financial psychology landscape. From unravelling risk behaviours, to dissecting the profound influence of family, society, and culture on our financial decisions, the authors navigate the psychological terrain that moulds our monetary choices. “Frontiers in Financial Psychology” casts its gaze beyond conventional boundaries, to consider how concepts such as intersectionality and social inequalities influence our financial destinies. The book's exploration of Black Tax and its far-reaching impact, sheds light on the complex interplay of history, identity, heritage, and economic reality. As you delve into the pages that follow, you will encounter not only a wealth of insights drawn from research but also practical strategies for effective communication, counsel- ling, and building trust in the realm of financial advice. The authors guide you through the art of connecting with clients on a deeper level, ensuring that the advice you offer reso- nates harmoniously with their unique life stories. Indeed, the journey through “Frontiers in Financial Psychology” is a testament to the authors’ dedication to unravelling the intricate threads of human behaviour and their indelible impact on our financial lives. So, dear reader, prepare to embark on a voyage of intellectual awakening and intro- spection, guided by the wisdom and expertise of the minds behind this work. May your journey through these frontiers be enlightening, transformative, and, above all, rewarding. Warm regards, Prince Sarpong, PhD, CFP® Associate Professor: School of Financial Planning Law | University of the Free State v About the authors Managing Editor Prince Sarpong, PhD, CFP® is an Associate Professor at the School of Financial Plan- ning Law, University of the Free State. Prof Sarpong holds a PhD and an MCom in Finance from the University of KwaZulu-Natal, a Postgraduate Diploma in Financial Planning from Nelson Mandela University, and a Bachelor of Education (Psychology) from the University of Cape Coast. He is the author of Portfolio Management for Financial Advisors and co-editor of Perspectives in Financial Therapy. Prof Sarpong is a Certified Financial Planner professional and a member of the Financial Planning Institute of Southern Africa. He is also a member (Associate) of the Psychology Society of South Africa, the Global Association of Applied Behavioural Scientists and a member of the Equity and Inclusion Committee of the Financial Therapy Association. Principal Authors Liezel Alsemgeest, PhD, CFP®, is a Director of the UFS School of Financial Planning Law, University of the Free State. She started her career as a Junior Lecturer at the Department of Business Management, in 2006. She completed her PhD in 2011 and also holds a Postgraduate Diploma in Financial Planning Law. She is the programme director for the Postgraduate Diploma in Investment Planning and the Postgraduate Diploma in Estate Planning. Prof Alsemgeest is a Certified Financial Planner professional and a member of the Financial Planning Institute of Southern Africa. She is a co-editor of Per- spectives in Financial Therapy. Her main area of research and passion is the subject area of personal finances and internal finance. Kim Potgieter, CFP® Registered Financial Life Planner, Professional Certified Coach (International Coaching Federation), Certified Dare to Lead™ Facilitator | New Money Story® Mentor Coach, (BSocSci) Clinical & Industrial Psychology. Kim is an author, speaker, voracious learner, and expert financial planner. She believes that you cannot plan for your money without planning for your life first and advocates that life planning is an integral part of financial planning. This allows her clients to live their best possible lives by aligning their money with purpose and meaning. As Director and Head of Life Planning at Chartered Wealth Solutions, she is able to combine her two passions: helping people with their relationship with money and guiding clients to get the most life from their money. Kim has written five eBooks and two books, Retiremeant – get more meaning for your money (2015), and her latest, Midlife Money Makeover (2021). Her message is clear; by understanding your relationship with money, you can begin to shift your mindset to create positive and powerful transitions. Kim is an inspirational speaker and active media personality and is regularly invited to speak at events. Using her Money, Meaning, Mindshift approach, she shifts individuals and groups to pay attention to their lives and give intention to their money. Paul Nixon CFP®, is the Head of Behavioural Finance for Momentum Investments. He established an applied behavioural finance capability after experiencing client and adviser investment behaviour for over 20 years with various SA insurers and Barclays Bank. Paul holds an MBA (with distinction) from Edinburgh Business School and recently completed a Master’s degree (with distinction) where he researched “risk behaviour” at Stellenbosch University. He recently completed a masterclass in behavioural science at the renowned iNudgeYou Institute in Denmark. Paul is a registered member of the Swiss-based Global Association of Applied Behavioural Scientists (GAABS) where he co-leads the Middle East and Africa regions. vii Frontiers in Financial Psychology Rob MacDonald CFP®, is the Head of Strategic Advisory Services at Fundhouse. He holds an M Phil (Management Studies) from Oxford University and is a Certified Financial Planner (CFP®) as well as a qualified coach and counsellor. In addition to having held several senior executive positions, he has extensive experience in coaching and consult- ing to hundreds of financial planners and investment advisers. Rob is a former Director of the MBA Programme at the Graduate School of Business, University of Cape Town; is currently co-organiser of the annual Humans Under Management South Africa confer- ence; and editorial adviser to the Blue Chip Journal. He is co-author of Rethinking Lead- ership (UCT Press, 2000) and author of The 7 Pillars of Financial Health - Partnering with a Professional to Thrive (Vindigo Press, 2023). Hendrik Crafford CFP®, holds a postgraduate Diploma in Financial Planning, an Ad- vanced Postgraduate Diploma in Financial Planning, is a Professional Certified Integral Coach and Credentialed COMENSA Senior Coach. He has developed the Purpose Driven Financial Coaching and Planning modelTM, providing comprehensive training to financial planners and coaches. This collaboration is in partnership with the School for Financial Planning Law at the University of the Free State. Hendrik's expertise extends to his dedicated full-time Financial Coach role. Contributing Authors Ayanda Khumalo has a diverse background in marketing and business administration. Holding a Diploma in Marketing and a Bachelor of Business Administration from the IMM Graduate School of Marketing, she further solidified her expertise with a Master of Busi- ness Administration from the University of KwaZulu-Natal. Ayanda began her career in the field of marketing, honing her skills and gaining valuable insights into the industry. With a wealth of experience under her belt, she transitioned into a role as the Director of the Centre of Financial Planning Studies. Ayanda’s proficiency spans various domains, including management, business development, research, sales, and marketing. Her qualifications and extensive experience highlight her role as a qualified and adept profes- sional in management and specialist roles. Chapter 2 on Behavioural Finance was originally compiled by the following authors for inclusion in the SA Financial Planning Handbook and updated by Prince Sarpong. Gerda van der Linde Gerda has spent over 25 years in the insurance and investment industry in South Africa. During this period she held several management positions at Sanlam and was General Manager Strategic Projects at Auto & General Insurance and was appointed managing director of Verso Wealth (Pty) Ltd in 2022. Her psychology studies and work experience in the investment arena has led to her interest in behavioural finance and she is currently doing research towards a master’s degree in behavioural finance. Gerda is currently the Executive Director of the Institute of Behavioural Finance South Africa. She presents training workshops and seminars and consults to institutions on the application of behav- ioural finance. Professor Zak Nel Professor Zak Nel is a founding member and the current Academic Head and Chairper- son of the Institute of Behavioural Finance. Over the past 35 years Zak filled many senior positions which included Chairman of the Department of Counselling Psychology at UJ, Executive Dean of Damelin International College and Academic Head of the Damelin Education Group. Zak still plays an active role in promoting higher education in southern Africa and holds various positions on the boards of training institutions. viii About the authors Cobus du Plessis Cobus has spent over 25 years in the financial services industry during which period he held various positions in product development, sales, marketing, recruitment and training. He was instrumental in setting up the linked investment services company for Sanlam and helped to build it into one of the leading LISPS within South Africa. He has a great understanding of the needs of the financial planner within the investment field. ix Table of contents Page Preface...................................................................................................................... v About the authors.................................................................................................... vii Chapters Chapter 1 Exploring the evolving field of financial psychology......................... 1 1.1 Introduction: Why financial psychology.................................................. 1 1.2 Financial well-being and mental well-being............................................ 1 1.3 Financial stress vs financial trauma........................................................ 2 1.4 The impact of financial stress and financial trauma on financial health. 4 1.5 Identifying and dealing with potentially traumatic financial events......... 5 1.6 The danger of a single story and the problem of speaking for others.... 6 1.7 Ubuntu: An alternate perspective on financial well-being....................... 8 1.8 Ubuntu and financial psychology............................................................ 10 1.9 Ethical considerations in financial psychology........................................ 11 1.10 Conclusion.............................................................................................. 