Biases in Behavioral Finance – How Emotions Can Impact Divorce Proceedings
By Alexander D. Sterba, CFP, Financial Advisor, Marcum Wealth
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.
DISCLOSURE
Marcum Wealth, LLC (“Marcum”) is an investment adviser registered with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply a specific level of skill or training. A copy of Marcum’s current written Disclosure Brochure discussing its advisory services, fees, and material conflicts of interest is available upon request.
Past performance does not guarantee future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Marcum), or any non-investment related content, made reference to directly or indirectly in this communication, will be profitable, equal any corresponding historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Certain strategies and vehicles referenced in this communication, such as private investments, Opportunity Zones, and ESG investing, may present increased or novel risks, including potentially higher management fees, reduced liquidity, shorter performance histories, or increased legal or regulatory exposure, compared to more traditional publicly traded securities and investment strategies. All investors should consider these potential risks in light of their individual circumstances, objectives, and risk tolerance. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Marcum. The asset allocations reflected in this communication are targets only. Actual allocations can and often will deviate from these targets, including in instances of volatile markets, large deposits, or withdrawals, or during account rebalancing.
Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your Marcum account holdings correspond directly to any comparative indices or categories. Please Also Note: (1) performance results do not reflect the impact of taxes; (2) comparative benchmarks/indices may be more or less volatile than your Marcum accounts; and (3) a description of each comparative benchmark/index is available upon request.
Not all services described herein will be necessary or appropriate for all clients. The scope of the services to be provided depends upon the needs of the client and the terms of the engagement. The potential value and benefit of the adviser’s services will vary based upon a variety of factors, such as the client’s investment, tax, and financial circumstances, and overall objectives. Neither personalized services nor financial or professional resources or processes should be construed as a guarantee of a particular outcome. All investing comes with risk, including risk of loss.
If you are a Marcum client, please remember that it remains your responsibility to advise Marcum, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify/advise us, in writing, to the contrary, we shall continue to provide services as we do currently. Marcum is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. Tax and accounting services provided by Marcum, LLP. Insurance services provided by Marcum Insurance Services, LLC.