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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 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 and managing director of Pacific Divorce Management, LLC, in San Diego.

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

Client Money Personalities: The Entrepreneur

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Client Money Personalities: The ‘Entrepreneur’

Overconfidence is a common personality trait exhibited by advisors’ entrepreneurial clients.

Justin A. Reckers and Robert A. Simon,

Originally published by on March 22nd 2012

We ended last month with some talking points to help advisors begin to understand the money personalities of their clients. To continue the conversation, we want to give some examples of typical discussions you might have with clients and the underlying personality features that might be coloring their decision-making.

The Entrepreneur

We all know an entrepreneur. Maybe a brother-in-law, maybe a neighbor, maybe a client. So what makes them tick? Is it ambition, creativity, perseverance, a dislike for taking orders from a boss, or perhaps a penchant for taking risks? More importantly, can you as an advisor recognize these personality traits and better understand your client? And can you understand how this money personality impacts your client’s investing goals and preferred approach to investing?

Many of the advisors reading this article probably consider themselves entrepreneurs. The majority of you are responsible for creating new business or got to where you are by having generated new business at some point in your career. What can you learn from your own personality? (The authors think of themselves as entrepreneurs because we are independent, self-employed, and self-directed–we establish goals and chart a path to achieve them.)

In conversations with entrepreneur clients we have learned that what motivates someone to be entrepreneurial and to accomplish ambitious goals is multi-determined, complex, and individual. We asked some clients why they thought they had become entrepreneurs. A biotech entrepreneur told us, “I had such a great idea that I couldn’t let it go, and no one else would listen so I had to do it myself.” A serial technology entrepreneur told us, “I don’t really know. I think I was left without a job at one point in my life. Faced with the possibility that I may not be able to feed my family I had to do something. Luckily I had an idea and wouldn’t take ‘no’ for an answer.” A CEO for hire in the start-up world told us, “I probably have attention deficit disorder because I come into ideas and opportunities with a limit to how long I will spend on something before moving on. That means I am constantly getting involved in new and different endeavors.” A successful attorney who built a large firm told us, “I wanted to practice law my way and the only way to do that was to strike out on my own.”

We do believe there are some common characteristics of entrepreneurs. One of them is overconfidence. The most endearing part of overconfidence is that it makes entrepreneurs very confident in their inventions, ideas, and decisions. They don’t take ‘no’ for an answer, and they stay motivated when things are difficult. They tend to see what is working versus what is not working. But that also means they make economically irrational decisions on a regular and consistent basis!

Interestingly, overconfident clients are often procrastinators. Although this may at first seem unexpected, overconfident people tend to procrastinate on current matters in favor of future opportunity. Thus, advisors must teach these clients the concept of how paying themselves first is a giant step in their financial planning and wealth accumulation. This is because such individuals’ overconfidence makes them unrealistically sure of their ability to keep generating flow. This leads them to think of how to make the next dollar rather than how to keep and grow the dollar they already have.

Entrepreneurs are often affected by a flaw in their planning skills that leads them to underestimate the time necessary to complete tasks. This, in turn, may prompt them to label such tasks as unimportant and, therefore, it is less likely that the task(s) will be completed. Whether rational or not, the mindset is consistently focused on the future because the entrepreneur is driven by the future, by opportunity and by risk taking.

Entrepreneurial personalities are often plagued by cognitive errors caused by the illusion of control and subsequent problems created by such individuals taking on escalating commitments. The illusion of control colors the decision-making of overconfident clients as they believe they have more control over a situation or variables than could rationally be explained.

The biggest struggles you will have with overconfident clients will be those where they really need to accept and act on your advice when it is counter to their own gut feeling. Overconfident clients may believe they are smart enough to do your job and rationalize their seeking your advice based on simply not having enough time to do it themselves.

Noted psychologist Daniel Kahneman said, “Overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion.”

So how do you know when a client may be suffering from overconfidence bias? Conversation topics should include:

–How did the client acquire their wealth?

–How realistically difficult was it for them to acquire the wealth? Have they risked their own capital to attain greater wealth?

–Has the client regularly sought the guidance of trusted experts?

–Do they often underestimate the amount of time or effort necessary to complete tasks?

Overconfidence is just one of many personality characteristics we encounter in financial decision-making. The exact combination of characteristics or qualities that form an individual’s distinctive character as a successful entrepreneur remain elusive, but we do know some tell-tale signs.

A client’s overconfident, entrepreneurial personality is the fundamental template through which they view the world. It affects risk aversion and complicates financial decision-making. If you, as an advisor, better understand the template they are working from, you can better guide them through the decision-making that will help them pay themselves first and take advantage of the opportunity their ambition and perseverance offers.

Next month, we will continue discussing common personality traits and guiding you through the process of uncovering them.

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

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

How is a Money Personality Developed?

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How Is a Money Personality Developed?

Understanding personality will help you understand your clients.

By Justin Reckers and Robert Simon

Originally published by 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.

