An interest in behavioral finance might boil down to one question, “What’s wrong with people?”
Researchers are looking to understand why people seem to act against their own interest and advisors want to know how they can help guide clients to take the best action for their future.
Find the bias and you might be looking at the answer.
Victor Ricciardi turned to the subject of bias soon after being asked about behavioral finance. The finance professor at Goucher College in Maryland co-wrote the book, Investor Behavior: The Psychology of Financial Planning and Investing.
The biases he pointed out were:
- Loss Aversion.
- Status Quo.
Representativeness bias might come into play with annuities. Perhaps an advisor recognizes that clients could use income security in retirement but resist even considering them. It might be a case of representativeness bias.
“Representativeness is where a person or a client may have experience with something, so let's say they have experience with a small sample size of something, and they draw a conclusion about it that it's either good or bad,” Ricciardi said. “For example, if somebody was sold an annuity product and they had a bad experience one time about that with an insurance agent, they draw the conclusion that all annuity products are bad.”
But it does not have to be personal experience. It could be as simple as seeing one ad and converting it to a blanket judgment.
“They see a commercial saying don't buy annuities because they have high fees and they draw a conclusion that all annuities should not be bought,” he said. “I think about it the way I imagine stereotyping. You see somebody a part of a racial group and you draw the conclusion.
You see The Godfather and draw the conclusion that all Italians are in the Mafia.”
But it is not always a negative conclusion. In finance, for example, a consumer might see a story or two about how an initial public offering made investors rich and conclude that all IPOs make money.
There is a little confirmation bias smuggled in here because the person drawing conclusions from a few stories was attracted to that information because it resonated with a current belief.
In an era of fake news, it can be a real problem.
Overconfidence bias might be what is triggering clients who trade too much.
“They move in and out of securities – it could be a variable annuity not making money. They don’t have patience,” Ricciardi said. “Overconfident behavior is represented in people trying to chase returns. So they incur too many fees and wind up with lower investment returns.”
But is it faith in their own judgment or just how they roll?
“It could be driven by two things,” he said. “It can be in their own judgement; it could be driven by their personality.”
Here is where the researchers step in. They have monitored chemical reactions and heart rates to see the mechanics of overconfidence.
“They have found, especially in men who are traders, they have higher levels of testosterone. So that also contributes to that overconfident behavior,” Ricciardi said, adding that it is not as simple as that, though. “Is it nurture or nature? It's a combination of both or may just depend on the individual.”
Loss aversion bias is one we have been hearing about since 2008. People tend not to see the same amount of gain and loss in equal measure. Gain is nice – loss is terrifying.
“People tend to not want to admit they made a mistake with investment because they don't want to feel regret,” Ricciardi said, taking an example of a $1,000 gain or loss. “On the downside an equivalent loss does not feel the same. It would feel like a $2,000 loss. It's kind of like a multiplier effect. The loss tends to be more painful on the downside than making money on the upside. So the losses can even get to be larger because it goes from $10,000 to $8,000 value than a $2,000.”
If they didn’t sell at $8,000, they are less likely to sell at $5,000 and so on. Then another frame of mind takes over as well. The stock could be seen as a bargain, so the investor buys more. But that could easily fall into something a little more risky.
“Some personality types wind up having a gambler's mentality.”
Status quo is the opposite of overconfidence. People are unlikely to act because things are fine right now, making it difficult to think of future problems. This could be one of the reasons that life insurance and long-term care insurance ownership are at record lows.
Here is where nudging comes in. Nudging behavior can bypass the inertia of inaction. For example, more companies are auto-enrolling people into 401(k) plans. And Ricciardi said a funny thing happens.
“What they find is that when people are automatically enrolled in a retirement plan or 401(k) plan, probably 90 percent of them stay in it,” he said. “So it's kind of a reverse – they're using status quo bias to their advantage.”
Self-control bias might be a cousin to the overconfidence bias, and one that Americans are rather fond of. The label might fool you – it’s a lack of self-control.
“People suffer from self-control bias, in which they would rather live in today,” said Ricciardi, who added that it is a national epidemic. We are dopamine addicts.
“It’s that same part of the brain that triggers money and music and same part of the brain that controls sex,” he said. “So we're predisposed to spend money today at the cost of saving for tomorrow.”
Making Annuities Sexy?
Just as auto-enrollment can take advantage of the status quo bias, the insurance and finance industries can also use the self-control bias. How do you ding the bell in the brain usually reserved for eating and sex? It is all in the framing.
With annuities? Yes, even with them. You can tell people in their 20s that if they put away a little money now, they can have $2,000 a month when they retire. However, that is far off and $2,000 in the future is not nearly as enticing as money currently in hand, ready to spend.
Ricciardi said research found that the key is in knowing what they want to spend it on.
“So, if you find out what interest people and what they enjoy, and you say in retirement that you're going to be able to use that $2,000 per month to play golf, take an extra vacation in a year, buy a car,” he said. “If you link that spending mentality with an investment objective, people are more likely to save for the future.”
It is a way to use a bias to connect with the client’s best interest, a secure future. Rather than fight it, use it, Ricciardi said.
“I'm trying to explain to people that there's nothing wrong with treating yourself to something, maybe once per month that really interests you because that's more likely to keep people in the financial plan,” he said. “It's all about balance, moderation.”
Moderation is in short supply, though.
“I tell my students the biggest problem is that Americans, in general, have poor financial health. Two things I look at is, only about 50 percent of American households either has stock or stock mutual funds. And then almost two-thirds of American households carry a credit card balance every month,” Ricciardi said, saying that the average interest payments add up to about three to four paychecks per year. “So, it's just going toward working for the bank. That's getting up 30 days a year just to work for the bank. This is what I tell my students: When you're paying interest with credit cards, would you rather work for a bank or would you rather have the bank work for you?”
Steven A. Morelli is editor-in-chief for AdvisorNews. He has more than 25 years of experience as a reporter and editor for newspapers, magazines and insurance periodicals. He was also vice president of communications for an insurance agents' association. Steve can be reached at firstname.lastname@example.org.
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