How is a Money Personality Developed?

March 21, 2012

Justin Reckers, CFP, CDFA Applied Behavioral Finance, Morningstar Advisor, Personality Leave a comment

How Is a Money Personality Developed?

Understanding personality will help you understand your clients.

By Justin Reckers and Robert Simon

Originally published by www.MorningstarAdvisor.com on February 16th 2012

We now turn our attention to one of the fundamental roots of behavioral economics by taking a more detailed look at the psychological underpinnings of our human nature.

Psychology systematically explores human behavior, motivation, cognition, emotion, and well being. Thus, psychology teaches us about important ways in which human decision-making differs from the rational assumptions of traditional economic models.

In previous articles, we have talked extensively about departures from economic rationality, their potential causes, and some of the outcomes that result from these departures. Most of our examples of departures from the rational models of economics have been cognitive departures or departures that result from errors in thinking processes. These cognitive distortions are far easier to counteract than departures that result from emotional or personality-based biases. Therefore, we have started with examples that are somewhat easier to explain and understand.

Now, we proceed to explain and help you understand how a client’s personality type impacts how they think, how they feel, and ultimately how they make financial decisions. We will now take a couple of articles to discuss personality traits–how they are developed, how they function, and how they malfunction.

What Is Personality?
Webster defines personality as, “The combination of characteristics or qualities that form an individual’s distinctive character.”

Simply put, personality is the fundamental template through which an individual experiences the world. It is an orientation toward others, toward oneself, and toward one’s life. It is a consistent and pervasive set of traits, assumptions, and frames through which one organizes and perceives.

The manifestations of personality are numerous. For example, is one likely to fight or to run away when confronted by a bully? Is one outgoing or introverted? Is she a risk taker or not? Does one trust easily or is one guarded?

Personality impacts the way we approach change or choose to take on challenges. Personality is relatively enduring; while traits and behaviors change, personality stays with us. It is our nature, our temperament. In many ways, personality informs the “essence” of who we are.

How Is Personality Developed?
Every personality is unique and makes even identical twins different from each other, despite having identical genetics. Personality is the result of genetics, experience, temperament, predisposition, values, morality, and sociology.

Over the years, many personality tests have been developed. The most widely used of these tests, and the most widely researched, is the The Minnesota Multiphasic Personality Inventory (MMPI). This test results in a psychometrically derived personality profile that is unique to each individual. Other tests, such as the Myers-Briggs Type Indicator (MBTI), yield results that depict the “type” of personality someone is.

The MMPI is mostly used by mental health practitioners and yields unique descriptions of individuals by measuring a wide variety of traits and, by relating these traits to one another, paints a picture of that individual’s unique personality. The MMPI is typically used by psychologists in clinical or forensic settings.

The Myers-Briggs Type Indicator suggests that there are as many as 16 possible personality types. This test is commonly used in the workplace to assist in determining how people will relate to one another and to assist in assessing if one is temperamentally suited to a certain job or a certain team.

Personality testing underlies all of the reality shows on television. Yes, they do cast people with conflicting personalities in order to create drama. You can also find psychometrics as a regular part of a clinical psychologist’s repertoire working with patients.

The bottom line is that we all have many different traits in our personality created by heredity, experience, and sociology. These traits working together can create a type. The problem lies in trying to create descriptions that actually characterize the humans they are meant to describe.

Beyond Tests and Types 
Many of the big box financial advisory firms, insurance companies, and brokerage businesses have developed their own “personality tests” and “personality types” in recent years. They use this information to assist in understanding clients, so as to tailor investment portfolios that match clients’ financial personality and objectives.

Tests that help assess traits and types can be valuable assessment tools in a financial advisory practice if they are used and interpreted by a qualified professional in the right context. Keep in mind that tests such as the MMPI and Myers-Briggs are tools and are not determinative in and of themselves. Further, such tests are probably most easily used for big box client assessments, where clients fill them out alone at their desk. Tests are not a replacement for a real client relationship, and gaining your own sense of who the client is and what the client needs and can accept.

A better way to determine a client’s personality traits and types is to have discussions with them. Ask yourself questions such as:

–How has the client’s tolerance of risk and general attitude toward money changed recently?

–What kind of career has the client undertaken? Is it risky and competitive, or safe and comfortable?

–Is money a topic of disagreement in their marriage? Was it in their parent’s marriage?

–Has the client risked his own capital in pursuit of greater wealth?

–Is the client willing to make lifestyle changes in pursuit of her goals?

Getting to know our clients better should naturally lead us to think about behavior, personality, and emotion every day in our financial advisory practices. Our articles in coming months will continue discussing personality, including some ways you can use personality traits to help build deeper relationships with clients, help them better understand themselves, and encourage economically rational decision-making for all.

Justin A. Reckers, CFP®, CDFA™, AIF® is Director of Financial Planning at Pacific Wealth Management® and Managing Director of Pacific Divorce Management, LLC based in San Diego, CA. www.pacwealth.com, www.pacdivorce.com

Robert A. Simon, Ph.D. is a forensic psychologist, trial consultant, expert witness and alternative dispute resolution specialist based in Del Mar, CA. www.dr-simon.com

The Pride of Ownership in Financial Decision-Making

December 21, 2011

Justin Reckers, CFP, CDFA Applied Behavioral Finance , , , , , , , Leave a comment

The Pride of Ownership in Financial Decision-Making

You may not realize it, but many of your clients have preconceived ideas of what the best financial plan might look like.

By Justin Reckers and Robert Simon,

Originally published by MorningstarAdvisor.com December 15th 2011.

Over the next couple of months, we will talk in detail about a general concept we refer to as the Pride of Ownership. There are many ways our clients develop the Pride of Ownership and many ways that the biased thought processes it creates can derail economically rational decision-making. We will talk about irrational financial decision-making thanks to the Endowment Effect, Not Invented Here Bias, and what Dan Ariely calls the Ikea Effect.

Selling the Experience
From baked goods to BMWs, marketing experts have long understood the power of ownership. Humans feel a sense of pride when they have created something. Whether we create ideas or customized luxury vehicles, we tend to overvalue, from an economic perspective, things we have had some hand in creating.

