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: Sensing vs. Intuitive Clients

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Sensing Versus Intuitive Clients and Their Financial Decision-Making

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

Justin A. Reckers and Robert A. Simon,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Behavioral Finance: Extroverted vs. Introverted Clients

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Extroverted Versus Introverted Clients and Their Financial Decision-Making

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

Justin A. Reckers and Robert A. Simon,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Client Personalities and Behavioral Bias

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

Justin A. Reckers and Robert A. Simon,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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 MorningstarAdvisor.com on July 21st 2011.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Benefits of a Financial Nudge

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The Benefits of a Financial Nudge

Reconciling the concepts of libertarian paternalism and self-determination.

by Justin A. Reckers and Robert A. Simon

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Resolving the Aversion to Estate Planning

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

Originally published by MorningstarAdvisor.com on April 21st 2011

Resolving the Aversion to Estate Planning

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Behavioral Finance and Long Term Care Insurance

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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 MorningstarAdvisor.com 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 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 and Life Insurance

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Behavioral Finance and Life Insurance

Emotions play a significant role in life insurance decisions.

By Justin Reckers and Robert Simon

Originally Published by MorningstarAdvisor.com 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 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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