11 1.11 References............................................................................................. 11 Chapter 2 Behavioural finance............................................................................... 15 2.1 Introduction: What is behavioural finance?............................................. 15 2.2 Historical overview.................................................................................. 15 2.3 Assumptions underlying behavioural finance......................................... 16 2.4 Behavioural finance and decision-making.............................................. 17 2.5 Cognitive and emotional behavioural biases.......................................... 19 2.6 The second generation of behavioural finance....................................... 30 2.7 Behavioural finance and regulatory compliance..................................... 32 2.8 Incorporating risk profiling and behavioural finance into constructing clients’ investment portfolios................................................................... 34 2.9 Taking behavioural finance from theory to practice................................ 42 2.10 Money, emotions and financial behaviour.............................................. 43 2.11 References............................................................................................. 44 Chapter 3 The science of financial decisions....................................................... 47 3.1 Introduction............................................................................................. 47 3.2 The rise of neuroeconomics and how it adds value............................... 47 3.3 Has neuroeconomics delivered a “silver bullet”?.................................... 50 3.4 An integrated model of decision-making................................................ 51 xi Frontiers in Financial Psychology 3.5 Conclusion.............................................................................................. 67 3.6 References............................................................................................. 67 Chapter 4 The long and short of investor risk behaviour.................................... 71 4.1 Introduction............................................................................................. 71 4.2 The South African investor “behaviour tax”............................................ 72 4.3 Theories of risk behaviour...................................................................... 73 4.4 Risk preferences and personality as stable dimensions of risk behaviour..................................................................................... 75 4.5 Risk perceptions in the short term where things go wrong..................... 76 4.6 Practical insights into risk perception and South African trading behaviour.................................................................................... 84 4.7 Conclusion.............................................................................................. 86 4.8 References............................................................................................. 87 Chapter 5 The psychology in risk profiling........................................................... 89 5.1 Introduction............................................................................................. 89 5.2 Current practices in risk profiling............................................................ 89 5.3 Investment suitability.............................................................................. 94 5.4 What “drives the bus”?........................................................................... 95 5.5 “Noise” in investment advice in South Africa.......................................... 96 5.6 Psychometrics and risk profiling............................................................. 101 5.7 Other tools that can provide important discussion points....................... 102 5.8 How technology can bolster personality theory and testing................... 103 5.9 Conclusion.............................................................................................. 104 5.10 References............................................................................................. 105 Chapter 6 Risk behaviour and behaviour tax: discussion of empirical evidence........................................................ 107 6.1 Introduction............................................................................................. 107 6.2 Understanding aggregate risk behaviour................................................ 107 6.3 South African risk behaviour archetypes................................................ 109 6.4 Evidence of stable risk preferences........................................................ 110 6.5 Changing risk perceptions...................................................................... 112 6.6 Archetypes and behaviour tax................................................................ 113 6.7 Conclusion.............................................................................................. 114 6.8 References............................................................................................. 115 Chapter 7 The psychology of retirement............................................................... 117 7.1 Introduction............................................................................................. 117 7.2 The unifying theory of personal finance.................................................. 118 7.3 Models for understanding retirement...................................................... 118 7.4 Dealing with self-control issues in retirement planning........................... 128 7.5 Leveraging mental accounting in retirement planning............................ 128 xii Table of contents 7.6 Reframing the conversation around Retirement..................................... 130 7.7 Mental time travel through prospection.................................................. 130 7.8 The role of financial services providers.................................................. 131 7.9 The role of employers............................................................................. 132 7.10 The role of financial counselling............................................................. 133 7.11 The role of financial planning.................................................................. 133 7.12 Financial education................................................................................. 134 7.13 Conclusion.............................................................................................. 134 7.14 References............................................................................................. 135 Chapter 8 The link between financial socialisation, money scripts and financial conflict............................................................................. 137 8.1 Introduction............................................................................................. 137 8.2 Financial socialisation............................................................................. 137 8.3 What is family financial socialisation?.................................................... 138 8.4 The conceptual financial socialisation model......................................... 138 8.5 Taboo subject......................................................................................... 140 8.6 Social and cultural impact of money....................................................... 140 8.7 Psychological impact of money.............................................................. 140 8.8 Money scripts......................................................................................... 141 8.9 Financial conflict..................................................................................... 143 8.10 Conclusion.............................................................................................. 145 8.11 Bibliography............................................................................................ 146 Chapter 9 Intersectionality and personal finance................................................. 147 9.1 Introduction............................................................................................. 147 9.2 What is intersectionality?........................................................................ 147 9.3 Where does intersectionality fit in personal finance?............................. 148 9.4 Social inequalities................................................................................... 149 9.5 Gender and social inequality.................................................................. 150 9.6 Skewed labour market dynamics and social inequalities....................... 150 9.7 A behavioural economics view on poverty............................................. 152 9.8 A behavioural economics perspective on discrimination........................ 154 9.9 Conclusion.............................................................................................. 161 9.10 References............................................................................................. 161 Chapter 10 Understanding Black Tax and personal finance............................... 163 10.1 Introduction............................................................................................. 163 10.2 The multi-dimensional nature of Black Tax............................................ 164 10.3 Other social phenomena and their impact on Black Tax........................ 167 10.4 Ubuntu and Black Tax............................................................................ 169 10.5 The anchoring bias and Black Tax......................................................... 169 10.6 Black Tax and post-apartheid melancholia............................................. 169 xiii Frontiers in Financial Psychology 10.7 The inherent power dynamics in Black Tax............................................ 171 10.8 Black Tax and narratives of change....................................................... 172 10.9 Black Tax and financial life planning...................................................... 175 10.10 Conclusion.............................................................................................. 176 10.11 References............................................................................................. 176 Chapter 11 Principles of effective communication............................................... 