Betty Crocker takes much of the difficult preparation out of making brownies but knows its customers well enough to understand the company should not be doing all the work. It wants to make sure the cook puts in some work to develop the Pride of Ownership based on the effort they exert. Most people will not have the time or skills to make perfectly moist fudge brownies from scratch, so they are willing to have a little help. The delicate part is determining just how much work people need to put in to create the Pride of Ownership without requiring so much work that they simply choose to forgo the brownies and grab the Chips Ahoy.

Similarly, luxury automakers allow us to pick the exterior color and trim, the performance features, and interior luxury accoutrements like misappropriated wood and bright red leather seats–all because they are selling the ownership experience, not the hunk of metal itself. There would be no reason to offer more than one version of a car if we cared only about the usefulness of it, so marketing experts aim more toward the experience factor and rarely talk about usefulness factors.

Try this tag line–Chrysler: We’ll get you from point A to point B. It certainly doesn’t make us want to buy. But when the marketers sell an experience, suddenly customers can imagine themselves pulling into the driveway of their brother-in-law’s house in a new luxury vehicle equipped with heated, reclining, lumbar-supporting, comfort-memorizing, bright red leather bucket seats. Who wouldn’t be proud of having seats that need seven or more adjectives to describe them?

Again, the Pride of Ownership kicks in. If the marketing experts were not able to make consumers feel the Pride of Ownership before buying, they may have problems convincing them to buy in the first place. This is why they sell the experience, not the product.Homo economicus would make choices based only on functionality and not care about the experience. But humans care more about the Pride of Ownership they gain as part of the overall experience.

Scientists, researchers, and counselors even have a cute way of alluding to the Pride of Ownership. They say theories are like tooth brushes; everyone has one and no one wants to use someone else’s. Apparently it is a common problem in their world if they have their own cliché.

Pride of Ownership in Finance
We all, including our clients in case you did not know, have thoughts and ideas about how best to manage money and make financial decisions. For example, we had a client tell us that the only possible way he could pay off a home equity line of credit is by using the proceeds from a life insurance policy he still owned on his former spouse. Our idea to use the large sums of cash he held in bank accounts, which were losing money after inflation, was instantly refused. There are many other reasons behind this extreme example, but the reason the client was able to immediately refuse our idea was because he had convinced himself that his idea was best, and the Pride of Ownership in that idea made it very difficult to convince him otherwise.

We have had clients argue that investing millions of dollars in hypothetical bonds earning a hypothetical yield of 3% is the best possible way to invest their money, forgetting the effect of inflation, the value of diversification, and the opportunity cost of not participating in the equity markets. They have no experience managing money, only ideas of how it should be done that they are very proud of and reluctant to let go of.

We also have had prospective clients refuse to yield to professional management of their financial assets because they are unable to separate themselves from the Pride of Ownership in their mediocre historical returns. They are proud of the 5% annual rate of return they attained, even if they know they have underperformed the 7% they might expect from a professional manager. The Pride of Ownership and the opportunity to perpetuate that Pride of Ownership looms far too large to give up, so they pass on 2 percentage points of annual performance.

Getting Past the Pride
So how can we beat this scourge of economically rational decision-making called the Pride of Ownership?

Step one is brainstorming options. Clients who are hell-bent on pursuing their own ideas may simply need to be enlightened about the myriad other possible options.

You, as an advisor, are relied upon because of experience and education. Use this experience and education to generate options from which your clients may choose a path that best fits their needs and, based on your projections, reaches their goals. They may still love their own idea, but they can probably appreciate the existence and possible value in the options you help generate. You can then lead them through the process of choosing the option best for their family.

As you review the options, be sure to check in with yourself and your clients to determine how your very vague preliminary ideas might be made less vague and tailored to fit a client’s individual financial reality. You must find the thin line where your clients are engaged enough in the process to facilitate the Pride of Ownership without letting them do it all to the point that they might decide they don’t need your help. Take a lesson from Betty Crocker.

We will talk more about the Pride of Ownership next month–specifically its use in marketing and how advisors should use it in creating the architecture for financial decision-making with clients.

Justin A. Reckers, CFP®, CDFA™, AIF® is Director of Financial Planning at Pacific Wealth Management® and Managing Director of Pacific Divorce Management, LLC based in San Diego, CA. www.pacwealth.com, www.pacdivorce.com

Robert A. Simon, Ph.D., is a forensic psychologist, trial consultant, expert witness and alternative dispute resolution specialist based in Del Mar, CA.
www.dr-simon.com

Are American Policymakers Using Behavioral Economics Against Us?

December 21, 2011

Justin Reckers, CFP, CDFA Applied Behavioral Finance, Behavioral Economics, Nudge , , , , , , , Leave a comment

Are American Policymakers Using Behavioral Economics Against Us?

Whether you know it or not, you and your clients encounter decision architecture based on behavioral economics in almost every financial decision.

By Justin Reckers and Robert Simon

Originally published by MorningstarAdvisor.com on November 17th 2011

Businessweek recently ran an article in its Opening Remarks section titled “Nudge Not.” The title is a play on Richard Thaler and Cass Sunstein’s book Nudge and offers a perfect segue into our next few articles. We are beginning to look into some amazing everyday applications of behavioral finance and economics. Some are obvious. Some are not. All are used to affect our decisions to buy, sell, borrow, and even cheat and steal.
We want to understand how the observations from behavioral economics are used against us so that we can make better decisions for ourselves and our clients. We say “against us” because whether the policymaker or marketer who is wielding these tools is doing so for positive or negative reasons, they are in fact trying to change the way we make financial decisions and, by extension, working against our natural human tendencies.
The “Nudge Not” article looks at the effect, positive or negative, of the Obama administration’s use of behavioral economic theory in the Making Work Pay tax credit. We are not privy to the underlying thought process that went into creating the tax policy, but the author submits that the Obama Administration structured the tax credit as a payment over time, rather than a lump sum as previous economic stimulus payments have been. They did so in the hope that this would encourage Americans to spend the money, and this would result in a bolstering of our economic circumstances.

The structure of this tax credit was meant to take advantage of our human tendency to do mental accounting. Policymakers hoped that a small incremental increase in monthly take-home pay would be accounted as current income and spent, rather than accounted as current assets and saved. It turns out we do have this tendency to make financial decisions differently based on whether we account for money as part of income or part of assets. The structure of the Making Work Pay credit is simply a clever way to combat the paradox of thrift using observations from behavioral economics.

We tip our hats to the Obama Administration for trying their hand at a Nudge. The jury is out on whether it worked.

