Behavioral Finance: Sensing vs. Intuitive Clients

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Sensing Versus Intuitive Clients and Their Financial Decision-Making

Determining if a client is more aligned with the sensing or intuition preference gives advisors two huge pieces of information about how best to work with them.

Justin A. Reckers and Robert A. Simon,

Originally published by www.MorningstarAdvisor.com on July 23rd 2012

In our last couple of articles, we began drilling down on the four continua of personality and psychological preferences that underlie the Myers-Briggs Type Indicator.

–Extraversion v. Introversion
–Sensing v. Intuition
–Thinking v. Feeling
–Judging v. Perceiving

An individual’s personality will give us vital guidance into that client’s psychological needs, behavioral patterns, and the way in which emotions interact with and interrupt financial decision-making.

Last month we reviewed the Extroversion vs. Introversion continua. We offered observations of both extroverts and introverts and uncovered some common biases and barriers they might encounter on the way to economically rational decision-making.

This month we take on the next leg of the Myers-Briggs Type Indicator and discuss the Sensing vs. Intuition preference. This overview will help you as an advisor to recognize which side of the ledger your clients occupy and give some ideas as to how you can best work with them and the specific behavioral and cognitive biases they may bring into their financial decision-making.

In previous articles we briefly outlined the “sensing” individual juxtaposed with the “intuitive” counterpart and gave a ten-thousand-foot view of their communication styles and tendencies toward certain economically irrational thought processes. Determining if a client is more aligned with the sensing or intuition preference gives advisors two huge pieces of information about how best to work with them.

1) How do they learn?
2) How do they perceive the future?

Clients are mostly sensing or intuitive but are likely to still have traits of the other. So it would not be accurate to pigeonhole individuals into one classification. However, we will discuss them as two separate categories for purposes of contrast.

Sensing 
Sensing individuals are attentive and immersed in the sensory intake from every environment they encounter. The individual exhibiting the psychological preferences of a sensing personality will use quotes like “live for today,” “here and now,” and “bottom line.”

Following are some brief descriptions of observations common in sensing clients that can help an advisor recognize an extroverted personality.

Observations of a Sensing Client
–Detail oriented
–Takes mental pictures
–Remembers events based on literal experience
–Concerned with the present
–Occupied by what is actual and tangible
–Trusting of experience
–Pragmatic
–Learns from practical application

We believe sensing individuals to be inclined to exhibit more passive biases. Following are some behavioral finance biases we believe should be expected in sensing personalities along with brief descriptions. The three biases below are different but interrelated, as you will see from the explanations:

Status Quo Bias: Sensing clients are concerned with the present, the here and now, and will have trouble committing to a deliberate conceptualization of the future. Because of this concern for the present, they will exhibit a bias toward the status quo and an aversion to change.

Aversion to Ambiguity: Sensing clients are occupied by what is actual and tangible, and just as they have an aversion to change, they have an aversion to the future. They are preoccupied with understanding the present and sensing the effect of the forces around them in a given moment. They require the details and the availability of current information, so the ambiguity represented by the future may cause them to withdrawal.

Inertia: Sensing client can be very detail oriented and pay so much attention to the current facts that they miss new and different possibilities, which can lead to inertia. The preference for the status quo combined with the heightened awareness of current tangible details will cause the sensing client to miss opportunities for progress.

Intuition 
Intuitive individuals are likely to be more future oriented and more capable of conceptualizing what might be possible. They will also be more skeptical of the future and always be calculating different angles and reading between the lines.

Observations of an Intuitive Client
–Remembers events based on an impression of the experience
–Constantly tries to read between the lines
–Learns by thinking through every angle
–Adventurous
–Trusts gut feelings
–Day dreamer
–Can be scatter-brained, jumping from one place to the other
–Thinks more of the future than the past

We believe intuitive clients may be more inclined to exhibit active biases. Following are some behavioral finance biases we believe to be common in intuitive personalities, with brief descriptions.

Analysis Paralysis: Intuitive individuals are always seeking deeper meanings in situations. In divorce negotiations, for instance, we commonly see intuitive clients balk at financial settlements offered them without consideration. The common reasoning is, “if my former spouse is offering it to me, it must not be a good deal.” The intuitive client may look for hidden meanings and wind up allowing a feeling that things are too good to be true hijack decision-making.

