“As a consultant, you need to understand how clients make decisions, their cognitive biases, and their behaviors that don’t necessarily belong to them,” Doyle says.
This is where behavioral finance comes in. A field of study that marries behavioral psychology with finance, it offers advisors a way to expand their field of perspective, allowing them to recognize patterns such as overconfidence, risk aversion, and anchoring Which pulls them away from being the rational profit optimizers that economic theory assumes are all human beings.
In addition to believing that humans can be irrational, behavioral finance recognizes that people can change their thinking over time. For example, instead of being permanently overconfident, one might be bullish and have a high risk appetite when the market is good, and then do 180 and avoid risk when positions change.
“Traditional KYC gives you a snapshot at a time, when what you really want is a risk threshold,” Doyle says. “Otherwise, when a customer reacts excessively to a slowdown, you’re going to be caught off-guard.”
Furthermore, Doyle says that advisors and clients do not necessarily define risk in the same way. While advisors look at risk through a quantitative lens, such as portfolio volatility and downside risk, clients tend to think in more qualitative and difficult-to-measure terms, such as minimizing feelings of regret or confidence that they will live comfortably in retirement. That disconnect can lead to significant misunderstandings that, over time, can lead to sub-optimal portfolio structures and erosion of trust.