One of us recently saw Dan Ariely, author of Predictably Irrational and The Upside of Irrationality, speak at the annual convention of the International Academy of Collaborative Professionals. The room was full of divorce lawyers, mediators, mental health experts, financial advisors, and other professionals interested in resolving disputes outside of court through a model known as “collaborative practice.” This is a growing avocation in the world of divorce and family law, and they were all very interested to hear Ariely’s insights into how we make financial decisions. One of the main takeaways from Ariely’s presentation was the value of default options or opt-out programs. Here is an example from American policymakers:

During the Bush Administration, concern over the health of the American Social Security retirement system and discussions about how to fix what ails the programs reached fervor. Policymakers asked how the average American might be encouraged to save for retirement on their own so they would not be forced to rely on the Social Security system alone. It turns out Americans aren’t very good at saving for themselves, so Congress took matters into their own hands and created the Pension Protection Act. Among other things, the Pension Protection Act creates incentives for employers to build opt outprovisions into 401(k) plans. Such plans automatically enroll employees into deferring a minimum amount of their pay into a 401(k) savings plan. They can only stop this automatic enrollment if they opt out of the plan. At the time of enactment, the Employee Benefit Research Institute projected that this change could double the number of American workers participating in 401(k) savings plans.

More saving means more economic security for Americans, so it seems like a great idea for the masses. But what it really tells us is that we, Americans at least, are not to be trusted with decisions about our own economic future. Why are we not to be trusted? Inertia is the key dilemma the Pension Protection Act attempts to employ and use against our human nature.

How much should I contribute? Should it be a fixed dollar amount or a percentage of my earnings? Can I afford to put food on the table if I take $150 per month out of my paycheck? Won’t Social Security take care of me? How should I invest? What is the difference between growth stocks, value stocks, bonds, mutual funds, and money market? Maybe I should just invest in the stock of my company. What happens to the money if something happens to me? When can I get the money back?

That sure is a lot of questions for an employee to answer at once. In the face of such complicated and difficult decision-making, many will procrastinate or simply make a conscious decision not to engage in the decision-making process at all. This is inertia. Because of this inertia, American policymakers believe they will make a better, more informed, well calculated decision about saving for your retirement than you will. Most importantly, they believe that removing the barrier caused by inertia in human cognitive functioning will lead to better financial decision-making by ultimately not requiring a decision to be made at all.

We find this realization of just how policymakers think of us to be sobering and also comforting. It is sobering to realize that they think most of us will not make good financial decisions for ourselves and that they think they can make better decisions for us. It is also a comforting thought to realize they do care about the welfare of the average American who is overwhelmed with complicated financial decisions. Or maybe they just care about the political fallout of a failed Social Security program and are doing an end-run to make it hurt less when we get the news that the Social Security Administration expects to be able to pay only about 70% of the benefit we have earned based on what has been paid in. It certainly does hurt less when I am told I won’t get something I wasn’t expecting anyway. I have no pride of ownership in what I have created, so I won’t feel a sense of loss when it is taken away.

We will talk more about the pride of ownership next month–its use in marketing and how advisors should use it in creating the architecture for financial decision-making with clients.

Justin A. Reckers, CFP®, CDFA™, AIF® is Director of Financial Planning at Pacific Wealth Management® and Managing Director of Pacific Divorce Management, LLC based in San Diego, Calif. www.pacwealth.com, www.pacdivorce.com

Robert A. Simon, Ph.D. is a forensic psychologist, trial consultant, expert witness and alternative dispute resolution specialist based in Del Mar, Calif. www.dr-simon.com

We Are the Ghosts of Economic Rationality Past

November 7, 2011

Justin Reckers, CFP, CDFA Applied Behavioral Finance, Economic Waste, Ghosts of Economic Rationality Past, Self Control Leave a comment

Economically Rational Holiday Shopping

Understanding how the concepts of economic waste and self control apply to gift-giving could bring some welcome rationality to the holiday season.

By Justin Reckers and Robert Simon

Originally published by MorningstarAdvisor.com on October 20th 2011

You may have noticed Christmas stores and decorations popping up in shopping malls in your community. (There seems to be plenty of empty space in strip shopping malls these days, but that is for another writer to discuss.) It’s mid-October and the retailers are ready to sell you holiday merchandise. You may buy decorations for your home and office and gifts for everyone you know, including your nuclear family, aunts, uncles and cousins, friends, clients, neighbors, and even office mates.

There are two main behavioral concepts that come to our minds when we consider the excess that is the holiday shopping binge: Economic Waste and Self Control. Getting a handle on both could bring some sanity back to the season.

Economic Waste: We are not here to be curmudgeons or penny pinchers or play the famous character Scrooge. Rather, we are the ghosts of economic rationality past. Do you really think we need to have stores that sell nothing but Christmas and Hanukah decorations, or are the retailers on to something else? Maybe they are using our self control against us. In times of great holiday cheer, why wouldn’t you want to go into credit card debt in order to buy a bunch of Chia Pets for your office mates? Chia Pets are the gift that keeps on giving, and it is the thought that counts after all. Or maybe this is just a saying that a marketing executive came up with.

The point is, they are trying to help you rationalize buying more crappy gifts in the future after Cousin Steve was rude enough to tell you the gift you gave him was a waste of money. Was it a waste of money? It is, after all, economically irrational to waste money. So wouldn’t it stand that buying gifts for ungrateful Cousin Steve in the future would be economically irrational?

We think it might be. You may never know what Steve would choose to spend that $20 on if given the opportunity, so no matter what gift you give, there will be a difference between what you pay for it and the value Steve gains from it. That difference is economic waste, and wasting economic resources is economically irrational. So why do we do it every year?

It is the thought that counts. Each and every human being derives pleasure from giving gifts at least as much as, if not more than, receiving them. The ones who derive exponentially more pleasure and joy from giving are called saints and have their names on plaques in civic centers, zoos, and places of worship. The ones who get caught up in the moment and let their emotions lead them into buying crappy gifts and overspending are called human beings.

Self Control: In the days of economic rationality past, it was not uncommon for a family to give fruit or whatever their family farm produced as holiday gifts. We can probably all derive relatively the same level of enjoyment from eating a pear. Certainly there are the outliers who just don’t like pears, but we all need the nourishment that is provided by the food and grains created by our neighboring farm, or the warmth of a sweater woven from the wool of your neighbor’s sheep.