179 11.1 Introduction............................................................................................. 179 11.2 Why do we communicate?..................................................................... 181 11.3 How to communicate.............................................................................. 182 11.4 Conversation skills.................................................................................. 185 11.5 Speaking, the subtle art of sharing your thoughts.................................. 188 11.6 Communication is key to successfully implementing advice.................. 188 11.7 Six principles that underpin the success of communication................... 189 11.8 Key questions to consider when deciding how you will communicate... 192 11.9 The more channels of communication, the better.................................. 193 11.10 The more often you communicate, the better......................................... 193 11.11 The content of your communication....................................................... 194 11.12 Conclusion.............................................................................................. 196 11.13 References............................................................................................. 196 Chapter 12 Principles of counselling and coaching............................................ 199 12.1 Introduction............................................................................................. 199 12.2 Financial planning is about life and money............................................. 199 12.3 Professional services that focus on a client’s life................................... 200 12.4 Implications for financial planners.......................................................... 203 12.5 Deep listening framework for client engagement................................... 205 12.6 Applying the deep listening framework................................................... 207 12.7 Conclusion.............................................................................................. 208 12.8 References............................................................................................. 209 Chapter 13 Principles of building trust.................................................................. 211 13.1 Introduction............................................................................................. 211 13.2 Why is trust such a big deal?.................................................................. 211 13.3 Ethical behaviour is the foundation upon which trust is built.................. 212 13.4 Why does this happen?.......................................................................... 213 13.5 Social impact on ethics........................................................................... 215 13.6 Business................................................................................................. 216 13.7 Five ways organisations provoke good people to be unethical.............. 216 13.8 Counteracting the risk of acting unethically............................................ 220 13.9 Developing an ethical culture in a business........................................... 226 13.10 Conclusion.............................................................................................. 227 13.11 References............................................................................................. 227 xiv Table of contents Chapter 14 Sustainable financial planning............................................................ 229 14.1 Introduction............................................................................................. 229 14.2 Understanding your clients before you understand the numbers........... 231 14.3 Framework for understanding................................................................. 231 14.4 Conversation for understanding............................................................. 232 14.5 The use of assessments......................................................................... 241 14.6 Creating more choice............................................................................. 242 14.7 Moods..................................................................................................... 243 14.8 Language................................................................................................ 244 14.9 Conclusion.............................................................................................. 245 14.10 Bibliography............................................................................................ 245 Chapter 15 Life planning – a connected and holistic approach.......................... 247 15.1 Introduction............................................................................................. 247 15.2 Changing client expectations – a case for life planning......................... 248 15.3 The life planning paradigm..................................................................... 249 15.4 The relationship people have with money.............................................. 251 15.5 Skill set required for life planning............................................................ 253 15.6 Conclusion.............................................................................................. 256 15.7 References............................................................................................. 257 xv 1 Exploring the evolving field of financial psychology 1.1 Introduction: Why financial psychology Epistemology without psychology is like a dinner without food, pure tastes arranged in a series of sweets, salts, bitters, and acids.1 Learning about finances, as it relates to individuals, will not be complete without an understanding of the psychological factors that influence financial behaviour, and this makes financial psychology a very important field in personal finance. Financial psychol- ogy is an interdisciplinary study that employs principles from psychology, neuroscience, behavioural economics, and finance. It explores the complex relationship between money and the human mind to understand how people think, feel and behave around money. Examining the nuances of financial psychology engenders a deeper understanding of the psychological factors that influence financial decision making and helps in devising approaches to help people achieve their financial goals effectively. Behaviours around money can sometimes lead to financial stress, and this is taking a massive toll on people globally. A 2021 study by Sanlam revealed that 57% of South Africans admit that financial stress has a huge effect on their mental well-being. The American Psychological Association (APA), in its yearly Stress in AmericaTM survey, found that 72% of Americans experience some level of stress about money. Although this percentage appears high; according to a 2021 report by ComparetheMarket, a UK-based price comparison organisation, Americans are the least stressed among a group of 36 OECD2 countries. 1.2 Financial well-being and mental well-being The Consumer Financial Protection Bureau defines financial well-being as a state where one can fully meet their current and future financial obligations, feel financially secure, and make decisions that allow one to enjoy life. There is a significant relationship be- tween financial stress and depression, therefore, people experiencing acute financial stress are likely to experience significant depression and vice versa. There is thus a comorbidity between financial distress and depression. This was confirmed in a 2020 study by Megan Ford and her colleague researchers in the United States in a study titled Conceptualising Financial Well-being, Salignac et al., defined financial well-being as the ability to cover expenses, having some money left after expenses, being in control of your finances, and feeling financially secure, both at present and in the future. Salignac et al. developed a conceptual framework of financial well-being which encapsulate the individ- ual, the household, the community, and the society at large (see Figure 1.1). _________________________ 1 George Boas, “Philosophy and Ritual” Proceedings and Addresses of the American Philosophical Association (1951– 1952). 2 Organisation of Economic Corporation and Development. 1 1.2 – 1.3 Frontiers in Financial Psychology Figure 1.1: Conceptual model of financial well-being Societal influencers Community influencers Household influencers Individual influencers FWB Source: Salignac et al. (2020) Models of financial and mental well-being acknowledge the significant impact of external and contextual factors such as the family, culture, society, gender, etc. These external and contextual factors can contribute to financial stress and financial trauma and can also play a crucial role in preventing or supporting attempts at achieving and maintaining desirable mental health. 1.3 Financial stress vs financial trauma According to Eric Gangloff and Neil Greenberg, stress is a response to new life or chal- lenging events such as a job loss, divorce, poor finances, preparing and sitting for examinations or meeting deadlines. Within certain limits, stress response is part of the normal functioning of healthy people. It is only when stressors are repeated, sustained, or extreme, do clinically conspicuous pathologies emerge. Stressors may be external (i.e., psychological, environmental, or social) or internal (for example, illness). Prolonged stress without any relief can lead to a situation called distress, which is an adverse reaction to stress, and may cause physical symptoms to manifest, such as loss of appetite, headaches, high blood pressure, sexual dysfunction, chest pain, and sleep problems. Furthermore, stress can play a role in the development of various physical 2 Exploring the evolving field of financial psychology 1.3 health conditions, such as diabetes, heart disease, impaired healing, and mental disor- ders like anxiety and depression. In addition to stress, we will experience one or more potentially traumatic events (PTE) in our lifetime. Although the connection between these events and the emergence of Post-traumatic Stress Disorder (PTSD) is widely recognised, according to Jaimie Gradus, Professor of Epidemiology at Boston University School of Public Health, a large percent- age of people who experience PTEs do not develop PTSDs. Sônia Silva, in her doctoral thesis on trauma, described trauma as an experience of extreme stress or shock that is, or was, at some point, part of life. The word trauma originates from