July 18, 2022
The “4 Rs” of Behavioral Finance
In his book, “Thinking, Fast and Slow” , psychologist Daniel Kahneman examines the two brain systems that drive the way we think while also shining light on the common biases that impact decision making.
As it turns out, our brains are hard-wired to make fast, intuitive and emotional decisions shaped by our own biases and generalizations. These mental glitches, Kahneman proposed, make us feel like we are using good judgement even though the results of these impulsive decisions often get us into trouble. Without pausing to engage the rational area of the brain when faced with a big decision, especially financial ones, you risk causing more harm than good.
High levels of uncertainty about the economy, rising inflation, global supply chain disruption, soaring gas prices and expectations of increased market volatility can stoke fear in the minds of investors planning their financial futures. This may even cause some to consider sidestepping the risk of loss by making an impulsive change to their investment strategy. Building off Kahneman’s work and behavioral economics, strategies have been developed to help investors make better decisions during periods of instability.
A methodical framework for decision making can assist in slowing down responses, hopefully reducing the likelihood that emotions and irrational thinking will get in the way. The Kaplan Behavioral Financial Advisor (BFA) course has broken this process down into “The 4 Rs”:
R #1: Recognize the Situation
When you become overwhelmed, pause and take a moment to verbalize what you are feeling. Describe the reasons for these emotions and identify the actions you are considering. Think about any previous experiences that may be shaping your perception, such as the 2008 market crash. Try to assess whether you are in a clear state of mind and if your decision could derail a well-designed financial plan.
R #2: Reflect on Your Values
Do your best to zoom out your perspective and verbalize the big picture as well as your desired long-term financial outcomes. Consider if any biases are shaping your worldview and if those biases are potentially clouding your decision-making ability.
R#3: Reframe Your Viewpoint
Describe how this potential decision relates to your values, goals and moral principles. Bring the focus back to the long-term view and concentrate on what truly impacts the likelihood of success for your financial plan. Identify any instances where a market pullback creates opportunity such as investing cash reserves to “buy low”.
Think about how similar instances in market history played out:
- Did markets recover?
- Have you previously made a decision with your investments that didn’t pan out?
- Is market volatility expected when invested for the long-term?
- What would be the impact on your values and goals if you made this decision?
R#4: Respond Purposefully
Make an educated decision based on the overall picture, not the immediacy of a market drop or a perception that you know something about the market others do not. Seek counsel from your trusted financial advisor on the best decision for your situation.
The “4 Rs” approach is designed to help you make decisions that are emotionally reflective rather than emotionally reflexive. Remember, think SLOWLY! If you have questions about your portfolio, speak with your advisor about your concerns.
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About the author: As a divisional manager at Buckingham Strategic Partners, Sean Brooks enjoys working with advisors in every area of their practice, from helping solve investment problems to sharing ways to run more efficient practices and build stronger client relationships. Prior to joining Buckingham, Sean was with AssetMark in a business development role, and he also worked as a banker and financial representative with JPMorgan Chase in Arizona and Illinois. Sean also spent time working as an estate planning consultant helping families avoid probate. He attended Loyola University of Chicago and earned a business degree in economics.