Those were simpler times. Christmas stores and credit cards didn’t exist, and I would have to assume most people did not feel obligated by the office Christmas party to buy a gift for their cubicle neighbor whom they otherwise would make an active choice to avoid on most days.

Over time the progressive erosion of human self control has played a role in creating the version of holiday celebrations we all now experience. As economic prosperity has become more widespread, the invention and production of lifestyle and luxury items have become more common. Instead of functional and important gifts such as carpentry, food, and clothing, we all now give entertainment, jewelry, and gadgets. Instead of working hard to create a gift, we go in debt to buy one.

Consider having these conversations with your family, friends, and clients in the coming weeks as shopping season kicks into full gear. Ask yourself whether your $20 would be better spent on a gift card to a store you know your friend frequents compared with the pocket knife flashlight combo on blue light special at your local department store. If you are not positive they will get the same enjoyment value as you put in, then you should default to buying a gift card. If anyone tells you gift cards are impersonal, tell them you believe the exact opposite because you know the $20 you give will be spent on exactly what the recipient wants. After all, they will be the ones making the purchase.

Also put yourself, your family, and your clients on a holiday shopping budget. Map out the spending goals exactly how you see them. Self control seems to run away just as quickly when buying gifts as it does when buying things for ourselves. Some people report it being even worse because they think the feeling of giving will stick with them longer than the feeling they get from consuming. A budget will help everyone avoid picking up that extra item they see in passing.

Lastly, consider the White Elephant party. Wikipedia says “the term white elephant refers to a gift whose maintenance costs exceed its usefulness.” Most of us go to White Elephant gift exchanges with the understanding that they are a big joke, and we don’t think about the underlying idea. But if we stop and consider the premise behind these comical exchanges, I bet most of us will realize we participate in a lot more White Elephant gift exchanges than we think.

We will continue our Applied Behavioral Finance series next month with some incredible and sobering real world examples of how others may be taking advantage of you and your clients’ economic irrationality.

The Blue Screen of Death in Financial Decision-Making

November 7, 2011

Justin Reckers, CFP, CDFA Applied Behavioral Finance, Aversion to Ambiguity, Blue Screen of Death, Fear, Morningstar Advisor Leave a comment

Fear is inevitable, so removing the ambiguity that causes that fear should be your approach with clients.

By Justin Reckers and Robert Simon

Originally published September 15th 2011.

We think we can all recall a moment in our lives when the personal computer has been more of a handicap than an asset. As Windows and other operating systems developed over the last thirty years there have inevitably been bugs in the system, or ghosts in the machine depending up on your level of belief in conspiracy theory. One of the main bugs that we can all remember is what came to be known as the Blue Screen of Death. Actually the Blue Screen of Death was more a reaction to a bug then a bug itself. The Blue Screen of Death is the error screen displayed by Microsoft Windows operating systems upon encountering a “critical error.” In computer speak it is known officially as a Stop Error. The term is named after the color of the screen generated by the error. Stop Errors cause the computer to stop responding in order to prevent damage to the hardware.

Does the explanation of a Stop Error sound familiar? Have you ever witnessed the exact moment when your client mentally checked out of a meeting? In financial decision making the Stop Error message is sent by your client’s brain. In the presence of risk and uncertainty the human brain is hard wired to protect itself. The Stop Error message from your client’s protective instinct tells them to stop responding to decision-making prompts in order to prevent damage. We find it eerily strange to imagine the artificial intelligence of even early personal computers to be so similar to the evolutionary intelligence of the human mind. Write a comment to let us know just how scared you are of the artificial intelligence someday controlling the world.

The point of our article is not to spout conspiracy theory or spew science fiction laden conjecture about robots ruling the world. It is to draw the advisors attention to the observations we can make about the financial decision making of our clients and offer Behavioral Finance based concepts to help advisors make the positive changes necessary for their clients to make financial decisions the way a human mind was meant to, rather than the way of a computer or Homo Economicus.

So why do advisors often encounter the Blue Screen of Death when working with clients in difficult financial decisions? Fear is the most common and most crippling cause of the Blue Screen of Death but what causes the fear and what brings it to the table in financial decisions? Aversion to Ambiguity is one of the most common fear inducing barriers we observe in financial decision making. Ambiguity often amounts to an unknown outcome which equates to an unknown future. The aversion to ambiguity as we experience it with clients often amounts to a cognitive barrier that manifests as the emotional reaction we recognize as fear. It turns clients into passive decision makers or induces enough fear to completely derail the decision making process and cause the Blue Screen of Death.

Our clients will, if educated and re-enforced, admit that uncertainty is part of the financial planning process. Signing up as a client in the first place required him to recognize the fact that uncertainty and ambiguity existed. He recognized at that moment the only way to control these complicating factors was to plan for them. Why then would a client be afraid of uncertainty and exhibit an aversion to ambiguity?

Fear of the unknown can be crippling in all parts of life. Asking for a promotion, scuba diving for the first time and speaking in public all strike fear in the hearts of many adults. All of these have uncertainty as there complicating factors. What will happen if something goes wrong? What if I get fired? Many learn to push off these kinds of fears by saying: What is the worst that could happen? If you are asking for a raise chances are you believe you are not fairly compensated for the value you provide. Getting fired after all may not be that bad if you feel you are treated unfairly. Assuming you are being responsible you will have insured a qualified teacher was on hand when learning scuba diving. The teacher will be well-qualified in life saving techniques. You might have a moment of panic but you are not likely to be fatally injured. Speaking in public may just take a vote of confidence. It is helpful to recognize that an invitation to speak to a group is a good indication the group considers you to be somewhat of an expert. The worst case is that you stumble over a section and have to ad-lib. We have found that moments like these are some of the best creators of innovation and new thoughts in our work.

The examples given together with their mitigating thought processes all demonstrate one concept. They all recognize the fear before trying to fix it. You will fail if you try to remove the fear created by uncertainty and ambiguity. Instead focus on removing the uncertainty and ambiguity by recognizing it exists and brainstorming the scenarios it may create. The examples given above all recognize the fear by delineating it in worst-case scenarios. Start with the worst case then work your way back to the likely outcomes. This process will remove ambiguity, recognize uncertainty, require dynamic thinking on behalf of your client and recognize the fear so the client is not left outside looking from behind the Blue Screen of Death.

