A basic principle of economics is that people are rational and make decisions that maximize their utility.
It's common sense: Why would they do otherwise?
That assumption facilitates economic models but reality proves otherwise. People can and will do irrational things with their finances.
Behavioral economics (also called behavioral finance) addresses these irrational aspects. David Zuckerman, CFP, CIMA, principal with Zuckerman Capital Management LLC in Los Angeles has been studying behavioral economics for about 10 years. Although his college major was traditional economics, he found that the longer he worked as a financial advisor, the more inconstancies he spotted between clients' behavior and what traditional economics posited they would do.
"The further I got into my career, the more I realized that people are not rational and that many of the biases embedded in the human psyche drive people to irrational decisions," he says. "I wanted to delve a bit deeper into that and find out more about why there's such a disconnect between reality, where people do not make rational decisions, and the traditional economic theory that holds that people always act rationally."
Behavioral finance isn't just an interesting academic subject — it has useful implications for understanding retirees' behavior and how their decision-making processes can help or hurt their finances. Because retirees can't hit the financial reset button as easily as younger people, it might not be possible for older clients to recover from their self-imposed mistakes. Here's what you need to know to keep retired clients on track.
The big biases
William "Marty" Martin, Psy.D. with The Planning Center Inc. in Chicago says advisors need to be aware of several key behavioral finance themes with their retired clients. First, everyone makes cognitive errors when they make decisions largely because of the amount and now speed of data in our daily lives. Recognizing the categories of cognitive errors enables clients to catch themselves while making these errors and later prevent most of the errors. In addition, financial advisors are subject to the same cognitive errors as their clients, he adds.
Read on to learn what the advisors interviewed for this article believe are specific biases worth monitoring.
1. Herding.
Back when human beings were hunter-gatherers, the instinct to herd and stay with large groups of people and follow their actions made a lot of sense. There was safety in numbers and herding increased the odds of survival. But that history doesn't translate well to personal finance decisions, Zuckerman cautions: "The instinct to herd can wreak havoc on investment returns. Warren Buffet's mantra — 'Be fearful when others are greedy, and be greedy when others are fearful' — is something that clients with the instinct to herd will often find meaningful."
See also…
2. Anchoring.
When clients anchor, they incorporate irrelevant information into their financial decisions. Philip Weiss, CFA, CPA, chief investment analyst with Baltimore-Washington Financial Advisors Inc. in Columbia, Maryland, gives the example of a client who expresses interest in a stock that previously traded at $100 and now trades at $60. The client points out that the price is down 40 percent, which makes it a bargain. Not necessarily, Weiss points out: "That $100 doesn't mean that that was really a reflection of value or anything else; that's just what the market paid for it then. That didn't mean that it was worth it."
Anchoring can also interfere with rational decisions to sell depreciated assets, whether it's a home — "It used to be worth $x and I won't sell for less than that" — or stocks. Weiss cites the price history of numerous stocks that hit historical highs and took years to subsequently revisit those highs, assuming they ever did. Microsoft's price, for instance, peaked in December 1999 and still hasn't regained that valuation. Advisors need to recognize when clients are locking on to a reference point by anchoring or the clients might set inappropriate reference values.
See also…
3. Confirmation bias.
Everyone likes to make correct, well-informed decisions. Consequently, we seek out information that supports our decisions and downplay or overlook contrary opinions. Think of the last time you bought a new car or made another major purchase — you probably sought out positive post-purchase reviews to reinforce your purchase.
This tendency to seek confirmation also occurs with negative opinions. For example, The Conference Board's measure of U.S. consumers' confidence fell from a revised 97.8 in January 2016 to 92.2 in February, the lowest level in seven months. At the same time, though, the U.S. unemployment rate in the United States was recorded at 4.9 percent for February 2016, unchanged from January and at its lowest level since April 2008, and other indicators also showed modest economic growth.
Nonetheless, some clients will focus on the negative number and ignore the positive result in an example of confirmation bias. "Clients who have become pessimistic gravitate toward news and information that confirms their pessimistic outlook," says Zuckerman. "Without diversity of information, it is difficult to make well-informed investment decisions. In order to be helpful I will often point out data and perspective that is contrary to a (client's) pessimistic outlook."
See also …
5. Base rate bias.
Spotting client biases
