Understanding the psychology of choice is beneficial for your relationship with your client.
In general, people make decisions in two fundamental ways: either with their head or their gut. When we make decisions with our head we slow things down, we think hard, we are less susceptible to framing. But the problem with this type of thinking is that it really tires you out – it’s hard work thinking too much. If you’re solving a really big problem it can physically hurt. However, thinking with your gut is easy. If I asked: “do you want a cup of tea or coffee?” that is a gut-based feeling, you don’t need to do an analysis on where the coffee beans come from; you just know you want a cup of coffee.
But when people need to make important financial decisions, thinking with your gut and being emotionally led can leave people open to being influenced by things such as framing. If you take the UK adult population, 66% of people make decisions predominantly with their gut. If it feels right it’s got to be right. But that’s a problem when you’re asking someone to make a financial decision that will have a significant impact on the rest of their life. They should not be making these decisions on what feels right. That is a really damaging situation to be in.
Decision-making is also affected by other psychological biases. One of them is a person’s level of confidence in their knowledge. How capable is someone of making an important financial decision? We measure this in two ways: we measure a person’s subjective knowledge; what they think they know. Then we measure a person’s objective knowledge, which is what they really do know. We all have huge amounts of subjective knowledge; we think we know far more than we actually do. So, what we do is take a person’s subjective knowledge and match it against their objective knowledge, which shows a person’s knowledge confidence.
The problem with thinking you know a lot but actually know very little, and conversely thinking you know very little but know a lot, is that they’re both as bad as each other. The person who thinks they know more than they do is over confident. These people won’t come to you for advice, why should they, they know what they’re doing, right? But what happens when they end up in a bad situation? The people know more than they think they do are under confident, and these people are likely to put off making decisions because they believe they don’t know what they’re doing.
We react more readily to negatively framed information than positively framed. Put a client in a supermarket to buy yoghurt. The fact is if you frame that yoghurt as 80% fat-free, that is much more inviting than saying it is 20% full fat.
Your eyes are drawn to the positive more than the negative. Imagine you’re sat in front of your client to tell them how a particular investment portfolio is performing. You can either tell them that the portfolio is generating positive or neutral returns 80% of the time – or that 20% of the time it generates negative returns. If you presented those two in isolation from each other, the majority of people would gravitate towards the former, because that sounds really good – it’s positive.
One of the most pervasive behaviours is loss aversion. Loss aversion is really important, as losses loom much longer and larger than gains.
Have you ever lost your wallet, purse or car keys? When you do you get a kind of gut wrenching feeling. That feeling of losing something that is valuable to you is horrid. Surely then, the equal reaction when you find it should be opening a bottle of champagne and having a party? But you don't do that - you just say “Phew, I’ve found it, I’m alright” and carry on as if it didn't happen. This is because the feeling of losing something has a greater impact than an equal gain. So loss aversion is a very important measure to understand in people.
However, loss aversion should be measured against a person’s subjective attitude to risk (or in traditional speak, their ATR). Subjective attitude asks questions such as “what would you do if...?” There’s a problem with asking people what they would do in a future state and expect them to answer with any authority. To do this we need to be in our environment with all the stimuli around us to make an informed decision.
If you ask a person what they think they’d do (ATR) and match that to their loss aversion you get a really interesting measure. What you get is whether their self-perception of what they’d do is balanced or not.
What happens if you speak to a client who thinks, through an attitude to risk, that they are high risk but their behaviour is screaming absolutely not high risk and they’re more cautious? When the portfolio goes down and they start to lose money, that behaviour (loss aversion) is going to trump subjective attitude every single time. Because subjective attitude is what you think you’ll do, and loss aversion is more of what you will do, and that is a very important distinction.
Sub-conscious behaviour affects conscious decisions
What does understanding all this mean for financial advisers? The way you approach clients must be with 21st century thinking. We need to be conscious that when we ask clients facts for your “fact-find” they probably don’t go enough of the way to really understanding who is in front of you.
Remember that people can be influenced by a whole raft of things. Your office environment, how you dress, how you speak, how you present information, and so on. These are further compounded by the sub-conscious behaviours we all have. As financial advisers, being aware of these influences, and a person's cognitive biases can help you provide clients with the best possible chance at achieving their financial goals. Surely that's a good thing?