We will continue our Applied Behavioral Finance series next month with a Holiday themed topic to kick off the season’s shopping in October followed by some incredible and sobering real world examples of how others may be taking advantage of you and your clients’ economic irrationality.

 

Justin A. Reckers, CFP, CDFA, AIF is Director of Financial Planning at Pacific Wealth Management www.pacwealth.com and Managing Director of Pacific Divorce Management, LLC www.pacdivorce.com, in San Diego.

Robert A. Simon, Ph.D. www.dr-simon.com is a forensic psychologist, trial consultant, expert witness, and alternative dispute resolution specialist based in Del Mar, Calif.

How Your Clients Can Ruin Even the Best-Laid Plans

November 7, 2011

Justin Reckers, CFP, CDFA Applied Behavioral Finance, Endowment Effect, Status Quo Bias Leave a comment

Client inertia and procrastination can put your financial plans on the back burner.

By Justin Reckers and Robert Simon

Originally published by MorningstarAdvisor.com on August 18th 2011

“The best-laid schemes of mice and men go often askew, and leave us nothing but grief and pain.”

This is an English translation of a piece of wisdom written by Robert Burns in 1785, and it rings true today. We know many advisors who wonder why their clients don’t follow up on the well-laid plans they propose. They wonder how a client can pay for the professional advice of a financial planner and then not follow it. They wonder why intelligent and responsible individuals and families can let the financial safety, security, and well being of their loved ones fall by the wayside. They wonder why a husband and father cannot bring himself to follow through on placing an inexpensive life insurance policy to insure against the loss of their income in the event of death. They wonder how a wealthy patriarch can pass away without having made the plans necessary to provide for conflict-free administration of their estate.

There are many reasons why even the best-laid plans often go awry, such as barriers to progress and biases that create delays. Procrastination and inertia are common barriers caused by cognitive and emotional bias that advisors can easily observe and in many cases just as easily implement a positive effect. Understanding the root cause of your client’s aversion to progress can have an amazing effect on the results of your hard work and the client-advisor relationship. No advisor likes leveling advice and sending a client away with a to-do list only to never see him again.

We all learn about the concept of procrastination at the moment we are given responsibility for a chore as children. In psychology, procrastination refers to the act of replacing high-priority actions with tasks of low-priority, ultimately putting off important tasks to a later time. Some psychologists believe procrastination to be a mechanism for coping with the anxiety associated with starting or completing tasks or decision-making processes in the presence of uncertainty or risk.

Inertia is the resistance to a change in a state of motion or rest, or the tendency to resist any change. The force of inertia is proportional to an object’s mass. In this case the object is a financial decision. The bigger the financial decision, the greater the role the force of inertia will play upon your clients’ ability to make progress.

So what causes procrastination and inertia in financial decision-making?

Status Quo
Status quo bias is the tendency for people to like things to stay relatively the same because the disadvantages of change loom larger than the advantages. When a client has a preference for the status quo they may procrastinate by replacing the high-priority tasks of enacting your financial-planning recommendations in the interest of less important and far less anxiety-producing tasks like organizing files or planning for events far into the future. They do this in order to reduce the importance of the anxiety-provoking decision problem you have laid out in front of them. They may also be seeking an answer to the problem that perpetuates the status quo. In the absence of such an option, they might shut down and attempt to remove themselves from the decision-making problem. This is a defense mechanism to reduce the stress they encounter when forced to make a change. This is inertia.

A preference for the status quo might be encountered in a client with any number of different underlying cognitive biases. Aversion to loss can lead your client to prioritize the realization of gains over the realization of losses. In doing so, he will have diminished the importance of realizing losses and ultimately they will have decided doing so was not necessary.

Endowment Effect
The Endowment Effect is another common cognitive bias that often leads to inertia. It can be a form of Status quo bias because a client can wind up overvaluing a home or other asset he currently owns. He may ascribe value to the asset in a way that perpetuates the status quo. If you overprice a home it is not likely to ever be sold, and the status quo is maintained.

The strong desire to keep things the same can cause opportunities to be missed and the best-laid plans to go awry. Dollar cost averaging is one of the old school mechanisms for combating inertia. Dollar cost averaging removes the necessity for an investor to make a decision about whether to invest each month. By removing that decision, the inventor of the program has removed the negative effects of inertia in financial decision making.

In recent years behavioral economists have been studying the cause and effect of inertia and have sought ways to positively affect decision-making through its application. “Opt-out”-style retirement plans are becoming more common. In an “opt out” plan employees are automatically enrolled in a company-sponsored retirement plan, often with a small contribution from the employer. They are given the opportunity to opt out of the plan only. There is no paperwork to fill out and box to check in order to participate. Everyone participates unless they opt out. Research shows most will opt to stay thanks to the effects of inertia and bias toward the status quo. The inertia of employees means more will participate in opt-out-style plans, and the greater financial good of Middle America will be better served.

Day-to-day financial advisory practices would be well-served to build in more high-touch client interaction with those they suspect might tend toward procrastination. Regular follow-up including timelines, meeting notes, and to-do lists can help increase accountability for procrastinators who might feel the pressure of an upcoming follow-up meeting to be significant enough motivation to get the job done.

We will continue our Applied Behavioral Finance series next month with a look at what we call the Blue Screen of Death in Financial Decision Making to close out the summer followed by a holiday-themed topic to kick off the season’s shopping in October.

Justin A. Reckers, CFP, CDFA, AIF is Director of Financial Planning at Pacific Wealth Management www.pacwealth.com and Managing Director of Pacific Divorce Management, LLC www.pacdivorce.com, in San Diego.

Robert A. Simon, Ph.D. www.dr-simon.com is a forensic psychologist, trial consultant, expert witness, and alternative dispute resolution specialist based in Del Mar, Calif.

Finding the Upside to Predictably Irrational Financial Decision-Making in Collaborative Divorce

July 26, 2011

Justin Reckers, CFP, CDFA Applied Behavioral Finance, Behavioral Economics, Behavioral Finance Leave a comment

Look for us at the 12th Annual International Academy of Collaborative Professionals Networking and Education Forum in San Francisco this October 27th through the 30th.

