We all make a multitude of decisions every day: what to wear to work, what kind of coffee to order, what to pack for our kids’ lunches.
But what about about more important, life changing decisions? Like ones about finances and investment. How do we arrive at these more complex decisions?
Daniel Kahneman (an Israeli-American psychologist, Nobel economics laureate, and author of Thinking, Fast and Slow) and Amos Tversky (the cognitive psychologist who collaborated with Kahneman) introduced the concept of legitimised behavioral economics — the study of how people really behave around money, as opposed to how economists say a rational person ought to behave. Together, they changed the way we think about thinking.
So what is behavioural economics and how can financial planners use it to achieve outstanding client results?
A quick lesson on behavioural economics
Behavioural economics (and behavioural finance) studies the effects of cognitive, psychological, social and emotional factors on how we make financial decisions.
It also looks at the consequences of our thinking processes on market prices, returns and resource allocation.
There are three (3) main areas of behavioural finance:
- Heuristics: Research shows that humans make 95% of their decisions using mental shortcuts or rules of thumb.
- Framing: The collection of stereotypes and anecdotes that form mental and emotional filters upon which we rely to understand and respond to events.
- Market inefficiencies: These include non-rational decision making and mis-pricings.
In his book, Kahneman also describes two systems of thinking:
- System 1: A fast, intuitive way of thinking which is often responsible for errors, snap assessments and quirks in our decision-making.
- System 2: Slow, deliberative thought processes that involves deeper analysis and makes us less prone to mistakes.
We tend to use System 2 thinking when we face complex problems and challenges but mostly we run with her more impulsive sister, System 1, to help us make decisions.
The key question here is: how can you apply these principles in your financial planning business?
6 ways to use investor psychology and behaviour in your business
- Understand the systems of human thinking
According to a survey of 2,000 UK adults by Barclays Blue Rewards, over 60% of Brits take less than a second to decide whether or not to take or enter into a financial deal, costing them an average of £520 a year.
Most consumers turned down a deal for fear of a hidden catch, while 17% were afraid they might “be tied into something”, according to the survey.
This means the majority of people appear to make split-second decisions, without even considering the pros and cons or consequences of the offer – a typical ‘System 1’ type of approach.
Once we understand when and how our clients use System 1 and 2 types of thinking, we can work with them to improve their financial decisions and (if applicable) allow the more rational ‘System 2’ to play a role in their thought processes.
2. Change the conversation
In volatile market times, financial planners need to do a lot more work to convince their clients they are on the right track. This is where the above principles come into play.
According to Stephen Wendel, Head of Behavioral Sciences at Chicago-based investment management firm, Morningstar, one way of using behavioural economics is to change the conversation.
By altering the language you use and the perspective you take, you can change the story for your client.
For example, rocky market conditions could mean an investment portfolio nightmare and large sums of money lost, OR an opportunity for profit and growth.
“As the markets are dropping, the chances for gain are increasing,” Wendel reported to the Financial Advisor.
When you’re engaging with, and advising clients, think about the story and the architecture of meaning rather than just the hard, cold facts.
3. Move beyond numbers
According to Richard Thaler, a behavioural economist and professor at the University of Chicago Booth School of Business, it begins with “simply recognizing that the job of understanding what your clients’ goals and fears and needs are is at least as important as crunching the numbers.”
Understanding how people think and feel aids communication and helps you devise financial strategies your clients will implement (and stick with).
4. Be aware of bias
Heuristics are a “cognitive instrument” to reduce the time and effort of the decision-making process for individual investors or investment professionals.
What this means is that we all have our own inherent biases and prejudices – so it pays to know yours (and understand your clients’ too).
The issue is that this type of thinking can lead to mental mistakes. Researchers suggest that many of these heuristics can lead to serious miscalculations, inaccurate categorisations of investors, and bad investment advice (Grable 2008).
Imagine a financial planner whose ‘heuristic’ is that female investors are less risk tolerant than their male counterparts; they may suggest more conservative portfolios. Because every female client does not fit this stereotype, applying such a heuristic could result in bad financial decisions.
Having some awareness around bias can help you become a more mature, intuitive adviser and develop unique and personalised financial plans for your valued clients.
5. Stop the decision paralysis
When we’re presented too many options, we often struggle and we’re less likely to choose anything at all.
According to the Behavioural Economics Field Guide, Californian researchers showed that consumers who were presented with only 6 jam flavours to sample were 10 times more likely to buy than consumers presented with 24 flavours.
Due to ‘ego depletion and default bias’, we tend to do what is easiest (not what may be the best for us).
Don’t overwhelm your client with too many financial options and decisions. Present smaller choice sets and make investment recommendations accordingly.
6. Understand risk-taking behavior and ‘anchoring’
Risk perception and tolerance differs for every client and organisation.
Many of us were hit hard by the GFC in 2007/2008 so we ‘anchor’ on this crisis as being a bad or stressful event. This, in turn, may make clients more risk averse and sensitive to loss.
To avoid this anchoring effect, stress to your clients the importance of not focusing on bad ‘anchors’ as their main reference point and make sure you take into account their emotional reactions to perceived risk.
Behavioural economic tools can have a huge impact in your business.
By exploring the psychology of decision-making and thought processes, you’ll not only develop stronger client rapport, you’ll be able to give tailored financial advice to your clients and beat the ‘robo-advice’ trend with sophistication and ease.
Chris Wrightson. Founder and CEO at Centurion Market Makers, the industry experts in the sale, acquisition and management of financial planning firms. If you’re planning on selling your firm in 2017, we’d love you to call us for a confidential discussion, or continue browsing our website for more tips, tools and info on the steps to take when buying or selling your financial planning firm.
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