Framing Effect: Intuitive people remember events and learn based on impressions. In the case of a memorable event, they may associate a feeling or a thought they had in the middle of the memory. They are constantly looking at all angles and seeking a different frame of reference for the memory or the learning experience. Because of this, they may be prone to framing effect or the tendency for people to draw different conclusions based on how data is presented. This includes the tendency to ignore that a solution exists, because the source is seen as an “enemy” or as “inferior” (see above).

Optimism Bias: Because intuitive individuals tend to trust their gut feelings, they may believe they are less at risk of experiencing a negative outcome. They simply believe the gut feeling they have based on their own knowledge and experience is the best resource to rely upon–which can lead to unrealistic optimism.

Next month we will have a more in-depth discussion and application of the Thinking vs. Feeling leg of the Myers-Briggs continua.

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.

Behavioral Finance: Extroverted vs. Introverted Clients

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Extroverted Versus Introverted Clients and Their Financial Decision-Making

If advisors can recognize which side of the ledger a client occupies, they can better address the specific behavioral and cognitive biases he may bring to financial decisions.

Justin A. Reckers and Robert A. Simon,

Originally published by www.MorningstarAdvisor.com on June 28th 2012

In our last article, we began drilling down on the four continua of personality that underlie the Myers-Briggs type indicator:

  • Extraversion v. Introversion
  • Sensing v. Intuition
  • Thinking v. Feeling
  • Judging v. Perceiving

An individual’s personality will give us vital guidance to that client’s psychological needs, behavioral patterns, and the way in which emotion interacts with the individual’s thought processes. Over the next few articles, we will take each of the four continua and individually drill down to provide ways that advisors might recognize which side of the ledger their clients occupy, and also give some ideas and advice as to how advisors can best work with clients and the specific behavioral and cognitive biases they may bring into their financial decision-making.

In previous articles we have given brief descriptions of the extroverted individual juxtaposed with the introverted counterpart, and offered a 10,000-foot view of their communication styles and tendencies toward certain economically irrational thought processes. It’s important to remember that even though clients are mostly introverted or extroverted, they are likely to still have traits of the other. So it would not be accurate to pigeonhole individuals into one classification. For instance, levels of comfort or security in specific situations and environments may help to fashion a person into an extrovert in comfortable, family-oriented situations, and an introvert in less-comfortable business meetings or social engagements.

Extroverts
Extroverts are often gregarious, confident, and prone to positive thinking. The extroverted individual would be outgoing and relatively less inhibited in interactions with others.

Following are some brief descriptions of observations common in extroverts that can help an advisor recognize an extroverted personality.

Observations of Extroverts
–Outgoing and friendly in social situations
–Self-confident
–Lovers of crowds, upbeat music, and community events
–Maintain large groups of marginal relationships but may have few close relationships
–Driven to sales and leadership positions in career choices
–Derive energy from others
–Good communicators
–More likely to engage in delinquent behavior as a child
–Generally self-classify as happy more frequently than introverted personalities
–More prone to react to pleasant events
–Better able to think positively in the midst of negative information or ambiguity

We believe extroverts to be inclined to exhibit active/emotional biases. Following are some behavioral finance biases we think should be expected in extroverted personalities:

Overconfidence Bias: Extroverts’ tendency toward self-confidence and need to exhibit this self confidence to manage social and business situations may lead to overconfidence. In situations where extroverts consider themselves to be well informed and socially positioned, they may believe so strongly in their own ability or knowledge that they will refuse to accept the input of others. The reason for their refusal might be the risk of taking a hit to their self-confidence should they be proven wrong.

Illusion of Control Bias: This bias may play into the extrovert’s love of crowds and community events. They are more prone to being swept into the joy of the masses. They will derive energy from the crowd. Extroverts’ self-confidence and illusion of controlling the situation are a large part of what allow them to be comfortable in crowds when introverts would be made nervous by their perceived lack of control.

Bandwagon Bias: Extroverts have a need for social interaction and thrive in social environments. For this reason we believe it more likely for them to exhibit a bias toward the social crowd, making them more prone to crowd behavior. They probably can’t help but chat up their office mates or cocktail buddies about their market performance. When they hear the consensus of the crowd, they may follow in order to avoid upsetting the social order.