World Renown Speaker, Behavioral Economist and Best-selling author Dan Ariely will enlighten us all on Saturday with a plenary session and we will follow Saturday afternoon with our observations from his research in a session titled FINDING THE UPSIDE TO PREDICTABLY IRRATIONAL FINANCIAL DECISION-MAKING IN COLLABORATIVE DIVORCE

Using observations from Dan Ariely’s research, this workshop will provide practical and pragmatic ways for Collaborative practtioners to recognize the common emotional and cognitive barriers to economically rational financial decision-making. We will illustrate common barriers through Mr. Ariely’s experiments and discuss how observations can be used to build economically “rational” financial decision-making processes in Collaborative Practice. Demonstrations and Lecture will rely upon research by Dan Ariely, et al., as detailed in his books, Predicatbly Irrational and the Upside of Irrationality.

 

How Professional Biases Can Cloud Judgment

July 26, 2011

Justin Reckers, CFP, CDFA Applied Behavioral Finance, Availability Bias, Confirmation Bias, Fiduciary Duty, Illusion of Control, Morningstar Advisor, Overconfidence Bias, Professional Bias, Recency Bias , , , , Leave a comment

How Professional Biases Can Cloud Your Judgment

Financial Advisors have to be aware of their own biases in order to guide clients effectively.

by Justin A. Reckers and Robert A. Simon

Originally published by MorningstarAdvisor.com on July 21st 2011.

The day-to-day operations of an investment advisor, financial planner, or wealth manager are complicated by incessant and unrelenting information overload, constant trials of our competency, and powerful tests of will. You are tasked with the management of other people’s financial matters. You are asked to earn competitive returns and never book losses. You are required to insure your advice is suitable for your clients and in their best interests.

In your discharge of these tasks and obligations, you have developed opinions over time–some rooted in education, others in experience. So what happens when your professional guidance becomes the barrier to economically rational financial decision-making for your clients? You are not a crook or out to do damage. You live by the Hippocratic Oath to do no harm. You read all of the research you can get your hands on. You watch CNBC and Bloomberg to make sure nothing gets past you. You maintain a fiduciary standard for all of your clients and keep up on your continuing education. So how could you be leading your clients into economically irrational financial decisions? Your professional biases can be the most powerful of all.

In previous articles, we have stressed the importance of self determination, informed consent, and a fiduciary standard of care in the professional financial advisory world. As architects of decision-making, these should be your main goals, but you also have to be aware of your own biases in order to guide your clients effectively to this end.

Professional biases come in all shapes and sizes. Just as clients exhibit aversion to loss, so do their advisors. It is incumbent upon the professional investment advisor to understand this and build a disciplined process for constantly monitoring and analyzing the performance of client assets without attaching emotional value to market performance. One of the most important roles of a professional investment advisor is to remove emotion from investment decisions. Some clients are completely unable to do so. Investment advisors have it as their job description.

You all know how much easier it is to deal with your aversion to loss in bull markets, but what happens in bear markets when your clients have lost money? Everyone lost money in 2008 and 2009. We have heard many advisors comment about how much more difficult their job had been during the Great Recession. Their will was tested, their investment discipline either hardened or destabilized, and in many cases client loyalty has come to the forefront.

Whether you are a buy-and-hold manager or an active one, your client review meetings have probably included many questions such as: Where is the bottom? When will we get out? In the buy-and-hold world, your answer is probably dictated only by change of time horizon because your discipline tells you to always be invested. Your job in the review meetings is to be the voice of economic rationality and deter your clients from making emotional decisions. But what if you also have an aversion to loss? Do you find yourself questioning your investment discipline? It was hard to watch the S&P 500 lose 56% in 2008 and 2009. Even the most hardened buy-and-hold advocates were tested.

We suggest using investment policy statements to clearly delineate downside risk tolerance and processes for evaluating the performance of investments. Writing it down commits your discipline to contract and removes much of the emotional connection. We suggest having checks and balances in place through an investment policy committee or board of advisors. Even the strongest willed advisors can be affected by temporary economic irrationality if left alone. Maybe even join a practice group through your local financial planning association.

Confirmation bias is another common professional bias for financial advisors. Confirmation bias is the tendency for advisors to seek and rely upon information that confirms their preconceived notions regardless of whether it is true. This bias is particularly strong in situations where advisors have attached significant value to large issues and established beliefs. Advisors can end up anchoring upon their established beliefs and refuse to receive or test the possibility that other options even exist.

Buy-and-hold investing may be a perfect example of confirmation bias. Many advisors were converted to buy-and-hold managers in the ’90s when the concept was popularized, index funds proliferated, and the rising tide of our 1982-2000 bull market lifted all ships. It is not our intention to support one investment management discipline over another, just to point out places where we see biased behavior. The choice of buy-and-hold discipline is not biased in and of itself. It is the devout belief system that often comes with this discipline that can cause problems. Many advisors will choose this discipline after seeing a demonstration that shows the S&P 500 returning 10% per year from 1906 to 2011. The data would be correct, but they will pay no attention to the complicating factors that must be incorporated if they are to be making economically rational decisions with all available information.

This is also known as availability bias, where the advisor is relying upon available information only. Similarly, your client may tell you that his parents lived only to age 70 so they will not live past that age, and it would be a waste to plan for it. Or maybe his father lived to age 90 smoking two packs of cigarettes a day so there is no reason for him to quit smoking. Both of these statements are beliefs created from the available experience of the client. This information will be the most easily recalled or available and may ultimately be relied upon. In the instance where an advisor’s belief system allows only for buy and hold, this is what will be recalled and relied upon.

What about the individual client time horizon? You certainly haven’t made 10% per year since 2000. What about price-to-earnings ratios? Ten-year trailing P/E ratios remain very expensive. What about global debt and banking crises? Everyone is waiting for the next shoe to drop.

The point is to remember that there is never a silver bullet in the world of investment advisory and financial planning. If there were, someone would have figured it out by now. If you make decisions and help your clients make decisions without all available information, these decisions may be based 100% on your own beliefs and biases. A decision-making process based solely upon your belief system is not an accurate and complete analysis, and could lead your clients down the road to economic irrationality.

We will continue our Applied Behavioral Finance series next month with a look at inertia in financial decision-making, and how to affect positive change when your client is disinterested or apathetic. We will follow with an analysis of what we call the Blue Screen of Death in financial decision-making to close out the summer in September.

Justin A. Reckers, CFP, CDFA, AIF is director of financial planning at Pacific Wealth Management www.pacwealth.com and managing director of Pacific Divorce Management, LLC www.pacdivorce.com, in San Diego.