the Greek word “trauma” (τραύμα), which means “to tear” or “to puncture”. South Africa is among the countries that has suffered prolonged political violence and is still experiencing high rates of domestic abuse, criminal violence, and accidental injury. This has led to a large number of trauma survivors in South Africa, and in one nationally representative survey conducted by Stacey Williams and her colleagues, 75% of re- spondents reported that they had experienced a traumatic event in their lifetime, and more than 50% had experienced multiple traumas. The study revealed that although some South Africans may not have directly experi- enced a trauma event, they may, in one way or the other, have experienced trauma through the sudden death of a loved one, the story of trauma a person close to them has experienced, or witnessed a traumatic incident. Kaminer and Eagle conclude that there are only very few South Africans who have experienced no trauma at all and, for many people, exposure to potentially traumatic experiences are an inevitable part of daily life. Although traumatic experiences are inevitable, they cannot be discounted. However, discussions around trauma can be complicated, given that people may react to the same traumatic experience differently. In this regard, Bonanno and Mancini posit that, given the different ways people adapt to traumatic events, the term traumatic is more of a misno- mer and they suggest using the phrase potentially traumatic event (PTE) since the majority of people who experience PTEs cope remarkably well. According to Bonanno and Mancini, the majority of people who experience traumatic events usually bounce back to the normal level of functioning or gain a semblance of normality within several months to several years after the event and, for the majority, signs of disruption in normal functioning are minimal or non-existent. However, some suffer chronic emotional difficulties. 3 1.3 – 1.4 Frontiers in Financial Psychology Figure 1.2: The Different Reactions to Potentially Traumatic Events Source: Bonanno (2004) shows some of the commonly observed trajectories of response to potential trauma. Galatzer-Levy et al. analysed convergences/divergences across 54 studies in the preva- lence and nature of response trajectories and out of the 67 cases that they gleaned from the 54 studies, they found that the most common trajectory after PTEs were: resilience (63 cases), recovery (49 cases), chronic (47 cases), and delayed onset (22 cases). The modal response across the studies was the resilience trajectory (with an average of 65.7% across populations), followed in prevalence by recovery (20.8%), chronicity (10.6%), and delayed onset (8.9%). 1.4 The impact of financial stress and financial trauma on financial health The Financial Health Institute defines financial health as “the dynamic relationship of one’s financial and economic resources as they are applied to or impact the state of physical, mental and social well-being”. Poor financial health and high financial stress are not only peculiar to low-income earners and people living in poverty. If an individual finds it difficult to meet current expenses or is worried about current or future finances, the individual is under financial stress. 1.4.1 Financial stress There are two components to financial stress namely: objective financial stress, and subjective financial stress. There is an objective financial stress when a person does not have enough funds to cover necessary expenses or debts, whereas subjective financial stress emanates from one’s perceptions about current or future finances, which leads to worry and distress. The two kinds of financial stress may impact people differently. For example, one person may have difficulties in meeting expenses, and consider it to be a normal experience and may not worry about the situation. However, another person may 4 Exploring the evolving field of financial psychology 1.4 – 1.5 be reasonably financially secure but still feel stressed about current and future finances. There are many factors, both contextual and personal, that can influence one’s current level of financial stress. Contextual factors emanate from the impact of socio-political and socio-economic influ- ences on the overall economy, and include financial market performance, economic growth rate, political and governmental policy, and the distribution of wealth. Personal factors vary from one person to the other, and the impact may vary as well. For example, demographic characteristics such as race, gender, ethnicity, age, and education may influence a person’s access to financial resources. Other personal factors that have financial implications include life scripts,3 personality traits, financial literacy, and signifi- cant life events such as marriage, retirement, disability, or having a child. A study by Elbogen et al., in the American Journal of Epidemiology revealed that peo- ple who experience significant financial stress are twenty (20) times more likely to attempt suicide than people who do not experience significant financial stress. Soomin Ryu and Lu Fan of the University of Maryland and the University of Georgia, respectively, argue that the existence of loans and other debt can increase the levels of anxiety, distress, and depression, and make a person susceptible to the risk of suicidal ideations. To compound this problem, financial stress and mental health issues reinforce each other, therefore, individuals experiencing mental health issues are more likely to experience financial stress and financial stress can also add to mental health problems. 1.4.2 Financial trauma Financial trauma is a dysfunctional reaction to chronic financial stress, and describes the cognitive, emotional, relational and physical symptoms triggered by significant financial stressors. Financial stressors include unemployment, homelessness, poverty and food insecurity, and can have a lasting impact on an individual’s physical, mental and financial health. An online article on financial trauma in Forbes written by Brianna Wiest quotes Galen Buckwalter, the CEO of psyML: “Our stress system was made to help us turn on every cell in our body in response to a threat to our existence. Fight or flight or freeze for those times when we just can’t cope... But all of these systems were developed long before humans had even figured out what money was. Now, when we can’t pay all our bills our stress system goes all in, much the same as if a streak of tigers had ambushed us back in the day. Except back in the day we either made it out of the tigers’ path and were able to relax that night or we were tiger food. But with financial trauma there is no downtime, our stress system is locked on overdrive. It’s not how we were designed.” To understand financial trauma, it is important to understand the contribution of both contextual and personal factors. Financial trauma, and poverty, in particular, cannot be understood fully without taking into consideration the intersectionality of oppressive systems such as classism and racism, as well as untreated mental health conditions, addiction and substance abuse, which inhibit upward social mobility. 1.5 Identifying and dealing with potentially traumatic financial events Financial stress, if not properly dealt with, can lead to financial distress, which in turn can lead to financial trauma. Luckily, there are tools in financial planning which can be used to identify financial stress and potentially traumatic financial events before they evolve into financial distress. The South African Financial Planning Handbook, for example, has a _________________________ 3 Unconscious systems of psychological self-regulation and organisation developed mainly from implicit memories and emanate from the cumulative failures in significant, dependent relationships. 5 1.5 – 1.6 Frontiers in Financial Psychology chapter on personal financial management which helps financial planners to gain insight into their clients’ financial situations. Where a client’s monthly expenses continually exceeds their monthly income, this could be a red flag that the planner can help the client address as a potential source of financial distress. Where a client is already experiencing financial distress, again, approaches in personal financial management can be employed, together with approaches in financial coaching and financial life planning, to help clients recover and/or develop resilience to overcome their financial distress. Where a client is experiencing financial trauma, approaches in financial counselling, financial therapy, financial coaching and/or personal financial management may also be employed to help a client. In her book, Healing Financial Trauma, Thembisa Luthuli, argues that the path to prosperity is not only a physical and mental journey, it is also a journey of self-awareness and restoration, therefore, any approach that the financial planner uses will also benefit from the incorporation of these approaches in life planning. The majority of people who experience PTEs will not experience financial distress or financial trauma, and some clients whose expenses continually exceed their incomes may also consider it normal and not experience any kind of stress. However, this could have other future implications. For example, this may prevent a client from saving enough for retirement, or a continual dependence on loans and credit to meet monthly expenses, which is not sustainable and could lead to a potentially traumatic experience in future. Assisting clients to effectively manage their money can potentially alleviate mental dis- tress. As a result, financial planners should use a comprehensive strategy when their clients are experiencing mental stress due to financial issues, and they should promote suitable referrals and collaborations among financial and mental health experts. Addition- ally, Ryu and Fan suggest that more financial counselling services aimed at helping to reduce financial stress should be customised to target financially vulnerable populations. 