Behavioral Finance: Thinking vs. Feeling Clients

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Uncovering Client Tendencies: Thinking vs Feeling

Determining if a client is more aligned with the Thinking or Feeling 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 August 30th 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 to the client’s psychological needs, behavioral patterns, and the way in which emotions interact with and interrupt financial decision-making. So far, we have covered the Extroversion vs. Introversion continua and the Sensing vs. Intuition continua. We offered observations of both sides of the continua and uncovered some common biases and barriers that advisors 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 Thinking vs. Feeling preference. As an advisor, this overview will help you 1) recognize which side of the ledger your clients occupy and 2) give some ideas and advice 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 presented a brief description of the Thinking individual juxtaposed with the Feeling 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 Thinking or Feeling tendency gives advisors two huge pieces of information about how best to work with them. Stated very simplistically:

1) The Thinking preference is objective in decision-making, placing more weight on facts.

2) The Feeling counterpart is expected to be more subjective and place more weight on personal concerns.

Clients are mostly Thinking or Feeling but are likely to still have traits of the other. A Thinking person may make a decision based on his or her need for objectivity but test the decision for success and soundness with a Feeling style of decision-making. So it would not be accurate to pigeonhole individuals into one classification. Although we will discuss them as two separate categories for purposes of contrast, advisors must avoid the misconception that a Thinking person must be overly intelligent and a Feeling person must be overly emotional.

Thinking
Thinking individuals are likely to be more successful at critical thinking and integrating logic-based data into decision-making processes. They may consider an option and convince themselves it is “irrational,” “illogical,” or “doesn’t make sense.” Following are some brief descriptions of observations common in Thinking clients that can help an advisor recognize their personality preferences.

Observations of a Thinking Client

–Drawn to technical and scientific fields
–Task oriented
–Values fairness
–Decisions happen in the head, not the gut
–Grounded in logical explanations
–Avoids personal interaction in favor of objectivity
–Thinks in terms of pros versus cons

We believe Thinking individuals are inclined to exhibit active, cognitive biases thanks to their preference for logic and thirst for data. Following are some behavioral finance biases we believe should be expected in Thinking personalities:

Aversion to ambiguity. Thinking clients are logical and meticulous in their decision-making. The existence of ambiguity will lead them to seek additional information and avoid options for which missing information makes the probability seem unknown and a pro versus con analysis is not possible.

Empathy gap. A Thinking client’s avoidance of personal interaction in support of their objectivity may leave them prone to a tendency to underestimate the influence or strength of feelings in others. This is especially true in the world of negotiations. The Thinking client will see divorce, probate, and other disputes as logical business deals to be made and miss the emotional components necessary to navigate.

Focusing effect. Our Thinking clients are very prone to the focusing effect as they actively seek data to inform their decision. Their focus will be the data search, which could lead them to place too much importance on one aspect of the decision-making process and cause errors in judgment when they miss other external information, such as emotional issues and the opinions of others.

Feeling
Feeling individuals are likely to be the conflict-avoidant type. They may float around with the hope and confidence that things will be OK and allow that belief to affect their decision-making. They have this confidence because they avoid tough decisions and tough communications. They may genuinely believe restoring harmony to their world after a difficult decision is more important than the outcome and long-term ramifications of the decision itself, leading them to look past the information at hand and the cold hard truth of decision problems.

Observations of a Feeling Client

–Values the opinion of others
–Is able to judge decisions from the point of view of another person
–Justifies decisions based on what they perceive to be best for others
–Caring and warm
–Decisions happen in the gut or the heart, not the head
–Mushy
–May sugar-coat or entirely avoid saying things in the interest of being tactful
–Crowd pleaser

We believe Feeling clients may be more inclined to exhibit emotional or social biases. Following are some behavioral finance biases we believe to be common in Feeling personalities.

Bandwagon effect, herd behavior. One of the pervasive elements of the Feeling personality preference is the desire to maintain harmony. The Feeling individual will look to others and rely heavily on their opinions and points of view to develop their own perspective, making them prone to the bandwagon effect and herd behavior.

Conflict avoidance, loss aversion. Feeling clients prefer to process information and relay their thinking via tactful, conflict-avoidant communication. We believe this to be true thanks to their desire to avoid the social loss they think that conflict represents. For that reason we consider them likely to suffer from loss aversion in their financial decision-making as well.

Planning fallacy. Feeling clients may suffer from planning fallacy because they underestimate the time necessary to complete important tasks. They might show up unprepared for meetings, even meetings with strict agendas and various reminders.

Confirmation bias, ease of information bias. Because Feeling clients have an overwhelming concern for harmony, and a nervousness when it is missing, they can be led to seek out easily available information that confirms preconceived notions in order to restore the social harmony that was lost. This can lead to missing the cold, logical truth.

Next month we will have a more in-depth discussion and application of the Judging v. Perceiving 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.

Personality and Finance

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Personality and Finance

Learn how personality is defined and the different personality types you may encounter among your financial advisory’s clients.