Introverts
More introverted individuals can be shy, inhibited, and have tendencies toward self-doubt and reliance on others.

Observations of Introverts
–Self-conscious, often wondering whether they fit in or are doing things right
–Nervous
–Close to the vest
–More focused and able to maintain focus in social situations and over longer periods of time
–Shy in new or uncertain situations
–Tend toward private reflection instead of public discussion in decision-making processes
–Take their time to think deeply and reflect internally; you say they think before they act
–Get their energy from within rather than feeding off of others like an extrovert will; they may even find groups of people to be emotionally and physically draining
–They enjoy alone time and need it to refuel after stressful or nerve-wracking social encounters
–Some studies suggest introverted personalities are strongly correlated with “gifted” intellect
–Careers such as academics and computer programming
–More prone to react to negativity and see ambiguity as negative

We believe introverts may be more inclined to exhibit passive biases. Following are some behavioral finance biases we believe to be common in introverted personalities:

Aversion to Ambiguity: Introverts are prone to negative reactions in the midst of ambiguity, and this negative reaction can often lead to a barrier in financial decision-making known as the Aversion to Ambiguity. They may see the presence of ambiguity as a negative and avoid any decision or decision-making problem that requires them to recognize its presence.

Status Quo Bias: Because introverts tend to be more inward looking and feeling, they may prefer the status quo over possible change. It may be hard for them to convince themselves that they have the strength necessary to survive the changes.

Decision Fatigue: Introverts need to have inward reflection time and alone time. They are unlikely to be easily engaged in large strategy meetings and may need to take long conversations in chunks in order to be sure they have the time to internalize the issues and process the decision problem.

Next month we will have a more in-depth discussion and application of the Sensing vs. Intuition leg of the Myers-Briggs continua.

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.

Behavioral Finance: Client Personalities and Behavioral Bias in Financial Decision-Making

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Client Personalities and Behavioral Bias

Identifying your clients’ personality-related biases can help you maintain a successful and productive professional relationship.

Justin A. Reckers and Robert A. Simon,

Originally published by www.MorningstarAdvisor.com on May 17th 2012

In our last article, we discussed the concept of personality and what personality is. We described personality as the “consistent, enduring, predictable manner of behaving, experiencing, and interacting with others and with the world.”

We described how, when forming relationships with clients and establishing trust and rapport, it is important to be aware of the client’s personality. This is because an individual’s personality will give us vital guidance to his or her psychological needs, behavioral patterns, and the way in which emotion interacts with that individual’s cognitive activity (thinking).

By having insight into these aspects of a client, you will be more likely to establish and maintain a successful and productive professional relationship that allows you to succeed. Knowing your client’s personality style can help you identify the cognitive distortions that are most likely at play for the individual. And, as we’ve been stating, knowing the distortions gives you insight into the “client mind.”

In our previous article, we described several different conceptual systems for classifying personality. So let us return to the four continua of personality that underlie the Myers-Briggs Type Indicator:

–Extraversion v. Introversion
–Sensing v. Intuition
–Thinking v. Feeling
–Judging v. Perceiving

(Note: There are no automatic applications of a particular Myers-Briggs type to the cognitive biases we have discussed. The following discussion is intended to illustrate ways in which you can begin to hypothesize which biases are most likely to be observed in a client. Of course, actual experience/interactions with your client will give you the information that will make you able to more accurately assess the biases that operate in a given client.)

Individuals occupying a more extroverted position would be outgoing and relatively less inhibited in their interactions with others. Such individuals are often gregarious and confident and prone to believing in themselves–at times overly so. These individuals may be using active/emotional biases such as the Overconfidence Bias and the Illusion of Control Bias. These clients may be the ones who remind you they are smart enough to do your job and rationalize they need your help because they just don’t have the time with all of the other important things on their plate.

On the other hand, more introverted individuals can be shy and inhibited, and may have tendencies toward self-doubt and reliance on others. You might hypothesize that such individuals are more prone to use the Status Quo Bias or the Framing Effect. These clients will thank you every time you pick up the phone to call with an update or send them an e-mail. These individuals appreciate knowing that you are thinking about them but may not pick up the phone to make sure you are.

