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September 27, 2018 at 09:00 AM
Psychology has infiltrated the field of financial advice and does not appear to be stopping its influence any time soon. This makes sense. With the popularity of outsourcing money management on the rise, many financial advisors are finding that their most valuable offering is the management of client behavior.
Every advisor seems to have his or her own story that underscores this point. The client temptations always vary — reaching into a 401(k) too soon, taking on unnecessary debt, dipping into savings, etc., but the image that advisors create is always the same: taking off their businessperson hat and playing the role of a psychologist.
These advisors would be the first to acknowledge a lack of formal training in psychology, but knew, most likely through professional intuition, that they had to do something. They needed to prevent their client from behaving in a way that would have a potentially profound negative impact on attaining their financial goals, even if it meant losing them as a client.
Two Systems at Work
In his book, “Thinking, Fast and Slow,” Daniel Kahneman, a modern-day psychologist who’s known for winning a Nobel Memorial Prize in economics for his work studying judgment and decision making, presents a framework for how the mind works, which he and his colleagues have labeled System 1 and System 2 thinking. System 1 thinking is described as automatic, intuitive and emotional, whereas System 2 thinking is deliberative, effortful and logical.
This framework for how people think implies one of the best arguments for having a financial advisor — to protect clients from the impulses of System 1, which is error-prone and sacrifices accuracy for speed and gratification.
Over the last several decades, researchers have identified a number of systematically occurring errors in human thought, which are referred to as cognitive biases. You’ve no doubt witnessed someone succumb to one or more cognitive biases, e.g. a disappointed gambler walks away empty-handed from the blackjack table, or a novice basketball player confidently shoots, but misses, a free throw. These two scenarios represent the gambler’s fallacy, an incorrect belief that a series of losses will decrease the chance of losing in the future (or vice versa), and overconfidence bias, an exaggerated belief in one’s abilities.
Have you caught yourself engaging in one of these biases? Naturally, we humans are not designed to catch ourselves engaging in biases — the exception being when they are brought to our attention. We are simply too limited in our span of attention and consciousness.
Even System 2, the effortful and logical counterpart, is not much help in preventing cognitive biases since System 2 generally takes its cue to engage in effortful thinking from error-prone System 1.
Although it may be tempting for investors to try to overcome these biases on their own, they should know that overriding the impulses of System 1 goes against its pursuit of efficiency, which more often than not seems to win.
On the surface, this might seem like a major design flaw, though it’s more likely the case that the mind balances System 1 and System 2 thinking fairly well for everyday tasks where there is plenty of opportunity for practice and feedback. To illustrate this point, you know right away if you’ve burnt the toast, and you will subsequently (we hope) turn your toaster to a lower setting the next time around.
Not Enough Practice?
In contrast, for the average investor, making decisions about their financial future not only happens less frequently compared to everyday tasks, such as preparing breakfast, driving to work, or performing one’s job, but there is also less opportunity to learn from mistakes.
Most Americans understand that saving and not overspending are important, but they find being disciplined in implementing this knowledge easy to put off until “next month’s paycheck.” Why? Because the most important consequences of putting them off aren’t necessarily experienced until decades later when they want to retire or have an unexpected life event such as a sudden decline in their health.
Financial advisors regularly tell me how amazed they are by the number of clients who are unaware of how much more quickly they can pay off their home by making one or two extra mortgage payments a year or how waiting to cash in on Social Security until age 70 can make these funds go significantly further.
Recognizing the benefits of compound interest does not come naturally for most people regardless of how their System 1 and System 2 work — it’s a concept that instead requires knowledge, experience, and expertise to fully grasp and apply.
Thus, the need for sound financial advice is still more apparent than ever, but, looking into the future, the role probably will have a greater emphasis on managing behavior due to several decades of behavioral research finally making its way into popular press thanks to Kahneman’s “Thinking, Fast and Slow,” and Richard Thaler’s “Misbehaving.” Both books provide a terrific overview of cognitive biases that financial advisors would find useful.
From Theory to Action
There is merit and practical application that extends beyond Kahneman’s original intent, who presents the System 1 and System 2 framework as internal mental (cognitive and perceptual) processes.
First, System 2 can be externalized or “outsourced,” meaning outside sources of feedback, such as financial advisors, can serve as proxies for deliberative, effortful and logical thought, or at a minimum serve to snap individuals out of the allure of System 1 (impulse and emotion).
Second, a person’s personality and environment (e.g., cultural and generational influence) play a role in shaping System 1. That insight into these forces can help financial advisors serve their clients more effectively.
The Influence of Personality
Since the mid-1990s, personality research has been getting a “second wind” thanks to a renewed interest in the subject, better methodologies, and the appeal of broad application. Prior to this time, research in personality was arguably overshadowed by what psychologists referred to as “behavioral and cognitive revolutions” — the latter of which led to many of the breakthroughs discussed in the previous section pertaining to cognitive biases.
Personality research will significantly contribute to the next generation of insights regarding how people plan and make decisions about their financial future. I recently led an effort to study the effect of personality on financial decision making — arguing and demonstrating that personality can indeed explain behaviors relevant to financial decision making above and beyond what we know from research on cognitive biases. As part of this effort, we have identified four distinct personality types based on a combination of two concepts: uncertainty control and social orientation.
