Professional Documents
Culture Documents
Part 1 Introduction:
Two Minds at Work
Introduction
Diagram 1:
substance of transactions, not on how they are superficially described. When faced with a choice between
having cold cuts that are ninety percent fat free or containing ten percent fat, people overwhelmingly select the
first option. Logically, the two are identical of course, but
people automatically respond negatively to containing
fat and positively to fat free, and choose accordingly.
This ubiquitous and powerful effect, the product of the
intuitive mind, is called framing (Tversky and
Kahneman, 1974).
We can see, then, that intuition is a powerful force. And
people typically place a great deal of faith in it. Kahnemans
discovery that under certain circumstances intuition can
systematically lead to incorrect decisions and judgments
changed psychologists understanding of decision making,
and, ultimately, economists, too.
Classical economics held that people are rational, selfinterested and have a firm grasp on self-control. Behavioral
economics (and common sense) showed instead that we
are not as logical as we might think, we do care about
others, and we are not as disciplined as we would like to be.
It is not that people are irrational in the colloquial sense,
but that by the nature of how our intuitive mind works we
are susceptible to mental shortcuts that lead to erroneous
decisions. Our intuitive mind delivers the products of these
mental shortcuts to us, and we accept them. Its hard to
help ourselves.
1 Kahneman did all the important work that underpins behavioral economics
with his colleague Amos Tversky, who had died before the Nobel Prize was
awarded. Nobel Prizes are never awarded posthumously.
BeFi-in-Action Framework
Two minds:
Intuitive mind
(fast, automatic, effortless):
Can often lead to wise decisions,
but sometimes leads
systematically to irrational,
poor financial decisions.
Reflective mind
(slow, conscious, effortful):
Can lead to more thoughtful,
rational decisions. Advisors can
engage their clients reflective
minds to improve outcomes by
correcting the mistakes of the
intuitive mind.
References
M. Keith Chen et al., How Basic Are Behavioral Biases: Evidence from Capuchin Monkey
Trading Behavior, Journal of Political
Economy, 114:3, pp 517 537 (2006).
Malcolm Gladwell, Blink: The Power of
Thinking Without Thinking, Hachette Book
Group USA, paperback, 2006.
Hewitt Associates, Hot Topics in Retirement,
2010.
Daniel Kahneman, Maps of Bounded Rationality: Psychology for Behavioral Economics,
The American Economic Review, vol 93, no. 5,
pp 1449 1475 (2003).
Daniel Kahneman and Gary Klein, Conditions
for intuitive expertise: A failure to disagree.
American Psychologist, vol 64, no. 4, pp 515
526 (2009).
(See Thaler and Johnson, 1990.) Under these circumstances, people become much more reluctant than usual to take
risks. In other words, investor paralysis now.
How can this be overcome? By means of what we can call
fuzzy mental accounting. Prospect Theory, which recognized the cogency of loss aversion, showed that in judging
gains and losses, people are exquisitely sensitive to what is
called the reference point (Kahneman and Tversky, 1979).
If an investor were to put all their cash into the market in
one single transaction, then that amount of money would
become the reference point. Any movement of the market
that increased or decreased the value of the investment,
above or below the reference point, would then be very
easily calculated. And the intuitive mind would respond
very negatively to losses.
University of Chicago,
Booth School of Business
Overcoming procrastination
SMarT worked around procrastination by asking people
to commit to increasing their contribution rate many
months in advance. Pre-commitment is important,
because it is psychologically palatable, and is linked to
the desired action actually taking place rather than just
a vague promise.
John Payne,
References
Daniel Kahneman and Amos Tversky,
Prospect Theory: An Analysis of Decisions
Under Risk, Econometrica, vol 47, no. 2,
pp 263 291 (1979).
Richard Thaler and Shlomo Benartzi,
Save More Tomorrow: Using Behavioral
Economics to Increase Employee Saving,
Journal of Political Economy, vol 112, no. 1,
pt 2, pp S164 S187 (2004).
Richard Thaler and Eric Johnson, Gambling
with the House Money and Trying to Break
Even, Management Science, vol 36, no. 6,
pp 643 660 (1990).
According to standard economic theory, people make investment decisions based on a rational analysis of the
present value and future prospects of equities. It is clear
from his advice to investors, however, that the Oracle of
Omaha recognizes that factors other than rational analysis
are sometimes at play.
Buffett understands from his years of experience that investors often buy high and sell low. They also often buy the
wrong stocks, sell the wrong stocks and, in normal times,
do far too much buying and selling. Academic insights
from Behavioral Finance help explain why people behave
the way they do, and they offer practical solutions to financial advisors to help their clients make better investment
decisions. The idea is that people are not being stupid,
they are just human.
Here, we introduce The Ulysses Strategy, which engages
the reflective mind for rational short- and long-term
investment strategies, thereby avoiding the errors that
the intuitive mind is otherwise prone to make.
take out the ear plugs and release him. Ulysses had committed himself to a rational course of action at a neutral
time, that is before he could hear the Sirens songs, and
ensured that he stuck with his decision. This action of
pre-commitment is the work of the reflective mind.
