Psychology shapes effective money management

John R. Shelton, a stock broker and financial adviser with decades of experience, was meeting with clients, a married couple of some wealth. Shelton had had many such meetings that spring to reassure clients that despite the chaos of the past few months, their own assets were in good shape and sufficient to maintain their life styles. Shelton was trying to keep clients from needlessly selling assets at what later proved to be the bottom of the market cycle and thereby turning paper losses into real losses.

After several minutes of conversation, the wife burst into tears and could not be consoled. She was terrified and demanded that Shelton get them out of the stock market, even if it was the worst possible time to sell.

It was about then, Shelton said, that he decided there had to be a better way to talk with clients about money.

Shelton and his colleagues at MarketSpace Financial in Albuquerque merged their firm two years ago with Newport Beach, Calif.-based United Capital Private Wealth Counseling so they could use that company’s psychology-based tools for money management.

“I’m doing things for clients differently and with more meaning and more value now than I ever was able to do before,” Shelton said.

Just about any financial planner asks clients many questions to understand their goals and their tolerance for risk. Their portfolios are designed using time-honored rules of thumb. People who say they have greater tolerance for risk are steered toward equities. People approaching retirement are encouraged to move into safer instruments that spin off cash. Clients are asked what they expect their need for cash will be, and withdrawals from portfolios are calculated accordingly.

This is all well and good, Shelton said, assuming the client really understands how he feels about risk, if his spouse or partner is on the same page, if his biases and fears don’t overwhelm his good sense. Managing a client’s money can be as much psychoanalysis as financial analysis.

Students of finance have long recognized that investors, and therefore markets, are not always rational, said Emmanuel Morales-Camargo, an assistant professor of finance at the University of New Mexico Anderson School of Management who studies the behavior of investors. But what does it mean to be rational?

“It means that when people receive new information, they update their beliefs and they do that properly,” Morales-Camargo said. “They make choices within the context of the expected-utility model.” That is, their decisions to buy or sell will be based entirely on what is likely to increase their wealth.

“If that’s the case, the price of all risky assets are currently fair,” Morales-Camargo said. “There shouldn’t be any opportunities to make excessive returns on stocks based on public information.” That is what is known as the efficient market hypothesis.

Clearly, that hypothesis does not always hold. Look at the way some investors consistently out-perform the market. Look at how internet-stock and real estate bubbles build over long periods of time. Look at the October 1987 stock market crash; it was the worst one-day drop in share prices ever, and as far as anyone can tell, it happened for no rational reason at all.

If people don’t make financial decisions that are based on current information and a goal to maximize their returns, how do they form beliefs and preferences?

“One bias psychology has identified is over-confidence,” Morales-Camargo said. People think they are better drivers, better employees and better investors than they really are.

Morales-Camargo and some colleagues set up an experiment where student volunteers participated in a simulated auction of securities.

“The students who were over-confident (about their investing abilities) seem to be over-confident all the time,” he said. “Even when they are losing, they don’t change their perception of their own abilities to perform.” Students with a more realistic sense of their own abilities, on the other hand, become less confident if they lose and more confident if they win.

Shelton and his colleagues at United Capital would rather not discuss your finances until you’ve done what they call a Money Mind assessment. The goal of Money Mind, a term they’ve trademarked, is to help clients understand why they do what they do with their money.

The process begins with seven questions. If you are offered a choice of jobs, do you take the one that pays the best, the one that allows you the most time with your family, or the one that brings you the most joy? If you get a chance to get away for two weeks, do you wonder what it will cost you, feel guilty about leaving loved ones behind or start packing? There are five other, similar questions.

Depending on how the client answers, he or she is either a protector, a giver or a pleasure seeker in the United Capital scheme. Most people are protectors.

A protector seeks security and safety, is cautious and deliberate when making decisions, frequently defers enjoyment, and is anxious when making big financial decisions.

A giver takes care of others first, is considerate of other people’s perspectives and is prone to making too many personal sacrifices.

A pleasure seeker never feels there is enough money, maximizes the pleasure he gets from his resources, doesn’t spend enough time evaluating financial decisions and is too casual about risks.

Couples, who do their Money Mind assessments separately, often discover they have a completely different attitude toward money. Often that has been a source of friction for some time, Shelton said. “We can open up an honest conversation,” he said. “We keep a box of Kleenex in the conference room.”

Couples will discover that she is afraid there won’t be enough money to live on, and he wants to take golf vacations in Scotland.

“Money is a very emotional subject,” said Christopher J. Villegas, a relationship manager with United Capital. “We talk about what’s important to you. Understanding your Money Mind can help you make better decisions.”

Since poor money decisions are often the result of emotional biases, Villegas said, the exercise tries to make the clients’ biases clear.

Shelton said the financial adviser comes away with a tool that can be used to help keep biases from over-ruling sound decisions.

People who win the lottery often end up miserable, Shelton said. “Their process for making financial decisions didn’t change. The money did.”

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