1.6 The danger of a single story and the problem of speaking for others In his book titled African Psychology: The Emergence of a Tradition, renowned academic in African psychology, Augustine Nwoye points to the dangers of a single story and the problems of speaking for others and recommends an inclusive engagement or multilogue in the field of psychology. Although the field of psychology prides itself as a data-driven science, Professor J.J. Arnett highlighted a major weakness in the evidence on which measures, models and theories in psychology are developed. His study revealed that the leading journals in six subdisciplines of psychology focused almost exclusively4 on a Western cultural context which is shared by only 5% of the world’s population. Therefore, the generalisability of findings based on an unrepresentative cultural context could be problematic. Relying only on a single perspective or narrative to understand the experiences, emo- tions or behaviours of a person can lead to oversimplification and misunderstanding. Humans are a complex amalgamation of unique factors shaped by culture, the environ- ment, and personal histories. Therefore, reducing one’s identity to a single story could lead to disregarding the richness of diverse experiences, and would perpetuate biases and stereotypes. Furthermore, in a profession like financial planning and related profes- sions where the planner is the expert, there is the risk of assuming that the professional’s own voice is the only valid one. _________________________ 4 Over 70% of samples and authors. 6 Exploring the evolving field of financial psychology 1.6 According to Prof Nwoye, the dangers of a single story and the problems of speaking for others make it necessary to consider factors that are not adequately dealt with in traditional/western psychology. For example, while it is common to hear statements such as “one’s relationship with money” or a “dysfunctional relationship with money”, within the framework of African philosophy and psychology, people relate to other people, their ancestors, etc.5 and not necessarily with money. However, money can introduce dysfunc- tion to relationships and even to non-relationships6 among people. Furthermore, in the case of Black Tax, the act of extending financial help to one’s ex- tended family may be viewed through two lenses: the lens of Ubuntu, and, on the other hand, the lens of utility maximisation (income, expense, net worth, and financial freedom). A person may, therefore, end up holding two contradicting beliefs. Within the framework of popular identified behavioural biases, one of the biases that come to mind is cognitive dissonance, which is the discomfort an individual feels when their behaviour is not aligned with their values or beliefs. It can also occur when an individual holds two contra- dictory beliefs at the same time, or when one encounters new information that contradicts existing ideas, beliefs or values. The concept of cognitive dissonance was developed by Leon Festinger and is based on how people try to achieve internal consistency. A person who experiences cognitive dissonance may develop psychological discomfort and strive to minimise this dissonance. This person will actively try to avoid information and situations that are likely to increase dissonance. Figure 1.3: Cognitive Dissonance Theory Action Change Belief Dissonance Change Action Dissonance Belief Change Action Perception The challenge with the interpretation of Black Tax within this framework is that, although there are two conflicting beliefs, contrary to the assertions of Cognitive Dissonance Theory, black people who talk about Black Tax may not be seeking internal consistency because there is Cognitive Tolerance. Findings from studies in Malawi, for example, provided psychological evidence to challenge the universality of the dissonance reduction process. Most Malawians were comfortable holding two different belief systems without any feeling of dissonance. The phenomenon of Cognitive Tolerance is among the many reasons why psychology is criticised for failing to meet the needs of other cultures. _________________________ 5 This is captured in the Ntu philosophy, which is based on the belief that there is a vital force or energy that connects all life, both human and non-human. 6 For example, a desire to keep up with the Joneses (people you may or may not even have any relationship with) may lead one to spend beyond one’s means. 7 1.6 – 1.7 Frontiers in Financial Psychology With Cognitive Dissonance, holding two opposing beliefs heightens dissonance which leads to the taking on of three routes to minimise the dissonance. The person can choose to change beliefs, change action, or change action perception. Taking any of these actions leads to the dissonance being eliminated or minimised to eliminate the psycholog- ical discomfort. Figure 1.4: Black Tax, Cognitive Tolerance and Psychological Distress Ubuntu Cognitive Overstretched Financial Tolerance Budget Distress Utility Maximisation With Black Tax, the source of the psychological distress may rather emanate from the ability to hold two opposing distresses without engendering any form of Cognitive Disso- nance. It is possible that the psychological discomfort does not emanate from holding non-aligned or opposing values/beliefs, rather, the ability to comfortably hold two oppos- ing values can lead to an overstretched budget which then leads to psychological distress. Cognitive Tolerance may, therefore, lead to financial inertia as one does not adopt an approach to change beliefs, action, or action perception. To better understand people’s behaviour around money in South Africa, and Africa in general, it is critical to consider the African worldview to avoid the danger of a single story and the problem of speaking for others. Furthermore, Professor Len Holdstock, an emi- nent foundational scholar in African psychology, points out that an African worldview supports the argument in cultural psychology that people cannot be studied in isolation from the context (social, geographical, and historical) in which they live. 1.7 Ubuntu: An alternate perspective on financial well-being What is financial freedom? The definitions are varied, and in this section, we will not attempt to provide a definition. However, an understanding of the concept of freedom may help us better understand what financial freedom is. In his book Psychopolitics, Byung-Chul Han provides an interesting perspective on the meaning of freedom. He argues that we live in an intriguing time where freedom is engendering compulsion and constraint. According to Han, the freedom of Can is more coercive than the disciplinarian Should, which issues prohibitions and instructions. While Should has a limit, Can has no limit. Therefore, the freedom of Can engenders unlimited compulsion. This creates a paradox since, essentially, freedom is the opposite of compulsion and coercion. Therefore, being free means freedom from constraint. However, freedom itself is producing coercion. Han argues that psychic maladies, such as burnout and depression, reveal a serious crisis of freedom since they represent pathological signs that freedom has now switched to com- pulsion. 8 Exploring the evolving field of financial psychology 1.7 “Only in community [with others does each] individual [have] the means of cultivating his gifts in all directions; only in the community, therefore, is personal freedom possible”.7 From this perspective, Han opines that being free essentially means self-realisation with others; therefore, freedom is synonymous with a (successful) working community. We can therefore argue that true financial freedom can be achieved if there is a mindset shift from having to being. Canadian sociologist, Michèle Lamont, argues that moving from “having” to “being” will require valuing oneself (and others) based on their relations to others, experiences, moral and other qualities, and not based on what material resources one has. Lamont argues that the heightened dissemination of neoliberal narratives centred around competition, material success and self-reliance is driving the upper-middle class towards a state of mental health crisis, while the working class and low-income earners lack the means to fulfil their aspirations. Han, for example, argues that: “Today, people no longer work to satisfy their own needs, rather, people work for Capital, and Capital generates needs of its own. However, people mistakenly perceive these needs to be theirs. Capital, thus, represents a new form of transcendence that entails a new kind of subjecti- vation. In essence we have moved away from the sphere of lived immanence – where life relates to life instead of subjugating itself to external ends.” Lamont argues that a possible pathway for progress involves expanding cultural inclusion through the promotion of alternative narratives that instil hope, incorporate diverse measures of value, embrace the concept of “ordinary universalism”, and reduce the stigma surrounding marginalised communities. The concept of ordinary universalism and shifting from having to being is the corner- stone of the Ubuntu philosophy: I am, because you are, because we are. True financial freedom can only be achieved within a successful working community.8 Therefore, re- gardless of the way financial freedom is defined, and regardless of the approach and philosophical orientation, any approach to achieving financial freedom will benefit from a reorientation on the essence of personhood. Holdstock linked the concept of Ubuntu to some aspects of the person-centred ap- proach developed by Carl Rogers in the 1940s. He argues that Rogers emphasised positive regard, empathy, and congruence as indispensable elements in establishing sound human relationships. These three conditions embody “the way the concept of Ubuntu comes to life in Africa” and are necessary and sufficient conditions for therapy. He concluded that Africa’s holism has crucial implications for psychology as an applied profession and as a scientific discipline. The principle of humanness embodied in Ubuntu can be beneficial to psychotherapy and will require a shift in focus towards actualising the potential of human beings and preventing mental illness. According to Holdstock, psychology cannot continue to be a purely reactive discipline that is mainly skilled in the application of band aids. While applying band aids may be necessary, they are not sufficient to alleviate the mental health crisis. The resources of the community in preventing and the treating of mental health issues must be utilised more efficiently beyond what has been done to date. The task for psychology is therefore not to simply help people cope with the difficulties in living, rather, it is to revise the nature and structure of the society in which we live to make it more facilitative and less harmful to the lives of its members. _________________________ 7 Karl Marx and Friedrich Engels, The German Ideology, Part One, ed. C. J. Arthur (New York: Interna- tional Publishers, 2004), 83. 