In the same way, financial advisors could invite their
clients to engage their reflective mind to pre-commit to
a rational investment strategy in advance of movements
of the market that might otherwise trigger irrational responses of the intuitive mind. This kind of Ulysses Strategy
has been shown to work with the Save More Tomorrow
program (Thaler and Benartzi, 2004), in a pilot savings
product in the Philippines (Ashraf et al., 2006) and in a
program to help smokers quit, which involved participants
depositing a sum of money in an account that they would
forfeit if they relapsed (Gin et al., 2008). Pre-commitment
to a rational investment plan is important, because the
intuitive impulse to act otherwise is strong.
The first step in the process is to help your clients understand the psychology of trading by individual investors
that can lead to poor decisions. Help them understand that
these misguided impulses of the intuitive mind are quite
natural, but that there is another, better path to follow,
one that is guided by the reflective mind.
The second step is to agree on an investment strategy,
which would include an acceptable balance between risky
and conservative instruments. As financial advisors, you
are already very familiar with this. What would be novel for
most advisors, however, is to commit to a specific contingency plan. This is an agreement made in advance about
what action will be taken should a certain event or condition occur: for example, if the market goes up 25 percent
or if the market goes down 25 percent.
References
Nava Ashraf et al., Tying Ulysses to the
Mast: Evidence from a commitment savings
product in the Philippines, The Quarterly
Journal of Economics, pp 635 672,
May 2006.
Nicholas Barberis and Wei Xiong, Realization
Utility, 2010, http://badger.som.yale.edu/
faculty/ncb25/rg40d.pdf
S. Bikhchandani et al., A theory of fads,
fashion, custom, and cultural change as
informational cascades, Journal of Political
Economy, vol 100, no. 5, pp 992 1026 (1992).
Brad M. Barber and Terrance Odean, Trading
Is Hazardous to Your Wealth: The common
stock investment performance of individual
investors, The Journal of Finance, vol LV, no. 2,
pp 773 806 (2000).
Brad M. Barber and Terrance Odean,
All that Glitters: The Effect of Attention and
News on the Buying Behavior of Individual
and Institutional Investors, The Review of
Financial Studies, vol 21, no. 2, pp 785 818
(2008).
Appendix A
As financial advisors know very well, their client relationships have two components: the technical and the
personal. Active demonstrations of professional competence and personal empathy have been identified as key
to building and maintaining trust, notes Noah Goldstein,1
of the UCLA Anderson School of Management (see Grling
et al., 2009). The following BeFi-in-Action strategies are
applicable not just to regaining trust in current circumstances, but also to maintaining trust in the ongoing
financial advisor/client relationship. Some of these
strategies might at first seem commonplace, but we
add a unique angle on them, often backed up by social
science research.
Active demonstrations of
professional competence and personal
empathy have been identified as key
to building and maintaining trust.
Noah Goldstein,
Demonstrating Competence
Clients understand that financial advisors are professionals with a demonstrated level of competence. Nevertheless,
research shows that clients perception of their financial
advisors competence can, and should, be constantly bolstered in many ways. Some of these actions seem basic and
perhaps obvious, while others are even counterintuitive.
Many financial advisors know intuitively that acknowledging shortcomings engenders trust in their client. And
social science research shows this to be the correct thing
to do (Lee et al., 2004). Moreover, a 2010 Golin/Harris survey
revealed that the most effective action a company can
take to restore broken trust is to be open and honest.
The same holds true for individuals. Honesty resonates
strongly, and enhances trust. Less intuitively obvious is
that admitting luck has the same effect. We will start
with this suggested action.
Admit luck. When performance meets or exceeds expectations it is only human nature to want to take full credit.
However, according to social science research, it is unwise
to do so. Warren Buffett shows himself to be a student of
psychology in understanding this.
Exhibiting Empathy
Most financial advisors know very well that there is more to
the advisor/client relationship than just shaping an investment portfolio: there is the human side of the relationship,
too. Those financial advisors who place great value on this
aspect of their interaction with clients should know that
their intuition to do so is strongly supported by research.
This research shows that paying genuine attention to the
human element in business transactions improves all
bottom-line measures (Pfeffer, 1998). Putting value on the
human side of business has been described as relational
intelligence (Saccone, 2009).
In the context of regaining and maintaining trust, therefore, exhibiting empathy with a client is not just being
nice: it is good business practice. And most financial
advisors know that exhibiting individualized care to their
clients is an integral part of the way they need to work,
in order to serve their clients most effectively. Here are
a few actions around exhibiting empathy that may be
less obvious.
call their clients more frequently than before, thus providing emotional support. They are regarded not only as
competent, but also as trustworthy. Their example is
worth emulating.
Allay embarrassment. Have you ever asked a client,
Is there anything about our strategy you dont understand? It is a perfectly valid, and very professional,
question because it comes from a desire to ensure that the
financial advisor/client relationship is on a sound footing.