Another Myers-Briggs continuum is that of Thinking v. Feeling. Those on the thinking end of the continuum emphasize cognitive, intellectual, objective information when it comes to decision-making. Those on the feeling end of the continuum emphasize emotional, subjective information when it comes to decision-making. With this in mind, it is possible to understand how those on the thinking side of the ledger would tend to cognitive distortions that emphasize “thinking” types of data, such as the Ease of Information Bias, Confirmatory Bias, or the Overconfidence Bias.

On the other hand, those that find themselves on the feeling side of the ledger tend to rely upon subjective and emotionally driven biases such as the Optimism Bias, Framing Effect, and Live for Today Bias. The Cognitive Dissonance Bias, when operating, will drive the “thinkers” to ignore the emotional data that they perceive, whereas it will drive the “feelers” to ignore the factual/cognitive data they perceive. A thinking client might be the one who always strikes up conversations with friends about money hoping to get little insights and ideas, while the feeling client will fear that conversation for the anxiety it may provoke.

Turning to the Five Factor Model of personality discussed in our last article, let’s explore the Conscientiousness Factor, which has efficient/organized on one end of the continuum and easygoing/careless on the other end. Clients who fall toward the efficient/organized end of the continuum might be conceptualized as having a tendency toward the Illusion of Control Bias. This may be because individuals who are highly organized and efficient tend to see this attribute as a way of mastering their surroundings and achieving a certain measure of control over their world. On the other hand, those who are easygoing and careless might be thought of as individuals who are less likely to plan or think ahead. Thus, one might hypothesize that these individuals would be more likely to display a Live For Today Bias or even an Optimism Bias.

Finally, let us turn to look at the personality disorders that we also discussed in our last article. We explained that when personality styles and tendencies become rigid, inflexible, and maladaptive–when they become unable to flex and adapt to the demands of the situation or the task at hand–the personality style moves into the realm of a personality disorder.

Personality disorders tend to be relatively fixed and rigid styles that, because of their rigidity, interfere with good psychosocial functioning and adaptation. An individual exhibiting signs of a Cluster B personality disorder (which features emotional or erratic behavior) might be more likely to present with a Self-fulfilling Prophecy Bias or an Overconfidence Bias. Individuals who present with Cluster C personality disorders (which feature anxious and fearful behavior) might be likely to demonstrate a Status Quo Bias or Cognitive Myopia.

Of course, there is no known way of being able to predict with a reasonable degree of certainty what bias a client may have, given their personality style or given the presence of a personality disorder. Although these systems are good at classifying groups of people conceptually, each individual is unique and must be assessed and understood on their own terms and in the context of their needs, their strengths and weaknesses, their life stage, and so forth. We want to emphasize that we do not propose a simple formula by which to identify the biases that individuals may present. At the outset of the relationship with a client, the skilled advisor will seek to understand the client and, therefore, the biases that the client presents.

We hope that the examples illustrated in this article will give you a starting place to begin your successful search for your client’s biases, which will, in turn, give you clues as to how best to interact with and meet the needs of your client. We will see you next month to continue our discussion of how your clients’ personality types come into the room during financial decision-making.

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.

Are American Policymakers Using Behavioral Economics Against Us?

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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. http://www.dr-simon.com

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

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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.

 

The Benefits of a Financial Nudge

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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.

Resolving the Aversion to Estate Planning

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Resolving the Aversion to Estate Planning
With a few key observations and calculated interventions, advisers should be able to remove a client’s barriers to creating, adjusting, and updating an estate plan.
by Justin A. Reckers and Robert A. Simon

Originally published by MorningstarAdvisor.com on April 21st 2011

Resolving the Aversion to Estate Planning

We see applications for behavioral finance at its most simple in estate planning. Classic stories abound involving the wealthy patriarch determined to control the lives of his decedents from beyond the grave. The trophy wife trying to strike gold when her spouse, 30 years her senior, kicks the bucket. Children fighting over parents intentions left unsaid. Step parents breaking wills and raiding the wealth of their short-term spouses at the protest of the rightful heirs. Trust fund kids left millions without restriction wasting their potential and letting the guarantee of financial security deter them from working to make their own money. We could write an entire article on each of these and many other examples from our practice and will do so, but not today.