Justin A. Reckers and Robert A. Simon,

Originally published by www.MorningstarAdvisor.com on April 19th 2012

In our next two columns, we are going to dive into personality–including personality types and when personality styles become problematic and maladaptive. We will relate how you, the advisor, might need to take different approaches for clients with different personality styles, including how you establish rapport and develop relationships with your clients. We’ll cover what personality might indicate about the client’s risk tolerance and needs with regard to investments and planning, and what kinds of cognitive distortions might be found in particular personality styles.

Personality is best thought of as an individual’s consistent, enduring, predictable manner of behaving, experiencing, and interacting with others and with the world. For example, some people are fundamentally emotional in their orientation, whereas others are more intellectual/cognitive. Some people are organized in their orientation, whereas others are disorganized or even chaotic.

There are numerous conceptual systems for understanding personality. Often, how personality is classified depends on the reason for the classification. For example, in the business world, the Myers-Briggs Type Indicator is a commonly used test that classifies personality types. This test, which many believe is particularly helpful in constructing work teams and in understanding how employees interact within the work environment, evolved from Carl Jung’s theory of types. Myers-Briggs classifies individuals along four continua:

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

The Five Factor Model of personality developed by Costa & McCrae emphasizes the following personality traits (factors):

–Openness to Experience (inventive/curious v. consistent/cautious)
–Conscientiousness (efficient/organized v. easygoing/careless)
–Extraversion (outgoing/energetic v. solitary/reserved)
–Agreeableness (friendly/compassionate v. cold/unkind)
–Neuroticism (sensitive/nervous v. secure/confident)

In systems such as the Myers-Briggs or the Five Factor Model, individuals are characterized on each of the dimensions, resulting in a multifaceted conceptualization of their personality. In such systems, there is no such thing as a “normal” or “ideal” personality. Instead, personality is seen as a consistent set of behaviors and attitudes.

Further, each personality style or type brings with it a set of strengths and a set of weaknesses. For example, a person who is inventive/careless/reserved might be a creative type who thinks outside the box but may also be shy and hesitant. Such an individual might be well suited to work in a creative environment where interactions with teams of people are not frequently necessary.

On the other hand, an individual who is consistent/compassionate/sensitive might tend to rely on structure, strive to please others, and seek the approval of others. Such an individual might not be suited to take on important leadership roles in the workplace but can be called upon to support and assist co-workers, especially when they are struggling.

As you can see, both of these hypothetical personality types, while very different, have positive aspects that serve the person well in different types of situations.

When personality styles and tendencies become rigid, inflexible, unable to adapt to the demands of the situation or the task at hand, the personality style moves into the realm of a personality disorder. The Diagnostic and Statistical Manual of Mental Disorders–IV TR (DSM-IV TR) is the manual used by mental health professionals to diagnose individuals whose personality traits have become maladaptive. Within the DSM-IV TR, there are three clusters of Personality Disorders:

Cluster A: Odd or Eccentric Behaviors

–Schizoid Personality Disorder
–Paranoid Personality Disorder
–Schizotypal Personality Disorder

Cluster B: Dramatic, Emotional or Erratic Behaviors

–Antisocial Personality Disorder
–Borderline Personality Disorder
–Narcissistic Personality Disorder
–Histrionic Personality Disorder

Cluster C: Anxious, Fearful Behaviors

–Avoidant Personality Disorder
–Dependent Personality Disorder
–Obsessive-Compulsive Personality Disorder

Again, a personality disorder is observed when someone’s personality style is so extreme, fixed, or rigid as to cause maladaptive behaviors. An individual who is very orderly, organized, and neat and who prefers a life that is predictable and routinized may have an obsessive-compulsive personality style. This individual can thrive in structured environments, will reliably keep on task and stick to the timeline when it comes to completing projects, and is likely to be the one who reminds others of project deadlines and who can bring a predictable structure to critical project requirements. These traits and behaviors are positive and adaptive. When something unexpected happens, this individual may be temporarily sidetracked but will use his or her personality traits to accommodate the unexpected events and will get back on task.

However, individuals with an obsessive-compulsive personality disorder have such an extreme need for order and predictability that it gets in the way of creativity, impairs their ability to take in and consider alternative points of view, and if something unexpected happens, they may fall apart and be unable to readily navigate hurdles and get themselves back on task.

In our next article, we will apply personality types and styles to the needs of your clients. For instance, consider this: A client whose orientation is primarily within Cluster C above is likely to approach planning from a cautious, fear-based point of view. You can assist such clients by giving them information, patiently and methodically answering their questions, and acknowledging that their primary financial-planning concern is preserving their asset base by minimizing losses.

On the other hand, an individual whose orientation is primarily from Cluster B will be more emotion driven, will utilize linear/rational information to a lesser degree, and may approach investing in a way that feels more exciting and fun.

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.

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

The Pride of Ownership in Financial Decision-Making

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The Pride of Ownership in Financial Decision-Making

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

By Justin Reckers and Robert Simon,

Originally published by MorningstarAdvisor.com December 15th 2011.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Are American Policymakers Using Behavioral Economics Against Us?

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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

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.

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 MorningstarAdvisor.com on May 19th 2011

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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