8 Community here is used loosely to mean anything from a small social circle to an entire community and even the country as a whole. 9 1.8 Frontiers in Financial Psychology 1.8 Ubuntu and financial psychology The African philosophy of Ubuntu has significant relevance in financial psychology as it highlights the importance of human relationships and interconnectedness in mental and physical well-being. Thomas Joiner in his book Lonely at the Top, for example, argues that men have made a Dorian Gray-like trade of success for an acute feeling of empti- ness, loneliness, and disconnection. Growing up, boys are just as connected in their close friendships as girls, however, boys tend to neglect their personal relationships in pursuit of external success. Besides its unpleasant feeling, loneliness is an interpersonal impairment which has a negative and significant impact on men. Studies have shown that solely focusing on accumulating material goods and wealth can lead to decreased overall happiness in life and decreased satisfaction in intimate relationships. As part of the Harvard study of adult development, one of the world’s longest studies of adult life, the researchers followed a group of men for eight decades and, throughout the study, and at different points in their lives, they were asked: “Who would you call in the middle of the night if you were sick or afraid?” The study found that the men who had someone to turn to were happier in their marriages and in their lives, and were also, physically healthier over time. In addition to its emotional cost, loneliness also has physical health implications. Stud- ies have shown that close relationships with other people have more of an impact on our longevity and physical health than even our genes do. A satisfying relationship life can increase longevity by as much as 22%. There is evidence that, as a risk factor, loneliness is comparable to high blood pressure, obesity, and smoking. Studies have also shown that there is a correlation between loneliness in men and car- diovascular disease as well as stroke. Furthermore, 80% of successful suicides are men, and loneliness is one of the main contributory factors to suicide. Since many physicians ask their patients about risk factors such as the consumption of alcohol and smoking during physical checkups, the research suggests physicians should also ask how satisfy- ing their patients’ closest relationships are. Just as physicians are advised to ask whether their clients have satisfying relationships, it will be helpful if financial planners and profes- sionals who focus on the financial health of clients also broaden their approach to ask not just about client relationships with money but also, relationships with others. In trying to deal with the distress that people experience with money, the approach has normally been focused on identifying and resolving dysfunctional relationships with one’s money which inadvertently makes money the focal point. From the African psychological perspective, the focus should be on the realms of existence. In this regard, the study of how money influences our behaviour will be incomplete if it focuses only on the individu- al’s behaviour around money (or relationships with money) without looking at the broader impact of the dysfunction that money can introduce in relationships with others, which in turn have an impact on mental and physical health. With respect to revising the nature and structure of the society in which we live to make it more facilitative and less harmful to the lives of its members, it is refreshing to note that this is taking shape within the field of financial life planning. Kim Potgieter, a renowned inspirational leader in the financial planning industry, in Chapter 15 for example, opines that in conversations with many South African planners, there appears to be a trend towards valuing relationships, health, purpose, give-back, experiences and learning above owning things. She concludes that the quest to find meaning and significance trumps making more money. Financial life planning as we know it, essentially, reflects the principle of Ubuntu, and can help people find harmony, meaning a sense of purpose and financial well-being. 10 Exploring the evolving field of financial psychology 1.9 – 1.11 1.9 Ethical considerations in financial psychology Since people experiencing significant financial stress are twenty (20) times more likely to attempt suicide, and the fact that financial stress and mental health issues reinforce each other, immediately, when the financial planner suspects any potential psychological issues, the planner must discuss them with the client the importance of seeking help from a suitably qualified mental health professional. Although the psychology of financial planning highlights the impact of client psychology on financial behaviour, financial plan- ners and related professionals within the financial services industry are bound by their various codes of ethics to only practice within their scope of expertise. It is important for financial planners who do not have therapeutic training, to be aware that going too far into mental health discussions can be a dangerous territory and can cause harm, particularly if planners evoke emotional responses that they are not trained to address. 1.10 Conclusion Financial psychology provides profound insights into the motivations and decisions that guide our financial choices. This chapter highlights the link between financial health and mental well-being and delves into the concepts of financial stress, trauma, and potentially traumatic financial events. The chapter cautions against the peril of a single story and reminds us that each person’s financial journey is a narrative woven from unique threads. Furthermore, incorporating cultural perspectives, including the Ubuntu philosophy and the contributions of African psychology, enhances our understanding of financial well-being as a collective endeavour that transcends individual pursuits. The chapter concludes with a note on ethical considerations, which serve as a guiding compass, and highlights the responsibility that accompanies our understanding of human behaviour and finance. 1.11 References Arnett, J. J. 2016. The neglected 95%: why American psychology needs to become less American. Bonanno, G. A. 2004. Loss, trauma, and human resilience: have we underestimated the human capacity to thrive after extremely aversive events? American psychologist 59 (1):20. ———. 2008. Loss, trauma, and human resilience: have we underestimated the human capacity to thrive after extremely aversive events? Bonanno, G. A., and A. D. Mancini. 2008. The human capacity to thrive in the face of potential trauma. Pediatrics 121 (2):369-375. ———. 2012. Beyond resilience and PTSD: Mapping the heterogeneity of responses to potential trauma. Psychological trauma: Theory, research, practice, and policy 4 (1):74. Compare the Market. Financially Stressed Countries 2021 [cited 21 February 2023. 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Rubin, D. Berntsen, and I. C. Siegler. 2013. The frequency and impact of exposure to potentially traumatic events over the life course. Clinical psychological science 1 (4):426-434. Ryu, S., and L. Fan. 2023. The relationship between financial worries and psychological distress among US adults. Journal of Family and Economic Issues 44 (1):16-33. Salignac, F., M. Hamilton, J. Noone, A. Marjolin, and K. Muir. 2020. Conceptualizing financial well-being: An ecological life-course approach. Journal of Happiness Studies 21 (5):1581-1602. Silva, S. 2014. Engaging touch & movement in somatic experiencing® Trauma resolution approach, Tesis de doctorado, International University for Graduate Studies). 12 Exploring the evolving field of financial psychology 1.11 Sue, S., J. K. Y. Cheng, and L. Sue. 2011. Problems in generalizing research to other cultures. In Understanding research in clinical and counseling psychology: Routledge, 355-376. Wiest, B. Financial Trauma Is A Reality For One Third Of Millennials, This Expert Ex- plains How To Recover. Forbes 2019 [cited 27 April 2023. Available from https://www.forbes.com/sites/briannawiest/2019/04/04/financial-trauma-is-a-reality-for- one-third-of-millennials-this-expert-explains-how-to-recover/?sh=13c4e3ed130c. Williams, S. L., D. R. Williams, D. J. Stein, S. Seedat, P. B. Jackson, and H. Moomal. 2007. Multiple traumatic events and psychological distress: the South Africa stress and health study. Journal of traumatic stress 20 (5):845-855. 13 Behavioural finance 2.1 Introduction: What is behavioural finance? The investor’s chief problem – and even his worst enemy – is likely to be himself. Benjamin Graham Behavioural finance seeks to identify mistakes made by a client and by the financial planner during the financial planning process. Most of the mistakes relate to the way we think and decide about financial matters, and include mistakes about investment decisions and the planning of an investment portfolio. These mistakes tend to be: (a) irrational, (b) that we are often unaware of our mistakes, and (c) the mistakes we make tend to repeat themselves in a systematic fashion. By describing the mistakes as irrational, we mean that the mistakes are clouded by illogical emotions and contrary to good reasoning. In our professional practices, we truly believe that the decisions we make are sound and logical and that they are made with good intentions. We endeavour to serve the interests of clients to the best of our abilities, but in essence, the decisions are intuitive, and it is often on an unconscious level of decision-making. It is for this reason that we say that we are unaware of the finan- cial planning mistakes that we make. In describing the mistakes as systematic we imply that the mistakes crop up in patterns and that they will be repeated if we do not intervene and rectify our thinking and decision-making. Behavioural finance is therefore not only about the negative aspect of identifying mistakes, but it serves the positive purpose of giving us the tools to make more informed and hopefully rational decisions. 