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May 01, 2007 at 08:00 PM
Classical economics says consumers are rational. Behavioral economics says consumers are normal, which is why dealing with prospects in a rational way doesn’t always work.
As an example, if a prospect should move money from a market-risk investment to a no-market risk-of-loss fixed annuity, would the prospect be more likely to move from the investment to the annuity if he was up 10 percent in his investment or down 10 percent in his investment? In other words, would he be more likely to move if he had a gain or a loss?
The answer is that a prospect would be more likely to move to the annuity if he had a 10 percent gain in his investment. That’s right, a gain. The reason is due to something called regret aversion. Although the rational answer is that consumers tend to avoid more risk, the behavioral reality is if we sell the investment at a loss, we would have to admit we were wrong and that we had made a bad previous decision.
In fact, we’re doubly cursed. What if we sell the investment at a loss and the investment subsequently goes back up? We’ve now made two bad decisions. This is why investors tend to hold lousy stocks much longer than they should – the mental pain of admitting we were wrong is harsh.
The stock market has been heading higher over the last four years and most investors have gains. This year’s market events have shown that investments still can go down. This is an excellent time to talk to consumers about whether they should take some money off the table and leave as a winner, and put that money into a fixed annuity where they can never be a loser.
