Decisions, learning & the role of advisors
Making good decisions requires a process of learning new information, synthesizing it into current modes of thinking and then applying that knowledge to the act of selection. This is no easy task when making financial planning decisions, which requires one to travel through an unfamiliar landscape of data, product features, processes, language and options. As anyone who has ever had to make a high stakes financial decision can attest to, the process can be quite complex, confusing and daunting. For this reason, bad decisions often result.
By acting as a guide through the planning process, financial advisors are crucial to their client’s success. It’s not hyperbole to say that the primary job of any advisor is to empower good decision making. Doing this requires equipping clients with the tools, knowledge and resources requisite in understanding their unfamiliar landscape that is fraught with the potential for both opportunity and danger.
This begs two questions: How do people go about making decisions, and how should they be making decisions?
Decision making defined
First off, what does it mean to make a decision? Sounds simple. But, it’s important to understand a few key components of any important financial decision. Specifically, a decision contains choosing between multiple options with varying degrees of risk and uncertainty. In addition, the client must find value in the possible outcomes. More simply put, there must be the potential for gains and losses, and the client should care what happens. Otherwise, there isn’t a decision to be made.
A very brief history of decision making
Attempts to understand decision making go back to the Renaissance period. Prior to this time, the subject wasn’t one worthy of any real consideration. In his book, Against the Gods: The Remarkable Story of Risk, Peter Bernstein writes, “When the conditions of life are so closely linked to nature, not much is left to human control…they are simply unable to conceive of circumstances in which they might be able to influence the outcomes of their decisions.”
If the primary philosophical slogans of the day were being printed on t-shirts, the most popular would be [Insert Expletive] Happens!
Even if people had felt in control of their destinies, they lacked the tools to understand the concepts of probability and risk that serve as the foundation to any theory about decision making. Prior to the crusades, the modern numbering system that was birthed in India had not yet made its way to European cultures via The Middle East. Without the modern numbering system, conceptualizing probabilities would have been impossible. As things stood, Europeans believed the outcomes of their choices to be the providence of luck and the will of the divine.
The new numbering system empowered Renaissance thinkers with the tools to look at human destiny and potential in a different way. It would not, however, be until the Age of Enlightenment that these intellectual tools would give rise to the field of economics, where much of the theory regarding risk and decision making is still used to this day.
How people make decisions…sort of, but not quite
According to the classical economic view of human behavior, decisions are made with the intention of maximizing one’s utility, i.e. satisfaction. Traditional utility theory assumes people are rational actors who objectively work through options in order to reach the best conclusion. According to the theory, there are four processes people – for our purposes, clients – utilize when making a decision.
Clients will engage in what is called cancellation, meaning they will not focus on options that yield the same results. For example, they aren’t going to waste time deciding between two different bonds with same rating, risk, yield and maturity.
They will dismiss any options subordinate to the primary choice. In other words, if they prefer investment A to investment B, and investment B is preferred over investment C, then investment A is preferred over investment C. Did you follow that? If so, you understand the principle of transitivity.
Next comes a concept referred to as dominance. If fund A is a better choice than fund B and at least as good as funds C and D, then fund A will be the dominant option.
Lastly, the client will form an objective opinion that is independent from the manner in which the information is presented. In other words, how information is communicated does not matter, only that it has been received by the client. They will then use it to make objective decisions. This is referred to as invariance.
Theory versus reality
Advisors reading this will likely call the principles of utility theory into question; specifically, the suggestion that people actually think this way. Though the four processes of cancellation, transitivity, dominance and invariance may be a good guide for how clients should make decisions, few people actually use them in practice. The human brain simply isn’t wired this way.
Emotions, biases, non-conscious cognitive shortcuts called heuristics, current knowledge and personal histories are powerful forces that constrain a person’s ability to take in and objectively integrate new information. This is especially true when it challenges their subjective perceptions and beliefs about themselves and the world.
A good advisor help guide their clients by separating the noise from important information, and by mitigating mental constraints and impulses that muddy their ability to be objective.
