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Financial Planning > Behavioral Finance

How Can Advisors Bridge the Emotional, Cultural and Generational Divides?

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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.

Uncertainty control tells us a lot about how people think about the future. People who are high on uncertainty control tend to be more confident and optimistic about the future. Conversely, people who are low on uncertainty control tend to be more prone to worry.

In terms of social orientation, which tells us how someone will relate to their financial advisor, people who are collectively oriented tend to be quick to build relationships and trust, while people who are individualistically oriented are comfortable expressing disagreement and slow to connect.

How people score in relation to these two concepts tells us a lot about them. In a recent study, we observed that both Mediators (low uncertainty control, collective oriented) and Commanders (high uncertainty control, individualistically oriented) engaged in the disposition effect, which is a cognitive bias that causes investors to hold onto losing assets while selling winners, about 50% of the time.

However, Auditors (low uncertainty control, individualistically oriented) engaged in it less frequently at a rate of 21%. Facilitators (high uncertainty control, socially oriented) tended to engage in the middle of the two ends at a rate of about 33%.

To summarize, while all groups engaged in the disposition effect, a cognitive bias, we do see differences in the extent to which people succumb to this bias (thanks to System 1) that’s explained by a person’s unique personality.

[Unfortunately, research looking at the effect of personality on financial decision making is sparse. However, I believe that looking at personality as a mechanism for explaining financial decision making is worthwhile, and I will continue to conduct research in this area.]

In terms of how personality might influence automatic thinking of System 1, we believe that personality influences the factors in a situation that people will pay most attention to, as well as determine how these factors will be perceived. For instance, someone who is risk averse will gravitate toward certain factors in a situation and interpret them as threatening. In contrast, someone who is risk seeking may look at the same factors positively and be excited by them.

Financial advisors who have insight into the personality of their clients will have better visibility into their clients’ perspectives (i.e., see things from their point of view) and coach them accordingly — in other words serve as a proxy for System 2.

Generational Differences

It seems almost impossible to browse the internet or read a magazine without coming across an article on the topic of generational differences, ironically tending to emphasize millennials (born in the early 1980s to mid-1990s) and stoking the virtually baseless fears people anticipate of their successor, most commonly labeled Generation Z (born in the mid-1990s and onward). Consequently, I am often asked by financial advisors about the impact that generational differences have on financial planning.

The short answer is that generational differences do exist, but quality research looking at generational differences is limited. There is also a lot of misinformation about how each generation is characterized.

Further, the information that is most widely distributed among the general population is, more often than not, based on an emotional indictment or defense of a particular generation, conjecture, anecdotes, and case studies (read: not reliable and valid methodologies). As a result, many of the generational characterizations are contradictory, which, unfortunately, will likely begin to undermine the credibility of this research field as a whole in regard to public opinion and acceptance.

I don’t necessarily fault the people who are interested in researching and getting a better understanding of this topic. The reality is that research in this area is limited mainly due to its difficulty. The most robust insights tend to be informed by longitudinal studies that track multiple generations over a period of time — most often several decades.

The challenge here should be obvious. People will inevitably drop out, research funding gets cut, and researchers die before their data ever gets analyzed or published (to name a few). To further complicate matters, much of what we observe is confounded by normal human development. For instance, younger people, regardless of generation, are typically concerned with starting careers and families, while older adults will at some point no doubt be concerned about end-of-life care.

Culture Matters

To disentangle these issues, it’s better understand that culture combined with normal human development gives each individual a unique perspective that in turn influences attitudes and beliefs (essentially System 1 territory). When observed in the aggregate, we will tend to see trends that are shared by groups of people who were born during a similar time — hence the generational labels such as Generation X and millennials. For instance, people who went to college before the age of the internet (baby boomers) will undoubtedly have shared meaningful experiences that are different than those who never experienced a world before smartphones (Generation Z).

That said, there are insights that should be helpful to financial advisors regarding generational differences. One study, conducted by Jean Twenge, San Diego State University, and Tim Kasser, Knox University, analyzed attitudinal data that was collected annually from 1976 to 2007 among American high school seniors. What they found is that materialism has steadily been on the rise.

They further identified that American high school seniors who experienced a decline in societal living standards (measured by looking at unemployment, divorce, and suicide rates) around the age of 10 tended to be more materialistic by the time they graduated high school.

It’s unclear whether this effect carries over into the later years, but it’s certainly something that financial advisors should be on the lookout for given the impact that materialism (i.e., greed) can have on investment behavior. For instance, people who are materialistic may be tempted to overspend, which could put attaining long-term financial goals at risk.

Also, Generation Z, a group of individuals who were roughly age 10 during the great recession of 2008, a period of significant decline in societal living standards, may be particularly vulnerable to this effect as they start investing and planning for their financial future.

Finally, a more immediate concern comes from a survey from the independent research organization NORC at the University of Chicago (see chart). It found a growing trend of inequality among age groups when asked whether they are concerned regarding their financial situation. The percentage of individuals who reported that they were satisfied had similar rates of satisfaction during the early 1970s across age groups. In contrast, the differences, most notably between the oldest and the youngest groups, have grown larger today.

I interpret this trend to indicate that while fewer people are obviously satisfied with their financial situation in current times, there is also likely many who probably see themselves as worse off than prior generations. From an emotional, System 1 level, this perception is likely creating fear and feelings of deprivation (i.e., “I got the short end of the stick”).

Financial advisors can play a System 2 role here by working to better understand their clients’ fears while empowering them to take control of their financial situation. Given the trend of increasing materialism, financial advisors will no doubt increasingly find themselves having conversations with their clients with the theme of convincing clients that they need to keep their materialistic drive in check.

Nicholas Arreola, Ph.D., is chief behavioral scientist and analytics officer at CLS Investments, LLC.


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