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

The Blue Screen of Death in Financial Decision-Making

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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 and Managing Director of Pacific Divorce Management, LLC, in San Diego.

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

How Professional Biases Can Cloud Judgment

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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 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 and managing director of Pacific Divorce Management, LLC, in San Diego.

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

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 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 and managing director of Pacific Divorce Management, LLC, in San Diego.

Robert A. Simon, Ph.D. 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

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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 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 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 and Managing Director of Pacific Divorce Management, LLC, in San Diego.

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

Behavioral Finance and Long Term Care Insurance


Behavioral Finance and Long Term Care Insurance

Long-term care insurance is a thorny, multifaceted issue.

By Justin Reckers and Robert Simon

Originally Published by on March 17th 2011

Last month we touched the subject of Behavioral Finance in Life Insurance decisions and saw quite a bit of feedback from the readership. Some was good, some was bad, some was indifferent. Many readers took the discussion of sales tactics pretty hard and felt the need to defend the insurance-sales industry. We want to stress again the underlying concept of the article was far from being a definitive answer to the perennial question of whether investors should buy term and invest the difference. It was certainly not aimed at impugning the sales tactics of the life insurance industry. Rather, we seek to uncover the relationship between emotion and economic theory at the point of financial decision-making. Make observations about the drive of each power and help others understand how these observations can be used in practice to help everyone make better financial decisions through applied behavioral finance.

This article focuses on long-term care insurance. We will look at the product itself, the emotional aversion or motivation to its use as well as how and why state and federal governments have gotten involved to help promote the economic “rationality” of the product.

Unlike life insurance, long-term care does not have an easily quantifiable probability of paying benefits. In order to receive benefits under a long-term care policy an insured must be considered chronically ill and unable to perform certain activities of daily living. Very few consumers understand what this means before meeting with an insurance agent. The ones that do will have been in a position to provide the necessary care for a loved one at some point in their lives. Those who have been in the caregivers role in the past will understand the two main reasons for most people to purchase long-term care insurance 1) protect against the potentially devastating effect of the cost on other financial goals and plans and 2) insulate the caregiver from the negative physical and financial affects of their role.

The first step in uncovering the emotional component of this step in the planning process lies in the client’s ability to comprehend the emotional cost of long-term care. Many will not immediately consider the emotional cost to their loved ones of providing care on a day to day basis. Many people will have a more visceral aversion to accepting care in a nursing home or other facility and completely avoid the conversation about long-term care. This may be rooted in an aversion to change or bias towards the status quo or a lack of understanding around the options they have for their care.

We believe that concern for caregivers is one of the greatest components of the underlying need for long-term care insurance. Helping clients connect the concern they have for the well-being of their spouse and children with the possibility that they may be the exact people charged with their daily care should help develop an emotional connection and motivation towards considering long-term care insurance.

Once the emotional connection is made the client should be more open to understanding the availability of in-home care versus nursing home care and all of the other truly valuable terms of current long-term care insurance products. Working through these policy provisions and concentrating on the options available for minimizing change should help remove the status quo bias of many clients who believe long-term care is only for nursing homes.

State and federal governments believe long-term care insurance is economically “rational,” at least from their perspective, and have thrown their support behind it in the last fifteen years.

The federal government most recently got involved in promoting long-term care insurance through a provision in the Deficit Reduction Act of 2005. The DRA created a national long-term care partnership program allowing each state to set up their own programs combining private long term care insurance as the primary payer of benefits with Medicaid as the secondary payer once the private policy benefits have been exhausted. Individuals are then allowed to protect a portion of their assets instead of spending them down to qualify for Medicaid coverage. The beauty the program is two-fold. Individuals are rewarded for planning ahead and purchasing long-term care policies while state budgets are preserved by requiring that the benefits of those qualifying insurance policies be paid before Medicaid benefits can be accessed.

Many states have followed the Fed’s lead and developed long-term care partnership programs over the years. The states want individuals to provide for at least a portion of their own care. In order to facilitate this they have developed plans that mandate certain provisions and guarantee asset protection strategies under Medicaid law. The details of each state program differ but the underlying idea is one rooted in behavioral finance. The states want citizens to buy long-term care insurance because Medicaid will be next in line to pay the costs if individuals do not plan for it themselves. More individual long-term care insurance means less drain upon state Medicaid budgets. Richard Thaler might call this “libertarian paternalism.”

The evolution of long-term care insurance products as well as state and federal government encouragement of their use has led to a tremendous increase in its use as a financial planning tool. So does it make economic sense? Clearly the state and federal powers that be have decided long-term care insurance makes economic sense and have chosen to throw their weight behind it via partnership programs and tax-qualified plans. They believe, from an actuarial perspective, an increase in individual coverage will help reduce state expenditures through Medicaid and bolster state budgets.

Economic “rationality” from the consumer side is complicated by the myriad of options and choices available in the market place today. Different options make economic sense for some and do not for others. A partnership policy makes little sense for a high-net-worth individual since the Medicaid asset protection likely has no value. We care more about getting to the bottom of the emotional motivation for clients in this case to help facilitate “rational” decision-making. The state and federal government support is just another great example of government involvement in our everyday financial decision-making.

