Behavioral Finance in Action

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1 Behavioral Finance in Action Psychological challenges in the financial advisor/ client relationship, and strategies to solve them Part 1 Introduction: Two Minds at Work By Shlomo Benartzi, Ph.D. Professor, UCLA Anderson School of Management, Chief Behavioral Economist, Allianz Global Investors Center for Behavioral Finance

2 Introduction Behavioral Finance: Two Minds at Work Behavioral finance is an extension of behavioral economics, which uses psychological insights to inform economic theory. When Daniel Kahneman was awarded the Nobel Prize in economics in 2002 for his contribution to behavioral economics, he was only the second psychologist to receive the economics prize. Part of Kahneman s insight that led to the prize was his recognition of the important role of emotion and intuition in people s decision making, which in certain circumstances leads to systematic and predictable errors (Kahneman, 2003). Kahneman uses the framework of two minds to describe the way people make decisions (Stanovich and West, 2000). Each of us behaves as if we have an intuitive mind, which forms rapid judgments with great ease and with no conscious input; knowing that a new acquaintance is going to become a good friend on first meeting is one such judgment. We often speak of intuitions as what comes to mind. We also have a reflective mind, which is slow, analytical and requires conscious effort. Financial advisors engage this mind when they sit down with clients and calculate a retirement framework based on their risk profile, current circumstances and future goals. Here s an illustration of what is meant by intuitive mind, and how it sometimes leads one astray. Take a look at Diagram 1 below. If you haven t seen it before you will immediately see that the bottom line is longer than the top line. Diagram 1: Most decisions that people make are products of the intuitive mind, and they are usually accepted as valid by the reflective mind, unless they are blatantly wrong (Klein and Kahneman, 2009). Indeed, intuitive decisions are often correct, some impressively so (Gladwell, 2006). However, it is the errors of the intuitive mind, along with failures of the reflective mind, that interest behavioral finance academics and have practical implications for how financial advisors work with their clients. Behavioral Finance in Action 1

3 Now take two small pieces of paper two Post-It Notes will work and use them to cover the fins on the bottom line. As those who are familiar with the diagram already know, you will discover that the lines are in fact the same length. You are the victim of an optical illusion, the famous Müller- Lyer illusion. The visual perception part of your mind is tricked into seeing something that doesn t exist, in this case because of the effect of the fins. The remarkable thing about this and other optical illusions is that even when you know the truth that the lines are the same length you still see one as being longer than the other. In the framework of the two minds, your reflective mind knows the lines are the same length, but your intuitive mind sees them as being different. The output of the intuitive mind is so powerful that it overrides any attempt by the reflective mind to see the lines in any other way. You can t help yourself. Intuitive judgments tend to be held with greater confidence, too another factor making them hard to override. One of the insights that earned Kahneman the Nobel Prize 1 is that we humans are sometimes as susceptible to cognitive illusions as we are to optical illusions. These illusions, also known as biases, result from the use of heuristics, or, more simply, mental shortcuts. For instance, people are supposed to make decisions based on the logic and substance of transactions, not on how they are superficially described. When faced with a choice between having cold cuts that are ninety percent fat free or containing ten percent fat, people overwhelmingly select the first option. Logically, the two are identical of course, but people automatically respond negatively to containing fat and positively to fat free, and choose accordingly. This ubiquitous and powerful effect, the product of the intuitive mind, is called framing (Tversky and Kahneman, 1974). We can see, then, that intuition is a powerful force. And people typically place a great deal of faith in it. Kahneman s discovery that under certain circumstances intuition can systematically lead to incorrect decisions and judgments changed psychologists understanding of decision making, and, ultimately, economists, too. Classical economics held that people are rational, selfinterested and have a firm grasp on self-control. Behavioral economics (and common sense) showed instead that we are not as logical as we might think, we do care about others, and we are not as disciplined as we would like to be. It is not that people are irrational in the colloquial sense, but that by the nature of how our intuitive mind works we are susceptible to mental shortcuts that lead to erroneous decisions. Our intuitive mind delivers the products of these mental shortcuts to us, and we accept them. It s hard to help ourselves. 1 Kahneman did all the important work that underpins behavioral economics with his colleague Amos Tversky, who had died before the Nobel Prize was awarded. Nobel Prizes are never awarded posthumously. Behavioral Finance in Action 2