Instead we want to concentrate on resolving the aversion to planning in general.

A sudden change in health status never fails to motivate Americans to plan for the worst. In the past six months, we’ve seen diagnoses of prostate cancer, aortic aneurysm, multiple sclerosis, heart attack, transient ischemic attack (TIA or mini-stroke), and a few others work as the catalyst for an individual or family to get their estate planning buttoned up, in some cases for the first time. Why is it so hard to convince our clients to do so before the crisis? Could it be that the average person doesn’t understand the need for an estate plan or the process necessary to create one? Or could it be that Americans hate the idea of undertaking such a process because they are avoiding the confirmation of their own mortality?

We believe it is a little bit of both, and with a few key observations and calculated interventions, advisers should be able to remove a client’s barriers to creating, adjusting, and updating an estate plan.

Aversion to ambiguity can paralyze clients in the face of difficult and fear-provoking decision-making processes. Believe it or not, there are clients in the high net worth market who don’t understand the process required to create a viable estate plan. They don’t know how to get started, how long it will take, or how much it will cost. There are even more in middle-class America. Many middle-class Americans believe estate planning is necessary only if you are wealthy, and they probably don’t consider themselves to be wealthy when they own a home and a million dollar 401(k).

The battleground to be conquered here is a simple one. Removing the ambiguity from the decision-making process will remove barriers to embarking on the process in the first place. This is a simple cognitive barrier that leads many Americans to move through life without the plans their family needs to transition safely after their loss. It can be remedied with education and advocacy.

A classic example of another kind of cognitive barrier was illustrated in an Aesop fable that gave rise to the term “sour grapes.” The story spoke of a fox that came across some high-hanging grapes and fancied himself a snack. He tried mightily to reach the grapes and eat them but could not. Instead he convinced himself they would probably be sour grapes anyway, so the endeavor was not worth undertaking. The fox desired the grapes, found them unattainable, so he not only gave up but also reduced their importance by criticizing them. This is also an example of cognitive dissonance.

Cognitive dissonance is a psychological phenomenon explaining the feeling of uncomfortable tension that comes from holding two conflicting thoughts in the mind at the same time. In the case of the fox, his two thoughts were first that the grapes would be a wonderful snack but second they were unattainable.

In the case of estate planning, the two conflicting thoughts are first, the notion that undertaking such planning is not only important to the individual but necessary for the protection of one’s family members. The second thought is that they will live long, happy, and fruitful lives, so there is no need to worry and certainly no need to rush into the estate planning process.

The result is a conflicted feeling about the importance of estate planning in the first place. Admitting that life is short and you must plan for the worst in order to protect your family will lead to the realization that life will end soon. This is in conflict to the often-reported thought, “it won’t happen to me and my family.” Thoughts like these are examples of the human criticizing the need for estate planning in the same way the fox criticized the grapes, thus diminishing the importance of estate planning and confirming their belief that it is not worth the worry.

Those who refuse to acknowledge their own mortality may have a deep emotional conflict that cannot be remedied by a financial advisor. They may have unexpectedly lost a loved one or been near death themselves and survived. An advisor would do well to learn about a client’s family history for the purpose of planning for life expectancy in retirement, risk management, and other applications. We believe it to be even more important to the planning process as a whole to help advisors understand the narrative that forms their clients’ feelings and opinions around emotionally charged financial decisions like planning for their own death. Getting to know the story behind the actions should help advisors use that story to build better decision-making processes, foster self determination, and make positive change in the financial lives of clients and their families.

We will continue our applied behavioral finance series next month with some details about why we believe applications of behavioral finance are so important in our current economic environment–including neuroscientific evidence supporting the importance of self determination in financial decision-making and a fiduciary standard of care for financial advisors before continuing with additional practice observations.

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.

Economics of Confidence

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Thank you to John Mauldin for tipping his hat to an interesting mind named Grant Williams. Mauldin’s “Outside the Box” featured The Confidence Game by Grant Williams earlier this week and a couple of thoughts stuck with me. Check out a few quick hitters below on the Economics of Confidence. Read the full article here.