Robert A. Simon, Ph.D. www.dr-simon.com is a forensic psychologist, trial consultant, expert witness, and alternative dispute resolution specialist based in Del Mar, Calif.

The Benefits of a Financial Nudge

July 26, 2011

Justin Reckers, CFP, CDFA Applied Behavioral Finance, Behavioral Economics, Morningstar Advisor, Nudge, Psychology , , , , , Leave a comment

The Benefits of a Financial Nudge

Reconciling the concepts of libertarian paternalism and self-determination.

by Justin A. Reckers and Robert A. Simon

Originally published by MorningstarAdvisor.com on June 16th 2011.

Richard Thaler is undeniably one of the godfathers of behavioral economics. Thaler is the professor of behavioral science and economics at the University of Chicago Booth School of Business and director of the Center for Decision Research. As an economist, he has collaborated with the founders of cognitive psychology and “prospect theory,” Amos Tversky and Daniel Kahneman.

Thaler’s publication credits are lengthy, his research important, and his ideas brilliant. He grasped the tenets of cognitive psychology early on in his career as an economist and has used those tenets to build an original model for effecting positive change in the world of economic policy and financial decision-making. He calls it the “Nudge.” Thaler penned a book along with Cass Sunstein by the same title in 2008.

In previous writings, Thaler and Sunstein detailed an economic strategy they call “libertarian paternalism.” The basic idea, in my words, proposes that private and public institutions might do well to nudge people (citizens) toward certain decisions the institution believes to be in the best interest of its constituents. The nudges should help people make decisions that improve their lives economically, while supporting each individual’s freedom of choice. The nudge represents paternalism and the freedom of choice represents libertarianism.

We wrote last month about the importance of self-determination in financial advisory practices and financial decision-making in general. This month we look, briefly, at whether Thaler and Sunstein’s nudge may be a successful way to effect positive change in daily financial decision-making and whether it meets with our goals of supporting self-determination and informed consent.

In the abstract of Thaler and Sunstein’s principal paper Libertarian Paternalism is Not an Oxymoron, it states “Often people’s preferences are unclear and ill-formed, and their choices will inevitably be influenced by default rules, framing effects, and starting points. … Equipped with an understanding of behavioral findings of bounded rationality and bounded self-control, libertarian paternalists should attempt to steer people’s choices in welfare-promoting directions without eliminating freedom of choice. It is also possible to show how a libertarian paternalist might select among the possible options and to assess how much choice to offer.”

Cognitive psychology studies how people perceive, remember, think, speak, and solve problems. The discoveries made since its founding in the 1970s have shaped how psychologists and economists perceive the science behind cognitive processes in financial decisions. We agree with Thaler and Sunstein that people’s preferences are often unclear or ill-informed when they are set in the midst of ambiguity and created by life experiences. We also agree that framing and other cognitive distortions will influence the decisions made to a greater extent in the midst of ambiguity and emotion. The part that deserves more attention, in our minds, is Thaler and Sunstein’s belief that “libertarian paternalists should attempt to steer people’s choices in welfare-promoting directions without eliminating freedom of choice.”

How is this done while supporting and maintaining true self-determination? We wrote in our last column that we believe self-determination to be the greatest motivation behind an advisor’s decision to incorporate behavioral finance into practice. Self-determination at its simplest is the power or ability to make a decision for oneself without influence from outside forces. Libertarian paternalism attempts to maintain the freedom of choice yet advocates for advisors and policymakers to “steer” the decision-making processes of those who would be helped in the direction of decisions the advisor or policymaker believes to be welfare promoting.

Can we really support self-determination while exerting our own influence as advisors and policymakers upon others? Doesn’t that fly in the face of the goal for self-determination if we believe that the absence of outside influence is necessary for true self-determination?

Thaler developed a great plan he calls Save More Tomorrow. This libertarian paternalism-inspired plan allows workers to sign up today to save more of their wages in the future. In this way workers are 1) encouraged to make the right choice and save more of their future earnings and 2) allowed to make their own choice and self-determine that they believe saving a greater percentage of their incomes over time is a prudent decision.

The difference between libertarian paternalism and true self-determination is slight but clear. In the instance of the Save More Tomorrow program, self-determination is encouraged, but the array of choices offered is predetermined by the advisor or policymaker. The only options are to Save More Tomorrow or not. Most people will realize the value of savings and choose this option, which the policymaker also believes to be in the individual’s best interest. When they are asked to part with future dollars not yet in their possession instead of current dollars they may have already allocated elsewhere, mental accounting will kick in and tell them to make the choice the policymaker suggests would be best, and they will choose to Save More Tomorrow. In this way it encourages people to make the right choice without imposing it upon them. This and many of Thaler’s other libertarian paternalism-inspired endeavors beg the question of where is the line between self-determination and choice architecture.

Each individual practitioner will ultimately make many choices over time as to how to encourage clients to choose the “best” avenue for their financial decision-making. If too much focus is given to the strategies, solutions, and implementation while ignoring the client needs, wants, and wishes, we risk the relevance of the advisory process and its ability to reflect the client’s unique circumstances.

We believe the choice architecture of financial decision-making must be built with self-determination as its main motivation. We also believe people can and should be encouraged to make better decisions with their money. Businesses have been using the nudge for years seeking to drive a wedge between people and their self-control in order to persuade them to purchase something or to spend on credit. So, without discussing the political ramifications of such policy intervention, we totally support the nudges behind libertarian paternalism and encourage the use of choice architecture in facilitating economically rational and informed financial decisions for clients. It does not destroy self-determination; it simply redefines the process.

We will continue our Applied Behavioral Finance series next month with a look at common professional biases such as confirmatory bias, attribution error, and availability, which can come into play when an advisor chooses to be the architect of a client’s financial decision-making.

Citation: Thaler, Richard H., and Cass R. Sunstein 2003. “Libertarian Paternalism .”American Economic Review, 93(2): 175-179.

Justin A. Reckers, CFP, CDFA, AIF is director of financial planning at Pacific Wealth Management www.pacwealth.com and managing director of Pacific Divorce Management, LLC www.pacdivorce.com, in San Diego.

Robert A. Simon, Ph.D. www.dr-simon.com is a forensic psychologist, trial consultant, expert witness, and alternative dispute resolution specialist based in Del Mar, Calif.