4 Loss Aversion Is Fundamental At the core of many of these powerful but erroneous intuitions is people s hyper-negative response to potential loss, or loss aversion, as described by Prospect Theory (Kahneman and Tversky, 1979). Simply put, losses loom larger than equal-sized gains. Psychologically speaking, the pain of losing $100 is approximately twice as great as the pleasure of winning the same amount. For this reason, most people are prepared to enter a 50:50 gamble of losing $100 on one hand, only if the sum to be won is at least $200. Loss aversion is a fundamental part of being human, and we are not alone in that. Yale economist M. Keith Chen did some ingenious preference experiments with capuchin monkeys in which they always finished up with one piece of apple. They got there in different ways, however, which affected the monkeys preferences. Sometimes the monkeys started off with two pieces of apple, one of which was taken away. At other times they started off with none, and were given one piece. The monkeys strongly preferred the second scenario, and disliked the first, where one piece of apple was taken from them (Chen, 2006). Psychologists speculate that loss aversion makes sense in terms of evolution and survival: better to be cautious and give that saber-toothed tiger a wide berth rather than take the risk of confronting it by yourself. Whatever its origin, loss aversion affects many of our decisions, including financial ones. For instance, people have a tendency to hold on to losing stocks too long. Selling a losing stock is extremely unpalatable because it brings the reality of loss very much to mind. On the other hand, people often sell winning stocks too soon because the act of selling a winning stock realizes a gain, and that gives us pleasure. We feel pain when we realize a loss and pleasure when we realize a gain. The mistake people are making here is one of mental accounting: instead of looking at their portfolio as a whole they look at each stock separately, and make decisions based on these separately perceived realities. Loss aversion also makes people reluctant to make decisions for change because they focus on what they could lose more than on what they might gain. This is called inertia, or the status quo bias (Samuelson and Zeckhauser, 1988). Inertia is at play when people know they should be doing certain things that are in their best interests (saving for retirement, dieting to lose weight, or exercising), but find it hard to do today. Procrastination and lack of self-control rule the day. However, people are usually willing to say they will do the right thing at some point in the future: I ll start that exercise program next week, I promise! We make intuitive judgments all the time, but it s very hard for us to tell which ones are right and which ones are wrong. Nicholas Barberis, Yale School of Management Behavioral Finance in Action 3

5 We make intuitive judgments all the time, says Nicholas Barberis, 2 a behavioral finance researcher at the Yale School of Management, but it s very hard for us to tell which ones are right and which ones are wrong. (See Kahneman and Klein, 2009.) Behavioral finance researchers have identified many circumstances in which the intuitive mind leads people to make money-related mistakes. For this paper, we have worked with these academic insights to develop techniques grounded in behavioral finance that financial advisors can use to help their clients discriminate between wise intuitions and erroneous judgments. inertia, loss aversion and immediate gratification and will be described in detail in the following section, Investor Paralysis. In the first case study of SMarT, employees at a midsize manufacturing company increased their contribution to their retirement fund from 3.5 percent to 13.6 percent of salary over a three-and-a-half-year period (Thaler and Benartzi, 2004). This is a remarkable improvement in saving behavior. As a result, the program is now offered by more than half of the large employers in the United States, and a variant of the program was incorporated in the Pension Protection Act of 2006 (Hewitt, 2010). SMarT: A Powerful Example Richard Thaler of the University of Chicago and Shlomo Benartzi of UCLA 3 used some of the above psychological insights in one of the earliest, and most successful, applications of behavioral finance, the Save More Tomorrow program (SMarT). The problem is widespread: An alarmingly large proportion of employees fail to participate in their company s defined contribution retirement plan, often forgoing matching funds (free money) from employers. SMarT effectively removes psychological obstacles to saving in the short and longer term, and helps people overcome them with very little effort on their part. SMarT was designed around the psychological principles of 2 Nicholas Barberis is a member of the Academic Advisory Board of the Allianz Global Investors Center for Behavioral Finance. 3 Shlomo Benartzi is the Chief Behavioral Economist for the Allianz Global Investors Center for Behavioral Finance. Richard Thaler is a member of the Center s Academic Advisory Board. The lesson of the experience with the SMarT program is general and powerful: the strategic application of a few key psychological principles can dramatically improve people s financial decisions. Shlomo Benartzi, UCLA Anderson School of Management The lesson of the experience with the SMarT program, therefore, is general and powerful, says Benartzi, the strategic application of a few key psychological principles can dramatically improve people s financial decisions. Financial advisors can take advantage of such insights in their own practices to help their clients make better decisions which, ultimately, should lead to better financial outcomes. Behavioral Finance in Action 4

6 The Path Ahead In the Behavioral Finance in Action series, we present three timely decision challenges and techniques from the behavioral toolbox to solve them: Investor paralysis Lack of investor discipline A crisis of trust We also present a tool in development that is designed to address a fourth decision challenge: The disinclination to save. These four challenges might seem diverse and unrelated at first glance. But they are united by being, first, the product of our intuitive minds; and, second, they are susceptible to solution by the careful application of behavioral finance tools based on a few simple, psychological principles. BeFi-in-Action Framework Two minds: Intuitive mind (fast, automatic, effortless): Can often lead to wise decisions, but sometimes leads systematically to irrational, poor financial decisions. Reflective mind (slow, conscious, effortful): Can lead to more thoughtful, rational decisions. Advisors can engage their clients reflective minds to improve outcomes by correcting the mistakes of the intuitive mind. Behavioral Finance in Action 5