2.2 Historical overview At the beginning of the 1940s, a dramatic revolution took place in the USA in the fields of economics and financial markets as the power of mathematical and statistical prediction models was discovered. Economists and stockbrokers were thrilled with the “objectivity” and “detachment” underlying the mathematical and statistical procedures, and as a result, the assumption was made that a person could automatically make rational decisions when confronted with financial options. In fact, this assumption was so strong that it became the basis of most economic models. The assumption is best expressed in the perspective that views man as Homo Economicus. In the 1970s some doubts developed about the underlying principles of man as an ever-rational financial decision-maker when Amos Tversky, a prominent Stanford Univer- sity academic, observed that investors repeatedly make errors in judgement, not random- ly, but in a way that can be predicted and categorised. As an outcome of his research, he became convinced that investors tended to focus more on risk than benefits, that people treat gains and losses differently and, in particular, that negative changes are weighted more heavily than gains. It was then realised that some of the common mistakes on which investment decisions are based are emotions (greed and fear), errors in thinking (investor over-confidence) and misinformation (for example, “noise”). In the end, it is the 15 2.2 – 2.3 Frontiers in Financial Psychology total person with emotions, prejudices, subjectivity and fears that make financial decisions – in other words, it is Homo Sapiens and not Homo Economicus who make financial decisions. Behavioural finance also has implications for financial markets. Going hand-in-hand with the earlier assumption that man is ever a rational financial decision-maker, is the notion that financial markets are also rational and highly efficient. This assumption, introduced in the 1950s, is best expressed by the Efficient Market Hypothesis (EMH). Behavioural finance does not totally reject the idea of the EMH, but believes that the market in the short term is affected by irrational sentiments and that the short-term share price therefore does not reflect all relevant information. To illustrate the irrationality of decision-makers and how it can affect the markets, Hersh Shefrin in his influential book entitled Beyond Fear and Greed gives a telling example, called “pick-a-number-game”. This game illustrates how people can commit errors while making decisions, and how these errors can cause the prices of securities to be different from what they could have been in an error-free market. 2.3 Assumptions underlying behavioural finance The EMH has been the central proposition of finance since the 1950s when it was intro- duced by Markowitz. The hypothesis is based mainly on three arguments: It is assumed that investors are always rational and therefore will value securities rationally. In cases where investors are not rational, their trades are random and therefore cancel each other out. In the case where investors are irrational their influence is eliminated by rational market arbitrageurs. Proponents of the EMH will therefore argue that prices of assets equal the fundamental values of assets and, as a result, investors find it impossible to beat the market that will always correct itself in a very short space of time. The behavioural finance approach on the contrary assumes a different point of departure as it postulates that people use rules of thumb, known as heuristics, to assess assets. As explained later, heuristics by their nature are imperfect and as a result will give rise to unsystematic biases that can move prices away from fundamental values on occasions for very long periods of time. Sometimes behavioural finance may mean many things to different people, but the editors of the Financial Analysts Journal are convinced that there are some common assumptions underlying it, namely: All investors, because they are human, are subject to making systematic errors as they are not as objective as they believe they are. Investors listen to all kinds of information, attaching different weights to pieces of information that most probably suit their personal convictions the best. Investment planners and investment analysts in the honest pursuit of their craft are subject to related and equally pernicious errors in judgement because they also are imperfect processors of information. An analysis of most investment decisions reveals the decisions contain emotional elements of hope and fear. Economists are more confident than they should be in their forecasting ability. 16 Behavioural finance 2.3 – 2.4 Often we are driven by the negative motives of greed and fear, meaning that investors repeatedly make all the wrong decisions at all the wrong times – buying in on greed when prices are peaking, selling out on fear after prices have plummeted. The result of this is that we jeopardise the achievement of our financial objectives. Peter Bernstein in his book Against the Gods concluded that when we face uncertainty in our financial decisions and choices, we tend to repeat patterns of irrationality, inconsistency and incompetence. O’Toole and Steiny say that in our financial decision-making, we often end up acting like confused Christmas shoppers who, instead of buying lots of gifts at a store with a 50% off sale, load up instead on items from the store that has marked every- thing up by 50%. They have labelled this pattern of behaviour as the “cycle of emotion”. 2.4 Behavioural finance and decision-making Behavioural finance attempts to explain and increase the understanding of how investors make decisions. Research focuses on the reasoning patterns of investors, including the emotional processes involved and the degree to which reasoning patterns and emotions influence the decision-making process. Behavioural finance theorists explain that, in practice, investment decisions are seldom made strictly according to rational choice. As already explained, investors have a predis- position for error in their decisions, but they are unaware of it, and an irrational investor is more often than not an unhappy and dissatisfied investor. The good news is that the mistakes they make are made in patterns that we can study and understand and are therefore systematic. In behavioural finance, we say that investors’ rationality is bounded and places limita- tions on their decision-making abilities. These boundaries originate from three areas: the investors’ cognition – the way they perceive and organise information and the resulting errors in their thinking, also referred to as heuristics and biases; the investors’ emotion – the way they feel when they register information, also referred to as their greed and fears; and the investors’ social environment – how they relate to the pressures and information from their social environment. We can add to this the influence of the specific investors’ personality type, gender, think- ing preference and intelligence (IQ and EQ). An investor is a complex human being and their decision behaviour is influenced by all the factors mentioned above and more. It is important to realise that behavioural finance does not replace the traditional finan- cial prediction models but strives to give explanations and improve insight into the deci- sion-making processes of individual investors (novice and experienced) as well as institutional investors. Because emotion and social forces often drive decision-making, investors will always try to find a rational reason for their irrational decision after it has been made. Behavioural finance attempts to explain to investors how they make judge- ments and then choose to take action. It was Kahneman and Tversky who introduced the two systems of cognitive functioning – intuition and reasoning, also referred to as the intuitive mind and reflective mind of the investor. Intuitive thinking is what we do most of the time and it happens fast, effortlessly and automatically. Although intuition might be an effortless thought, it does not always occur without self-monitoring of the quality of mental operations taking place. Ellen J Langer labelled it as “mindless behaviour”. Reasoning or reflective thinking is slow, conscious, orderly and requires effort and attention. When engaging in reasoning a 17 2.4 Frontiers in Financial Psychology person can only pay deliberate attention to one task at a time, and will respond mindless- ly to other tasks done at the same time. A financial planner can assist investors in managing the cognitive errors associated with irrational investment decisions. However, to be able to assist clients, the financial planner must have some knowledge regarding the two modes of thinking. It is also im- portant to be able to recognise thinking errors – biases – originating from the intuitive mind and happening without the client being aware of it. Whilst it is not possible for the financial planner to help their clients avoid all mistakes, clients can be taught to recognise situations in which they are likely to make mistakes and can be given assistance to try and avoid them. Kahneman reminds us that it is easier to recognise other people’s mis- takes than our own. In decision-making, the ease of remembering and retrieving old information and bring- ing it in relation to new information is important. Kahneman explains that it is important to remember the previous information on which decisions were based and equally important to “marry” new information with the knowledge already gained. The skill lies in using old and newly gained knowledge and then making an optimal decision. This skill is important when a financial planner transfers information to clients. The financial planner needs to establish the level of financial knowledge of a specific client and explain the proposed solution accordingly. Because clients tend to make decisions intuitively, there is always the risk that the client may not remember why they made the decision in the first place. The financial planner must always be aware of the risk of intuitive decisions, not only by clients, but also by themselves. For an inexperienced decision-maker mostly one option or answer will come to mind. People are not used to thinking hard and reasoning before making decisions and often trust any reasonable answer that comes to mind. This bounded rationality (limited atten- tion) makes the average investor prone to fads as they will focus on the prominent infor- mation, says Robert Shiller, and will therefore easily be manipulated by others. The financial planner must force deliberate reasoning by themselves and their client. This is very important in the current regulatory environment as the average investor will trust any reasonable explanation given of a product without questioning the logic thereof. But if the financial planner chooses to use this fact to guide their client to less optimal decision- making, it may come back to them as a complaint at the FAIS Ombud. It is not easy to find a model of rational decision-making to follow whilst