Biases in Behavioral Finance – How Emotions Can Impact Divorce Proceedings
Behavioral Finance can be described as “The intersection of behavioral psychology and finance that helps explain why people make irrational financial decisions.” In simpler terms, humans are emotional, often leading us to make sub-optimal decisions.
The classic theory posits that all humans are rational and will make decisions based on a fixed set of inputs to maximize gain. This is not true in almost all cases, especially ones involving emotional fixtures like divorce.
Behavioral Finance theory states that our brains engage in two types of thinking. The first is our ‘fast brain,’ which makes snap judgments, is subconscious, and uses emotion and intuition. Our ‘slow brain’ is more logical and calculating and uses conscious thoughts. Because we make thousands upon thousands of decisions a day, our brain prefers the fast system. It will process as many decisions as it can as quickly as possible to be more efficient. The interplay between the two systems and our baseline tendency to use the fast brain causes behavioral effects that lead to irrational decisions.
There are certain behavioral biases that time and time again show up in client decision-making during divorce proceedings. As professionals, it is first important to understand when emotions skew perception. After that, it is incumbent on us to know how to navigate and utilize these biases to our client’s advantage. The following three behavioral biases show up most often and can lead to opportunities for you to demonstrate additional value to your clients.
- Anchoring is the subconscious decision to place extra importance or significance on the first piece of information received about a subject. This anchor does not have to be important, accurate, or even properly vetted information. Clients often have unrealistic opinions on the valuation of a house, business, or other asset because they overheard a conversation or read something in the news that anchored their thinking to a specific starting value.
It is important to realize where perceived value comes from and if it is based on logic and fact or is just an anchor that drives decision-making. One way to combat the anchoring bias is to introduce a timeline of events to document how valuations may change over time. As information changes, so too does value. Also, when initially presenting different settlement options, it can be wise to offer data in various forms or as a range of outcomes. This helps individuals understand that ranges and other choices are available, helping to negate the anchoring bias of a fixed number.
- Loss aversion states that losses and potential losses are perceived more severely than gains. This bias can help explain why often, no one feels like the “winner” in a divorce case. Equitable splits still result in a net emotional loss for both parties. This is doubly the case in custody battles, where any loss of time with children is seen as a negative rather than a way to spend uninterrupted time with family.
Though hard to overcome, one common tactic to negate this bias is to shift the framework of the conversation. Focusing on the benefits of a particular course of action and emphasizing future positives can have an outsized effect on a client’s emotional well-being. From a planning standpoint, loss aversion can be avoided by talking about the positives of future lifestyle goals (new house, vacations, funded college expenses, etc.). In addition, focusing on the process and the path of moving forward can help put losses into perspective.
- The endowment effect explains how individuals value what they already own higher than if it was not already in their possession. This can be seen in many ways, most commonly with a family home or business. Though the true market value of a home might be $500,000, it will inevitably have a higher emotional value to the property owner.
This is highly correlated with present bias, where objects in the immediate future have more value. On the surface, a house you can sleep in offers more current value than a pension or retirement account value in 20 years. Knowing how different sides in a divorce may value assets can be useful. When evaluating how to split assets, knowledge of the endowment effect can lead to more realistic ideas to find common ground between parties.
As you can see, rational thoughts and decisions are rarely found in real life. Understanding how emotions tie into finances, and the divorce process is integral to providing value to clients. Please reach out to our team at Marcum Wealth to help your clients build a financial plan and help them navigate behavioral biases.
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