How would you respond in the below scenario?
Imagine that the United States is preparing for the outbreak of an unusual disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows:
- If program A is adopted, 200 people will be saved.
- If program B is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved.
Which option would you choose?
Daniel Kahneman, a psychologist who won the Nobel Prize in Economics for his work into the understanding human behavior, presents this scenario in his seminal book, Thinking Fast and Slow. He, along with his now deceased research partner, Amos Tversky, used this question several decades ago in a study to evaluate how people make decisions.
If you are like most who participated in the study, you chose program A. Certainty reduces risk, and program A presents a sure bet, while program B has an unknown, riskier outcome. Due to this risk aversion, most people seek the safety of certainty in this type of situation. Let’s try another one:
- If program A is adopted, 400 people will die.
- If program B is adopted, there is a one-third probability that nobody will die and a two-thirds probability that 600 people will die.
How about now? Did you choose program A or B? Most people choose option B in this adjusted scenario. But, look a little closer. Options A and B in each of the scenarios are the same. Yet, most people choose A in the first scenario and B in the second. So, what gives?
The reason is due to how the information is framed and presented. The first scenario focuses on how many lives will be saved, in other words, what can be gained. The second scenario frames things differently, addressing losses by discussing how many people could die. The study illustrates a fundamental factor about human behavior that every advisor should understand when communicating to clients.
These principles are key foundations in what is called prospect theory.
Understanding risk-avoidance and risk-seeking behavior is crucial to whether financial advisors, representative and educators either communicate-to-action or communicate-to-inaction. Let’s rework the above scenario, making it more aligned to financial planning, to see how this can look when working with clients.
Imagine that you are advising a client during a volatile market, where analysts expect crashing declines of 40 percent. The client has a short time horizon before needing to access their funds. You present two alternative plans.
- If plan A is adopted, 80% of their current account value will be saved.
- If plan B is adopted, there is a one-third probability that 100% of their account will be saved and a two-thirds probability that nothing will be saved – they will incur the full brunt of the 40% market drop.
- If plan A is adopted, they will lose 20% of their value.
- If plan B is adopted, there is a one-third probability they will not lose anything and a two-thirds probability they will lose the full 40%.
What would your clients choose to do? This example may be a little simplistic from how things actually play out in the real world. But, it illustrates how a client’s risk-seeking and avoidance behaviors can occur. As with Kahneman’s study, options A and B in each scenario are the same; it is how they are framed that differs. As a result, the client may make a completely different choice, simply because of how options were communicated.
If, as an advisor, your goal is to guide clients and help them to make informed and educated decisions, where they are fully cognizant of their choices and possible outcomes, this presents a problem. Simply, how you frame options could direct their decision making. For those advisors committed to working in their client’s best interest, there is a solution. Advisors can expand their client’s understanding of their decisions and better empower them by taking their perspective from the vacuum of a narrow to a broad frame of information.
In their Journal of Portfolio Management article, “Aspects of Investor Psychology,” Kahneman and the Senior Vice President for the Schwab Center for Financial Research, Mark Riepe, present 10 recommendations for creating a broad frame:
- Encourage clients to adopt a broad view of their wealth, prospects, and objectives.
- Encourage clients to make long-term commitments to investment policies.
- Encourage clients not to monitor results too frequently.
- Discuss the possibility of future regret with your clients.
- Ask yourself if a course of action is out of character for your client.
- Verify that the client has a realistic view of the odds, particularly when a normally cautious investor is attracted to a risk venture.
- Encourage the client to adopt different attitudes toward risk for small and large decisions.
- Attempt to structure the client’s portfolio to the shape that the client likes best (such as insuring a decent return with a small change of large gain).
- Make clients aware of the uncertainty involved in investment decisions.
- Identify the aversion of your clients to the different aspects of risk, and incorporate their risk aversions when structuring an investment.
How do you broaden the decision-making frame for your clients?