After all, no financial advisor wants a client to be going
along with a strategy that he/she doesnt fully grasp.
However, the wording of the question might not elicit the
truth. Many people dont like to admit ignorance. A client
might not understand everything, but will nevertheless
answer, No, there isnt, rather than face that embarrassment. A slightly different wording of the same question,
such as Is there anything about our strategy that I can
clarify? allows the client to admit ignorance without it
being so labeled. The same goal is achieved.
Empathy
1. Admit luck.
2. Allay embarrassment.
3. Seek feedback, especially
in difficult times.
References
Kenneth Arrow, Gifts and Exchanges,
Philosophy and Public Affairs, vol 1, pp 343
362 (1972).
R.C. Atkinson and R.M. Shiffrin, Human
Memory: A proposed system and its control
processes, in K.W. Spence and J.T. Spence,
Psychology of Learning and Motivation, II,
Academic Press, pp 89 195 (1968).
In Development:
Addressing the Disinclination to Save
The Behavioral Time Machine
Many people were caught off guard in the recent financial crisis as they watched with alarm
the value of their 401(k) accounts plummet, the price of their house decline and their job
security threatened or even lost entirely. Most people imagined these three pillars of future
financial stability to be separate: if one pillar started to crumble, the other two would
compensate. The fact that under a confluence of certain financial circumstances their fates
might be closely correlated was a timely reminder of the interconnectedness of things in
our financial worlds. It also exposed a chronic problem: inadequate savings, not just for
retirement but also for a source of stability in blustery financial climates in the future.
of Management, Northwestern University, saving for retirement may feel to the present self like giving money to a
stranger years in the future. That is a strong disincentive
to saving now.
The Behavioral Time Machine currently under development offers the prospect of a simple tool that effectively
reduces the gap between present and future selves. It will
assist peoples imagination to understand the impact of
present decisions on the future self, thereby enhancing
peoples willingness to save now (Ersner-Hershfield et al.,
in press).
Two Selves
The notion of a disconnection between present and future
selves has fascinated philosophers since the time of Plato.
Many young people view their older selves heading into
retirement as strangers. The British philosopher Derek
Parfit famously described this lack of comprehension of
future selves as a failure of imagination, or some false
belief (Parfit, 1971). It is a failure to identify with oneself
in the future.
This unconscious assumption of a different self in the
future is demonstrated graphically by brain scans. Researchers at Northwestern University and elsewhere find
that when people think about their future selves, the same
brain region lights up as when they think about strangers.
This neurological response to thinking about future selves
is stronger in some people than in others. And those in
whom the brain region is activated most when looking at
future selves also show the steepest discounting of the
future (Ersner-Hershfield et al., 2009). The degree of psychological disconnection is reflected in an unwillingness
to save.
To a failure of imagination we might add many young
peoples seeming sense of immortality, or denial that one
day they, too, will be old.
In any case, the disconnection between present and future
selves is well recognized, and it correlates with a reluctance to save. The question is, can the psychological gap
between the two selves be closed, and would this affect
willingness to save?
In a second study these same experimenters added an emotional dimension to the future selves. They first
took three photographs of each
participant, one with a very happy
expression, another with a very sad
expression and a third one with a
neutral face. These three images were
then digitally processed to form a
series of about a dozen expressions in
a future self-image, progressing from
very happy to very sad. The experimenters then linked this sliding
emotional scale to a sliding financial
scale, going from minimal allocation
of savings for retirement on the left to
optimal allocation on the right.
References
Daniel M. Bartels and Lance J. Rips,
Psychological Connectedness and Intertemporal Choice, Journal of Experimental
PsychologyGeneral, vol 139, no. 1,
pp 49 69 (2010).
Hal Ersner-Hershfield, 2011,
personal communication.
Hal Ersner-Hershfield et al., Saving for the
Future Self: Neural measures of future selfcontinuity predict temporal discounting,
Social Cognitive and Affective Neuroscience,
vol 4, no. 1, pp 85 92 (2009).
Hal Ersner-Hershfield et al., Increasing
Saving Behavior Through Age-Progressed
Renderings of the Future Self, Journal of
Marketing Research, in press.
Derek Parfit, Personal Identity, Philosophical
Review, vol 80, no. 1, pp 3 27 (1971).
Elke U. Weber et al., Asymmetric Discounting in Intertemporal Choice, Psychological
Science, vol 18, no. 6, pp 516 523 (2007).
Acknowledgements
We would like to thank the following experts in behavioral finance for their input to the intellectual
content of the Behavioral Finance in Action series. Each of them is a member or past member of the
Academic Advisory Board of the Allianz Global Investors Center for Behavioral Finance.
Richard H. Thaler
Daniel G. Goldstein
Nicholas Barberis
Noah Goldstein
Kent Daniel
John Payne
We would also like to thank the financial advisors who provided feedback on the Behavioral Finance in Action series.
And we welcome further comments from our readers. Email us at contactus@AllianzBefi.com.
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