A schooling in psychology drives LOUIS WILLIAMS – Head of Psychology & Behavioural Insights at Dynamic Planner – to question what we know about your clients, people who invest. By learning more, he believes we can help them weather financial crises better in future

We know, according to research, that someone’s emotional state can strongly influence financial decisions they make. I want to explore how individual differences make investors more susceptible to either positive or negative emotions.

In that light, I have been looking closely at an individual’s emotional resilience or stability and their subsequent ability or strategy for regulating their emotions during difficult market periods.

Mind the behaviour gap

We might find that an individual or client has an attitude behaviour gap, whereby they are broadly risk tolerant, but during difficult market periods they are prone to panic and disinvesting from their current position. That gap manifests when risk becomes reality and they experience actual losses in their portfolio.

Ultimately, what I am trying to do, through my work at Dynamic Planner, is reduce this potential gap.

To do this, I have taken a step back and looked at psychology theory from the 1980s and ‘90s. For example, the theory of planned behaviour first proposed by Icek Ajzen in 1985, which shows how our attitudes influence our behaviour. Alongside that, all of us are also impacted by social pressure from family and friends or, in this context, from a financial adviser. Does such pressure lead us to behave in a certain way or not?

We can further consider what is called perceived behavioural control – an individual’s self-efficacy – or, in more layman terms, our ability to believe in ourselves in different situations. Does an individual feel confident managing their finances? The answer to that question of course can impact actual behaviour.

For example, if an individual has very low confidence in their ability to manage their finances, they may not act at all in a given situation or act contrary to what would be expected by an adviser in respect of their agreed attitude to risk.

In another way, we can look at this using the example of someone trying to quit smoking. They may know it’s an expensive habit and one they don’t enjoy anymore. Social and peer pressure comes into play here too. However, if an individual has very low belief in their ability to successfully quit, that then can significantly influence how someone will ultimately behave and in this example whether or not they actually stop smoking.

Confidence is key for your clients

Studies already completed have looked at financial self-efficacy and they revealed that people with low levels of this were most negatively affected during extreme periods of market volatility. That is what we might expect.

Having confidence in our ability, in all area of our lives, can make us more resilient when we face adversity, thereby allowing us to better manage stress and our emotions. Naturally, in this context, financial advice firms want to have resilient clients.

When I first began working with Dynamic Planner, in autumn 2019, I discovered that while psychology has broader measures of an individual’s resilience, there is no explicit measure of an individual’s financial resilience. That’s important. We arguably need one, because measuring resilience can be very domain specific. For example, my resilience regarding a health issue could be very different in comparison to my resilience regarding my finances.

What is resilience?

It is of course our ability to bounce back following a difficult period, but it also reveals our ability to adapt in the face of adversity.

In 2019, the French professor Dr Fanny Salignac created a model which looked at financial resilience and identified four key influences: an individual’s economic resources, their social connections, support network and lastly, financial knowledge. I would argue Salignac’s model fails to encompass an individual’s personality traits and qualities. Indeed, their experimental results show that optimism was a good indicator of whether someone would be financially resilient, yet was not used to inform their financial resilience model.

I have conducted some research myself to explore this issue by using hypothetical scenarios to test someone’s financial resilience. Serendipitously, after I had begun this research, we experienced a real-life market crash in February 2020 at the beginning of the Covid-19 crisis. I was therefore further able to look at results of people who completed the survey before February and or after. I also wanted to study the benefits potentially of an individual having worked with a financial adviser previously.

2020 Dynamic Planner study

The survey questioned different things. For example, we asked someone what their response would be to their portfolio suddenly falling in value by 20%. We also asked them how they would feel in that scenario.

Broadly speaking, we found that people who had worked previously with a financial adviser were more comfortable with taking risk. Interestingly, this group was also generally more resilient. Demographic variables – for example, males, who have been found historically to be more comfortable with risk – could in part explain such results, but when we controlled such variables more tightly, these trends were still apparent.

When it came to studying the results of people surveyed before the real-life crash in February and afterwards, we found that people afterwards experienced more negative emotions, like distress, anxiety and guilt. Those people also had lower levels of financial self-efficacy.

Again, people who had previously worked with a financial adviser were more optimistic and less concerned about the hypothetical scenarios, than those who had not. Interestingly, we also found that of the people who had worked previously with a financial adviser – who completed the survey both before and after February – the post-February group were most optimistic, suggesting that after experiencing the ‘real life’ adversity of last year’s crash, that core message from their adviser of staying invested resonated more strongly during the hypothetical scenarios.

Regarding low levels of financial self-efficacy, someone worrying about running out of money in retirement, for example, can be a good predictor of negative reactions to periods of adversity. In contrast, individuals with high levels of financial self-efficacy are more likely to be resilient, optimistic and to stay invested.

When it comes to personality traits, introverts, for example, are more likely to disinvest during a difficult period and are more susceptible to herding behaviour, following the crowd. Individuals with less emotional stability are more likely to base decisions on much more recent events or experiences, or are more likely to avoid reaching a decision altogether.

How can we improve clients’ financial self-efficacy?

First, set realistic goals with a client and start by working with them on smaller tasks. For example, cash flow planning may be useful to help clients achieve modest successes and therefore feel more confident when it comes to tackling the bigger picture regarding their overall finances.

Second, as their adviser, you can celebrate these successes and thereby help build a client’s confidence, like a coach. The relationship here and trust within it naturally is key. A client may well look to their adviser as a financial role model. Communication is crucial, with the adviser providing relevant information and collateral for their client to read and engage with; and they can speak regularly with their client.

Finally, an adviser can consider their client’s emotions and help decide when they are best suited, or ill-suited, to make an important decision. Can a client be encouraged to reappraise their position more positively, if they are experiencing negative emotions?

Ultimately, the end goal is a confident client and a resilient one in terms of managing their finances.

“Using Dynamic Planner Cash flow, you don’t just have to tell a client why you think something’s not a good idea – you can show them.” What does one firm think?