Still, this doesn’t mean that the traditional economic theory of utility is not useful to advisors. Though it may not prove to be a true descriptive approach to human behavior, it does offer a good prescriptive approach for guiding clients through the decision making process.
The economic theory of utility also helps as a starting point for advisor to understand something very important in the planning process: why people make bad decisions.
Mental constraints and perception filters
Regardless of the strength and quality of an advisor’s decision making and planning process, they still need to contend with the client’s mental constraints. These constraints create a perception filter that acts as a film, limiting their ability to objectively see, process and understand the world as it truly is as opposed to how they perceive it to be. The result is a series of decisions and actions that may not serve their best interests.
The human brain is wired to see new information that conflicts with its status quo beliefs as a potential threat. This is an evolutionary function that identifies anything unfamiliar as being a potential risk to survival. Consequently, it seeks to defend all of those thoughts, beliefs and motives that create one’s subjective perception of themselves and the world.
To guide clients towards beneficial outcomes requires communicating in a way that minimizes and removes those constraining mental barriers that conspire against good decision making.
Frictions and Mental Gaps
In their paper, Frictions or Mental Gaps: What’s Behind the Information We (Don’t) Use and When Do We Care?, Benjamin Handel and Joshua Schwartzstein write, “In a number of situations, there is strong evidence that people do not translate readily available information into the knowledge that would help them make better decisions. For example, people may choose a health insurance plan that costs $500 per year more in premiums in order to obtain a deductible that is $250 lower-despite having access to open enrollment booklets containing relevant information.”
In the above situation, there is readily available information the client could use in order to make a decision that better benefits their needs. But, they don’t use it. This gets at the heart of the paper; specifically, Handel and Schwartzstein pose the question, “Why don’t people use available information?” The research suggests two possible explanations, which are referred to as frictions and mental gaps.
Frictions result from information acquisition costs. There is a cost to learning, whether it be in time, money or mental comfort. As a result, frictions influence clients to make decisions using only readily available information.
The concept of frictions fits in nicely with classical economic theory. Even if the client has moved through the four processes of selection to determine utility, they may be doing so with limited information. The cost in time, effort or energy limits their desire to obtain a broader purview and frame of reference. Clients then take ill advised actions like selecting a fund due to recent, short-term performance, or purchasing insurance without determining their income replacement need.
Frictions can easily be overcome when working with a good advisor who acts as an unbiased steward of information, minimizing the need for clients to spend time and energy seeking it out on their own. Perhaps of greater importance, many clients are not equipped to know what information should actually be included in their thought process. The excess information creates confusion due to cognitive overload and lack of focus. Advisors create focus on that which is useful.
Where advisors can get into trouble, however, is not in what information they communicate, but in how it is communicated. As any advisor can attest to, simply presenting useful information with the expectation that clients will then leverage it to make good decisions is not enough. As has already been discussed, this information will pass through a perception filter that affects how the client perceives its meaning and intent. Poor and seemingly irrational decisions can then result. This brings our discussion to what are referred to as mental gaps, which, as will be demonstrated, completely violate the principles of traditional utility theory.
In contrast to frictions, those who make poor decisions as a result of mental gaps may have access to relevant information. However, their perceptions, beliefs and experiences create psychological distortions that shape their understanding of the information in ways that differ from objective reality. As Handel and Schwartzstein put it, “there is a gap between what people think and what they should rationally think.” These distortions then influence client behaviors in ways that can appear irrational to those who possess more well informed and objective perspectives.
Think of mental gaps like heat reflecting off of hot pavement, causing whatever you are looking at on the other side to lightly shimmer. It’s an illusion created by bending light. The image you are taking in is information. But, before your visual senses receive that information, the heat shimmer distorts your perception. What you are seeing is not a clear reflection of reality.
