James J. Green’s editorial in the latest Investment Advisor magazine reports on talks given at the annual Morningstar Investment conference. Green reports:

Advisors are in the behavior modification business, not the investing business, said Don Phillips of Morningstar at his company’s 28th annual investment conference in June…

Steve Wendel and Sarah Newcomb of Morningstar (disclosure: both Wendel and Newcomb blog for ThinkAdvisor.com) related the findings of Morningstar’s behavioral economics unit to help advisors efficiently guide their clients away from self-defeating behavior. One behavioral bias that’s under-appreciated, Wendel said, was the bias toward taking action. That is, when humans are faced with a particular challenge, like a plunging stock market, they want to do something — anything, really — to make themselves less anxious. However, in many of those situations, the best course of action is to not act at all, but rather stay committed to a financial plan made at a time of calm, not anxiety.

Our minds are wired to quickly generalize on perceived trends and react to them. These instincts work well in preventing threats to life and limb, but can easily convince us to react wrongly in other circumstances based on fear.

Clinical psychologist Brad Klontz writes in Financial Planning Magazine about how this relates to financial habits:

Stalling – and other seemingly illogical client behavior – makes total sense when we have insight into what I call “money scripts.” They are those typically unconscious, but deeply held beliefs we have about money that drive all of our financial behavior. It is likely that a significant part of the financial distress that brought your client through your door is the result of the same beliefs that are keeping him or her from following your plan.

Money scripts are developed in childhood. The child-mind is a simple one, and a child’s need to figure out how the world works is great. Children have a tendency to see things in all-or-nothing terms, especially when the learning experience is emotionally charged or painful. After you have been bitten by a snake, it makes sense to run the next time you see something stirring in the grass, although this time you could be running from a squirrel.

Since most families don’t talk much about money, teaching more by example than words, parents may not notice misunderstandings or key experiences. The euphoria that comes with watching a parent win at the horse track may end up in a lifelong gambling problem; growing up in poverty can set up a workaholic personality; or hearing family discussions about betrayal can lead you to keep financial secrets from a trustworthy partner. The human brain automatically takes on the job of protecting us from experiencing more pain or works to re-create remembered pleasures.

Rarely do we take the time and energy to think about our thinking, digging into our histories to discover the origins of our assumptions about money, or anything else for that matter. Our cultural taboo against talking about money also allows the scripts to run unchallenged. Psychologically minded financial planners are in an excellent position to help clients become conscious of their assumptions about money, the first step to changing them.

You don’t need to tell clients they are wrong. Even the most outrageous money scripts are 100% true in a specific set of circumstances.

My grandfather’s family lost all their money when the banks collapsed during the Great Depression. As a young man, my grandfather concluded that he wouldn’t make the same mistake, and for the rest of his 94-year life, he refused to put a dime in a bank and kept his money in a lockbox in his attic. It didn’t matter that laws had passed insuring bank deposits. Instead of telling clients they are wrong, you can help them see that their beliefs are based on real experiences and it’s the facts that have changed.

Chances are your client is going along with or reacting against family history. My grandfather passed down his financial mistrust to my mother. As a result, she was very conservative with her money, preferring CDs and savings accounts and avoiding the stock market.

Until I investigated my own family financial history, I had no idea why I was anxious about money, especially about being poor. In an effort to do things differently, I swung in the opposite direction of their caution and ended up losing half of my money when the tech bubble burst.

At that point, it would have been easy for me to revert to my grandfather’s all-encompassing mistrust of financial institutions and repeat the family cycle. Instead, I began questioning my assumptions, exploring the emotional intensity of my fear of ending up poor. I interviewed family members and sought advice and counsel from others. Knowing their family history will give your clients insight and allow them to change their behavior.

My own family’s experience with investing began in 1966 when I was about six years old. My father, George Marotta, had purchased term life insurance and was investing the difference between term and whole life insurance in stock mutual funds. For 16 years, the value of the stock market went sideways and experienced extremely high inflation. In terms of real dollars, his investment made very little.

Because of this, when I graduated from college, my own experience could easily have taught me that the stock market is just a great place to lose a lot of money. This experiential so-called wisdom would have kept me from making any investments during the roaring 1980s and 1990s. Only by studying historical returns outside of our experience can we avoid learning the wrong lessons.

At Marotta, we strive to avoid fear-based investment mistakes by being students of history. We look backward to see what we would have experienced if we implemented any strategy consistently over the past few decades. This kind of long-term analysis helps us see the effects of various market scenarios before they arise and plan accordingly. By having a dress rehearsal for a market downturn, we can steel ourselves against doing the wrong thing when the real event happens.

Are the markets fickle and volatile? Yes. But they are also very profitable over the long run.

Historical wisdom helps us craft long-term investment plans. It helps us avoid giving up on one asset category simply because it is currently out of favor. It helps us reduce the volatility of a portfolio by investing small amounts in extremely volatile assets. It helps boost returns by investing in something with a lower mean return.

Although the crowd is usually wrong, it’s not enough to just do something different. You have to do the right different thing. You have to slow down, make a written investment plan, and then stick to it.

Taking the emotional reaction out of investing helps protect us from the errors of the money scripts we have developed as habits of reaction.

Photo used here under Flickr Creative Commons.