How Neuroscience Supports a Fiduciary Standard for Financial Advisors

June 10, 2011

Justin Reckers, CFP, CDFA Applied Behavioral Finance, Confirmation Bias, Morningstar Advisor, Neuroscience, Self Determination , , , , , Leave a comment

Neuroscience Supports a Fiduciary Standard for Financial Advisors

Because clients are predisposed to ‘offload’ important financial decisions, a mandatory fiduciary standard of care should be applied to any individuals who purport to provide financial advice.

by Justin A. Reckers and Robert A. Simon

Originally published by MorningstarAdvisor.com on May 19th 2011

The first article in this behavioral finance-focused series was titled “Financial Advisors as Architects of Decision Making” and included the following message:

“Effective and rewarding client relationships require the comfort of factual data, trust in the expert, and a personal relationship re-enforced by the advisor’s ability to recognize and address the cognitive and emotional barriers a client faces in decision making.”

We have now written 12 articles on the topic and want to go back to the roots of our motivation and the concepts we rely upon to form our commitment to the work.

We believe there are two important goals that should remain at the forefront of advisors’ minds in all advisory relationships. These two goals are the basis for our belief that financial advisors should become architects of financial decision-making and that a fiduciary standard of care should be mandatory when providing financial advice. They are the motivation for all of our work in the world of behavioral finance. The first is to encourage self-determination. The second is to facilitate informed consent.

Too often advisors become expert wielders of advice and commentary like talking heads on CNBC, product pushers, and newsletter salespeople. They lose the human connection that is necessary to truly reflect each client’s individual financial reality. If you miss each individual’s beliefs, values, fears, biases, and tendencies, you will miss the connection. If you miss the connection, you will fail to facilitate a decision-making process, and you will be nothing but a salesperson pushing your own agenda conflicted by your own confirmatory bias.

The real value in financial advisory practice is helping each individual client make the best financial decisions for his or her family, circumstances, and goals by encouraging self-determination and informed consent. These two tenants form the architecture of “rational” decision-making.

Self-Determination
Self-determination at its simplest is the power or ability to make a decision for oneself without influence from outside forces. Self Determination Theory is concerned with human motivation related to our innate psychological needs and studies the motivation behind choices people make away from external influence and interference. In order to truly encourage ownership of financial decisions, advisors must learn to encourage self-determination. This means moderating or removing the external forces that influence the client.

Neuroscience has shown that receiving expert financial advice can neurobiologically “offload” the responsibility for financial decision-making in circumstances complicated by the presence of risk. As described in 2009 study titled, “Expert Financial Advice Neurobiologically ‘Offloads’ Financial Decision-Making Under Risk,” a group of economists and psychiatrists used magnetic resonance imaging (MRI) to investigate the neurobiological processes associated with making financial decisions in risky circumstances with and without expert advice. The results of the study showed that expert financial advice significantly swayed results in the direction suggested by the expert advice. Effectively your client is offloading the responsibility for making financial decisions to you because they believe relying upon the external force will help reduce the perceived risk in the decision-making process. This is a clear departure from the concept of self-determination and leaves clients with decisions made by an unrelated party. In the absence of self-determination and informed consent, clients will never choose what is best for their family because they will not be the ones making the decision. You will.

Risk is inherent in the financial decision-making of all parties: the risk that goals will not be met, that premature death will negatively affect one’s family, that the stock market will crash, that disability will damage earning capacity, that a municipality will default on its debt, that an economic recovery will falter, that a job will be lost, or that a business will fail. Every client has risk involved in every financial decision they make.

If risk is present in all financial decisions, then clients run the risk of giving up the responsibility for their financial decision-making for the good of their family’s financial future or for the good of their business partners to someone in the financial-services industry. Many times in the world of financial advice, this unrelated party is a salesperson and has no mandatory fiduciary duty to the client. They must only prove that what they sold their client was suitable at the time of the transaction, not that they had the client’s best interests in mind or that they, if given the choice and same circumstances, would make the same decision for their own family.

Informed Consent
So what happens if the client throws his hands up and says, “I don’t know what I am doing; isn’t it your job to tell me what I should do?” We fully recognize that self-determination is not always possible. Aside from circumstances where parties lack the mental faculties to be an active participant in decision-making, we still have the obligation to seek informed consent.

In situations where it is decided to rely upon the advice of an investment manager and grant that person discretionary authority to manage investments, it should be absolutely mandatory to have a written and signed contract or Investment Policy Statement delineating the client’s informed consent to a risk tolerance level, detailing the client’s objectives and the responsibilities of each party to the contract. These types of engagement agreements, investment policy statements, and other contracts have been in use within the independent financial advisor community for many years, but are not mandatory unless advisors have taken the extra steps to become a Certified Financial Planner practitioner, Accredited Investment Fiduciary, or other accreditation demonstrating commitment to fiduciary duty.

We believe the value of self-determination and the neuroscientific evidence proving the offloading of financial decision-making under risk are the two most important arguments for a mandatory fiduciary standard of care to be applied to individuals of all types who purport to provide financial advice.

If we are to move successfully toward a required fiduciary standard of care as contemplated in recent legislation, it may require a move away from economic analysis to prove or disprove the efficacy and importance of the standard. Instead we might concentrate on a more serious look at the psychology behind financial decision-making, the value of self-determination, and the risk of Americans neurobiologically offloading the responsibility for financial decisions to a salesperson who may not have their best interests in mind.

We will continue our applied behavioral finance series next month with a look at the concept of Libertarian Paternalism as coined by Richard Thaler and Cass Sunstein and how it interacts with self-determination, and then we will begin a short foray into common professional biases such as confirmatory bias, attribution error, and availability.

Citation: Engelmann JB, Capra CM, Noussair C, Berns GS, 2009 Expert Financial Advice Neurobiologically “Offloads” Financial Decision-Making under Risk. PLoS ONE 4(3): e4957. doi:10.1371/journal.pone.0004957

Justin A. Reckers, CFP, CDFA, AIF is Director of Financial Planning at Pacific Wealth Management  www.pacwealth.com and Managing Director of Pacific Divorce Management, LLC www.pacdivorce.com, in San Diego.

Robert A. Simon, Ph.D. www.dr-simon.com is a forensic psychologist, trial consultant, expert witness, and alternative dispute resolution specialist based in Del Mar, Calif.

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