“If people are confident about their own prospects as well as those of the economy as a whole, they will be happier to spend their money. If they spend that money then other people will make more ‘stuff’ for them to spend it on which, in turn will put more money in the pockets of those making that ‘stuff’ who will then go out and buy ‘stuff of their own. Everybody ends up with a lot of ‘stuff’ which makes everybody happy. Stuff equals happiness. There. Economics for Dummies.”

“In any confidence trick, there are two parties. One is the ‘confidence man’ or ‘grifter’, the other is the ‘mark’. According to wikipedia: Confidence men or women exploit characteristics of the human psyche such as greed, both dishonesty and honesty, vanity, compassion, credulity, irresponsibility, naïveté, and the thought of trying to get something of value for nothing or for something far less valuable.”

“Through the years, the term ‘Confidence Trick’ has been shortened to ‘con’ (also known as a bunko, flim-flam, gaffle, grift, hustle, scam, scheme, swindle or bamboozle) and has become a catch-all for any ruse designed to dupe someone into believing something that isn’t true in order to relieve them of something of value.”

“Look around you today and you will see an endless stream of politicians, Central Bankers and Heads of State telling us that things are on the mend and that we should be confident about the future. These people are most definitely trying everything they can to appeal to the human psyche.

And as we know, there are two parties to every confidence trick…

HMMM……”

I am always intrigued when I hear discussions about consumer confidence on CNBC and other financial media. It is economically irrational for one human to make financial decisions based upon how another feels. The confidence, or lack there of, of a crowd may be no more than reaction to news of the day or the next great ‘con’. It certainly does not make for good financial decisions. My parents taught me that with the classic cliche “If your friend jumped off a bridge…would you do it too?” The field of Behavioral Economics has grown out of the desire to create a profit center preying upon the unsuspecting, economically irrational human and we know that crowd behavior can be very powerful. So why not create a measurement of how confident the crowd is and try to exploit it by telling everyone about it to see if they will follow.

If we know Americans are confident in the economic outlook this should make it more likely they will spend more on certain things. If we invest in the companies that make those certain things before the wave of confidence takes affect we should be able to profit as investors.

Unfortunately, humans are fickle, indecisive and tend to waffle or change their minds often based on the most recent and most persuasive arguments.  Beware the survey of confidence today, I lose confidence every time I hear news about a measurement of confidence. I can’t help but wonder if I am a ‘mark’, just part of a great ‘con’ trying to catch me up in the crowd.

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.

Financial advisor prescription by Statman evokes strong response

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By Justin A. Reckers

Susan Weiner hosted economist Meir Statman on a recnt blog tour promoting release of his new book “What Investors Really Want”. Susan invited me to join the conversation. Read more here.

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.

Gift Cards – Not Chia Pets

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Gift Cards – Not Chia Pets

By Justin A. Reckers

The Holiday Season is one of the most financially stressfull times of year for many families. The pressure of holiday gift giving often encourages us to overspend, huge sales entice the reluctant consumer to can’t miss price breaks and ultimately millions of people make terrible decisions to buy fruit cakes and Chia Pets. It is, after all, the thought that counts and we would all rather give than receive.

The number one problem with bad gift ideas is that there is a disconnect between the giver and the receiver. The disconnect I speak of is of financial nature. The giver places a greater economic value on the gift than the receiver. If you spend $20 on a Chia Pet shaped like President Obama you must be prepared for the recipient to be disapointed with your gift. They may not think very highly of President Obama or Chia Pets which probably means they would not have chosen to spend $20 of their own money to acquire the gift. If they value the gift at just $5 the gift exchange has just wasted $15. Most would agree that wasting money is pretty irrational from an economic perspective.

So what really happened? How did such a generous thought go so badly? The gift giver allowed the emotional value of gift giving to cloud their financial decision making. They didn’t think about the value the receiver might place on their gift. Only the value they collected from the act of giving it.

You can do your part to eliminate this economic waste and encourage economic rationality this holiday season. Do not buy gifts for someone unless you are absolutely certain of what they would spend your $20 on given the opportunity to shop for themselves. Instead; give gift cards. That way you know the hard earned $20 you put towards a gift for the lady in the cubicle nextdoor will be spent wisely. Do your part to eliminate uncomforatble moments at gift exchanges and cut down on re-gifting. Call me if you need an ugly tie or Chia Pet.

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.

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