Mental gaps – the sum total of a person’s perceptions, biases, beliefs and attitudes – are like a heat shimmer that distorts objective information your clients see and hear. Unlike the illusion generated by a heat shimmer, people are not always aware that psychological distortions are creating mental gaps that bend how they subjectively receive information. A misguided sense of overconfidence results, however faulty.
In his book, Thinking Fast and Slow, Daniel Kahneman discusses several cognitive illusions, writing, “You cannot help dealing with the limited information you have as if it were all there is to know. You build the best possible story from the information available to you, and if it is a good story, you believe it. Paradoxically, it is easier to construct a coherent story when you know little, when there are fewer pieces to fit into the puzzle. Our comforting conviction that the world makes sense rests on a secure foundation: our almost unlimited ability to ignore our ignorance…The core of illusion is that we believe we understand the past, which implies that the future also should be knowable, but in fact we understand the past less than we believe we do.” (Text bolding added for emphasis.)
These illusions include psychological distortions that elevate a client’s confidence in their skills and abilities as well as the value and validity they place on information that supports their beliefs and actions. As Kahneman’s quote illustrates, this illusion of understanding leads to overconfidence in one’s own knowledge and competence, and is greatest in those who understand the least. (See also the Dunning-Kruger Effect.)
When presented with information that conflicts with their distorted perspectives, clients are unlikely to change their minds by incorporating new information into their belief systems. In fact, it is more likely to strengthen their beliefs as they consciously and unconsciously seek out only that information which upholds their perspectives and perceptions. Remember, the brain’s default is to interpret new information as a potential threat to be minimized.
These cognitive illusions and the associated biases violate the traditional economic theory of utility presented earlier. HanNa Lim, one of the contributing authors to the book, Client Psychology, writes how, “research found failures of expected utility theory in describing how individuals actually make decisions under risk.”
Utility theory assumes that clients will not only apply consistent and objective value in the rank ordering of options, but also that that they will subjectively receive information in a manner consistent with its objective value. This does not happen.
One of the most striking examples of this violation of utility theory is evident in the proclivity of most clients to be risk averse. Behavioral finance research has repeatedly demonstrated how people react differently to information depending on how it is framed. Specifically, clients will be more likely to act on information framed in terms of potential loss than that framed as providing an opportunity for gain. According to utility theory, framing should not matter if decisions were based on the objective evaluation of information. (I have written about this in past posts. Click here to read further.)
Advisor takeaways & five steps to empowering client decision making
As an advisor, this means that not only do you need to be a steward of information by defining what is relevant, but also in how it is communicated. Moreover, when acting in the client’s best interest, guiding them through the decision making process should be focused on empowering them to make informed and self-possessed decisions – not influencing them to act based on what you, their advisor, believe to be in their best interest, even if well intentioned.
There are five steps advisors can take to help overcome frictions and mental gaps when making decisions in the financial planning process.
Educate the client about cognitive illusions and biases
Research has demonstrated that simply discussing the idea of mental gaps with clients and how it impacts their decision making abilities improves their judgement and objectivity.
Remove irrelevant and duplicative information
Don’t overload and confuse clients with information that does not add value. Remove any unnecessary details, features or options from the conversation that do not directly contribute to them making informed decisions.
Communicate with a broad frame
Though you want to limit irrelevant information, you still need to ensure the client transparently understands the risks and benefits as well as potential outcomes of their options. Addressing potential risks and losses as well as possible benefits and gains will help to mitigate the influence of the framing effect.
Gain commitment to long-term goals and objectives
Simply gaining agreement from the client regarding the scope of the planning engagement, and then discussing how each decision aligns to goals and objectives will help to remove constraining mental gaps.
Address feelings of loss and regret
Have the client think about a time when they experienced loss and regret as the result of a poor or misguided decision where, had they known then what they know now, they would have done things differently. Then, have them imagine their future self and how they will suffer or benefit from the decisions they make today. Explain that your goal is to eliminate those feelings of loss and regret.
There are numerous other methods to help clients make good decisions. However, these simple five steps serve as a great starting point for any advisor.