making decisions. To guide the financial planner in the decision-making process we would like to propose a normative decision-making model consisting of four phases (see Figure 2.1). This model is complementary to the advisory process proposed in the FAIS General Code of Conduct (GCC): The first step is problem recognition and identification. From contemplating the prob- lem it will be clear to you that this step is not always as easy as it sounds. In fact, peo- ple often distort, omit, ignore and discount information that provides clues regarding the existence of problems. As already explained, it is also obvious that an investor’s personal history, personality dispositions, assumptions and lack of information are some of the factors that inhibit them from framing a clear problem statement. In the financial context, we can refer to a needs and/or goals statement. The next step is alternative generation in which possible solutions are identified. Greenberg and Baron say that it is important to conceive problems in a way that allows possible solutions to be identified. In many financial planning situations, the problem identified may be a problem of seeking sensible investment opportunities for the stage 18 Behavioural finance 2.4 – 2.5 of life in which clients find themselves. In many situations, it is evident that financial planners as well as clients tend to rely too much on previously used approaches that might lead to wrong decisions. The third step is to evaluate alternatives and choose a solution. It may be about alter- native investment options, each with its specific level of risk. In the last step, the choice must be implemented, and reviews must be planned and executed to evaluate the decision against the goals. Figure 2.1: Decision-making phases 2.5 Cognitive and emotional behavioural biases We will not attempt to mention or explain the full list of behavioural biases currently linked to decisions made in personal finance. We will introduce you to the most commonly encountered biases in the wealth management context, found to be observed in the decision behaviour of fund managers, financial planners and their clients. More importantly, we will attempt to leave you with a framework within which you will be able to understand and categorise the behavioural biases to be explained. Some re- searchers refer to heuristics which are described as rules of thumb that assist the investor to make quick decisions in the presence of substantial information and complexity. They explain that heuristics are not always bad as they assist investors to make quick deci- sions enabling them to cope with everyday decisions, but it is not optimal when complex decisions need to be made. Heuristics do not lead to superior decisions as they do not force investors to consider as much information as they should to make an optimal deci- sion. We choose to refer to biases and classify them as either cognitive or emotional in the wealth management context. We will classify each bias discussed as either cognitive or 19 2.5 Frontiers in Financial Psychology emotional and then give a general description of the bias. The biases listed in this section are not exhaustive. There are over 200 identified biases. 2.5.1 The representativeness bias The representativeness bias is a cognitive bias and refers to an overreliance on stereo- types. Investors will see identical situations, where in fact there are important differences. Give investors a little information about a product and they are quick to form a conclusion that the product is the same as a product with which they are familiar, even though it only remotely resembles the product you are telling them about. Although representativeness assists a person to organise, categorise and quickly process large amounts of data, it can cause investors to quickly react to new information by applying insight gained from hope- fully relevant past experiences. This behaviour assists investors to effectively process large amounts of data and react to it but can also result in the incorrect understanding of the new information. The representativeness bias and resulting behaviour cause inves- tors to perceive new information as confirming their pre-existing ideas. The representativeness bias can be referred to as the law of small numbers or sample- size neglect. Investors tend to be quick to draw conclusions from very limited data sets. This bias is endemic in the financial services industry, and we see the best examples when investors evaluate the performance of investment managers. A few good years are almost certain to be seen as evidence of skill which, even if it may be true, can be subject to mean reversion in the period that lies ahead. The result is that investors systematically buy high and sell low as they are trailing results. They almost always overweight recent performances and underweight long-term profitability. The representativeness bias can also be referred to as base-rate neglect. An investor may give too much weight to similarities between market events or investment opportuni- ties and ignore the importance of unrelated variables that can impact on the outcome of an investment result or the possibility that a market event will not occur in a similar way. Some investors continue to believe that holding gold shares will protect clever investors in times of political turmoil. Even though there might be some truth in such a belief they completely ignore other variables such as the management of the company and the potential lifetime of the mine. Advice for dealing with the representativeness bias Warn your client not to become caught up in fads. Hot information invariably means that overreaction has already set in. If there was money to be made, the time is already past. Assist your client to consider the following questions regarding an investment they want to make: How does the investment they are considering perform relative to similar-sized and styled investments available in the market? How long have the cur- rent managers been at the fund or company considered? Are the fund managers well- known and highly regarded? Do the fund’s one-, three-, five- and ten-year returns all exceed market averages? Caution your client to stick to switching funds only at predetermined intervals and to change their investment strategy only when life changes occur. Remind your clients that patience is a rare but crucial investment commodity. If the strategy is right for the goal, the gain will come through. Look for alternative patterns and explanations. Play devil’s advocate and try to take apart the arguments to see if they hold up. This is vital where clients want to follow new trends. 20 Behavioural finance 2.5 2.5.2 The availability bias The availability bias is a cognitive bias and refers to the tendency to rely on the most available information to make a decision, even though the information may not be accu- rate. As with the representativeness bias, the availability bias is a mental shortcut or a rule of thumb used by investors to simplify the process of decision-making. Investors access the frequency, probability or likely causes of an event by the ability of the memory to recall similar previous occurrences. Michael Pompian suggests that investors tend to view easier-recalled explanations or possibilities as more likely than those prospects that are harder to remember and more difficult to comprehend. As we remember frequent events easily, it often leads to inaccurate judgements. How recent and prominent the previously stored information also influenced the availability of the information. The availability bias arises because there are factors beyond those mentioned that also play a role in the understanding and availability of information. Readily available information may not always be objective, complete or factually correct. There are numerous examples of this easy-to-recall bias. People living in the United States were asked what would more likely kill them: shark attacks or parts falling from aeroplanes. Most answered shark attacks, as we recall sensational information easily. But according to statisticians, it is 30% more likely that people in the United States will be killed by falling airplane parts. Surveys of returns expected by investors show the same easy-to-recall bias. There are many research projects that ask investors about their expectations of market returns over the subsequent twelve months, one of them being the Yale Investor Confidence Index. In 1998, 76% expected returns of 10% and higher and 20% anticipated returns of 20% and higher (long-term returns averaged around 10% at the time). In March 2001, following a year of poor returns, about 50% anticipated returns at about 10%, and only 8% saw prospects for a 20% plus return. Investors are biased in the direction of the most recent information. Research identifies four categories of availability bias that are most applicable to inves- tors and their financial planners: Retrievability. Because investors tend to regard information most easily retrievable as the most credible, they tend to choose investments based on information available to them. They may choose to invest in products of a company that advertises heavily, such as some of the direct players in the market. Investors also tend to rely on infor- mation passed on by friends regarding a good investment. They normally fail to en- gage in a more disciplined due diligence investigation to verify that the product they choose is indeed superior and that the information regarding the company is accurate and comprehensive. Categorisation. All people categorise new information according to certain unique classification schemes in their brains to enable them to use and recall the information when needed. When new information is encountered, the brain generates a search engine to find the data needed to categorise or comprehend the new information. When it is difficult to find related data easily the brain may take an easy way out and link the new information to less optimal results. Investors therefore may choose in- vestments from investment categories and lists available in their memory. Hence the overexposure to investments in properties can be explained where potentially good investments in less prominent categories may be ignored. Narrow range of experience. Often investors have a restricted frame of reference from which they can retrieve available information to form an objective opinion. The result is that investors might choose investments representing sectors and companies s

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