We will continue our applied behavioral finance series next month with observations and applications in estate planning and probate.

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

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

Behavioral Finance and Life Insurance


Behavioral Finance and Life Insurance

Emotions play a significant role in life insurance decisions.

By Justin Reckers and Robert Simon

Originally Published by on February 17th 2011

There is one reason to buy most insurance products: aversion to loss. More specifically, aversion to a substantial loss. Term life insurance is what we call a pure insurance policy. If you don’t die during the term, the policy pays nothing. Unfortunately, we all die some day. The term life insurance buyer is insuring against a premature death, not death in general. Coming to grips with the possibility of premature death is not easy for some. Luckily, term life insurance is relatively cheap, so the decision to buy might be easier. As you hear on radio commercials all the time “a 40-year-old male in good health can get a $500,000 policy for $35 per month”. A whole (permanent) life insurance buyer is insuring against death in general. They know that they will die and so does the insurance company. The gamble is just how long it will take for the eventuality to be realized. Because the insurance company knows it is going to be on the hook someday, the policy is more expensive.

So let’s look at the underlying decision-making process that clients often encounter when making the decision to buy different types of life insurance, how psychology wreaks havoc upon them, and what economic theory might expect “rational” humans to do.

Life insurance has long been a cornerstone of financial plans. In some cases, when pushed by agents, it can be the entire financial plan. Life insurance products and the related sales strategies have been at the front of incorporating observations from applied behavioral finance for decades. Agents take advantage of mental accounting by pushing whole life policies as mandated savings plans. Whole life insurance accumulates cash value based on the client paying greater premiums when compared with a term policy. The difference in the premiums accumulates as cash value inside the policy. The sales pitch will say that the life insurance not only offers protection for your family in the event of the insured’s death, but it also offers a disciplined, mandatory savings plan that will help the insured stick to their retirement savings goals. The insured will then have the ability to draw funds from the mandatory savings account after a portion of every premium payment is allocated to the accumulation of cash value. This sales pitch is taking advantage of a human tendency for mental accounting. An agent will also likely inform a prospective buyer that the policy will eventually be “free,” because the cash value will have accumulated to the point at which it can pay for itself later in life. How can you turn it down? Protection for the family today in the event of death, a disciplined savings strategy that guarantees you will continue saving for retirement and “free” insurance some day. Sounds like a great deal.

So what would an economically “rational” insurance shopper do? An economically “rational” person would have no emotional attachment to the concept of “free” insurance, because we all know there is no such thing as a free lunch. An economically “rational” insurance buyer would also have no need for imposed savings discipline. They would commit to their savings goals and never depart from that commitment. Two of the three enticements to buy whole life insurance disappear along with emotional awareness. The only thing left is the need to protect the insured’s family in the event of premature death and the things that come with it. We think they would buy term and invest the difference. The economically “rational” thing to do would be to remove any emotional factors from the decision-making process. When emotional factors are removed, we can see the true purpose of insurance. The true purpose is to insure against a catastrophic loss that could have major negative effects on the financial circumstances of a family.

Why do they go ahead with each subsequent decision to write a check for a monthly or annual premium? The value for a life insurance policyholder, at the moment when a decision is made to write a check for premium, is derived not from an actual claim event, but from the peace of mind experienced by the person writing the check. The peace of mind is obtained by knowing they have provided for their family in the event of their death. That their spouse and children will not be forced to move out of a home they can no longer afford. These are visceral feelings that are hard to deny and create a framework for conceptualizing the outcome of their actions. The way a client frames an outcome in their mind affects the utility they expect. This is the concept of framing.

The visceral reaction to conceptualizing life after one’s own death keeps people writing their annual premium checks but a “rational” participant in the insurance world might second guess. The insurance company knows that the smaller number of decisions you are faced with the greater likelihood that you will make the decision they want and pay your premium. This is part of the reason why they charge additional fees for monthly or quarterly payment plans compared a single annual premium.

Life insurance is almost always a function of protecting one’s family and can be a source of disagreement among couples. Helping a couple understand the actual process of decision-making regarding life insurance with the emotions brought to the front of the conversation will help dispel 90% of disagreements on the matter. Those disagreements left over will be about the numbers–either dollar amount or duration–and these should be easy to work through given some thorough analysis.

We do not have space to debate which insurance strategy is superior, and we would certainly never say categorically that one size fits all. We believe that there are many really good uses for permanent life insurance. Everyone reading this will have their own opinion built by their experiences and preferences. We also have to pass on the opportunity to discuss the merits of Richard Thaler and Cass Sunstein’s “Libertarian Paternalism” which might encourage the types of nudges used in insurance sales tactics. We will tackle the topics of professional biases and “Libertarian Paternalism” another time.

We will continue our Applied Behavioral Finance series next month with a continued look at decisions about Insurance.

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

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

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