7 References M. Keith Chen et al., How Basic Are Behavioral Biases: Evidence from Capuchin Monkey Trading Behavior, Journal of Political Economy, 114:3, pp (2006). Malcolm Gladwell, Blink: The Power of Thinking Without Thinking, Hachette Book Group USA, paperback, Hewitt Associates, Hot Topics in Retirement, Daniel Kahneman, Maps of Bounded Rationality: Psychology for Behavioral Economics, The American Economic Review, vol 93, no. 5, pp (2003). Daniel Kahneman and Gary Klein, Conditions for intuitive expertise: A failure to disagree. American Psychologist, vol 64, no. 4, pp (2009). William Samuelson and Richard Zeckhauser, Status Quo Bias in Decision Making, Journal of Risk and Uncertainty, vol 1, pp 7 59 (1988). Keith E. Stanovich and Richard F. West, Individual Differences in Reasoning: Implications for the Rationality Debate, Behavioral and Brain Sciences, vol 23, no. 5, pp (2000). Richard Thaler and Shlomo Benartzi, Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving, Journal of Political Economy, vol 112, no. 1, pt 2, pp S164 S187 (2004). Amos Tversky and Daniel Kahneman, Judgment Under Uncertainty: Heuristics and Biases, Science, vol 185, pp (1974). Daniel Kahneman and Amos Tversky, Prospect Theory: An Analysis of Decisions Under Risk, Econometrica, vol 47, no. 2, pp (1979). Behavioral Finance in Action 6

8 About the Author The Behavioral Finance in Action series was written by Shlomo Benartzi, Ph.D., Professor, UCLA Anderson School of Management, and Chief Behavioral Economist of the Allianz Global Investors Center for Behavioral Finance. Professor Benartzi is a leading authority on behavioral finance with a special interest in personal finance and participant behavior in defined contribution plans. He received his Ph.D. from Cornell University s Johnson Graduate School of Management, and he is currently co-chair of the Behavioral Decision-Making Group at The Anderson School at UCLA. Professor Benartzi is also co-founder of the Behavioral Finance Forum ( a collective of 40 prominent academics and 40 major financial institutions from around the globe. The Forum helps consumers make better financial decisions by fostering collaborative research efforts between academics and industry leaders. Professor Benartzi s most significant research contribution is the development of Save More Tomorrow (SMarT), a behavioral prescription designed to help employees increase their savings rates gradually over time. Along with Richard Thaler of the University of Chicago, he was recognized by Money as one of 2004 s Class Acts for SMarT s success increasing savings rates in one plan from 3.5% to 13.6%. The SMarT program is now offered by approximately half of the large retirement plans in the U.S. and a growing number of plans in Australia and the U.K. Professor Benartzi has supplemented his academic research with practical experience, serving on the advisory boards of the Alaska State Pension, Fuller and Thaler Asset Management, Guggenheim Partners, Morningstar and the U.S. Department of Labor. Behavioral Finance in Action 7

9 Acknowledgements We would like to thank the following experts in behavioral finance for their input to the intellectual content of the Behavioral Finance in Action series. Each of them is a member or past member of the Academic Advisory Board of the Allianz Global Investors Center for Behavioral Finance. Richard H. Thaler The University of Chicago Booth School of Business Ralph and Dorothy Keller Distinguished Service Professor of Behavioral Science and Economics aspx?person_id= Daniel G. Goldstein Yahoo Research, Research Scientist London Business School, Assistant Professor of Marketing faculty/search. do?uid=dgoldstein Nicholas Barberis Yale School of Management Stephen & Camille Schramm Professor of Finance Noah Goldstein UCLA Anderson School of Management Assistant Professor of Human Resources and Organizational Behavior Kent Daniel Graduate School of Business, Columbia University Professor of Finance John Payne Duke University, The Fuqua School of Business, Joseph J. Ruvane, Jr. Professor of Business Administration Director, Center for Decision Studies, Fuqua School of Business We would also like to thank the financial advisors who provided feedback on the Behavioral Finance in Action series. And we welcome further comments from our readers. us at Behavioral Finance in Action 8

10 The Allianz Global Investors Center for Behavioral Finance is committed to empowering clients to make better financial decisions by offering them actionable insights and practical tools. We developed Behavioral Finance in Action to present potential solutions to some of the key challenges financial advisors are facing. We consider this a work in progress. Our goal is to build on what we ve begun, to improve and expand upon the contents. We can do this most effectively in partnership with you. We therefore invite you to give us your feedback. To do so, please befi.allianzgi.com Allianz Global Investors is the asset management arm of Allianz SE. The Center for Behavioral Finance is sponsored by Allianz Global Investors Capital and Allianz Global Investors Distributors LLC. The principles and strategies suggested do not constitute legal advice and do not address the legal issues associated with implementing any recommendations, or associated with establishing or amending employee benefit plans. There are many legal and other considerations plan sponsors and plan fiduciaries should consider prior to adopting any of the recommendations herein, and legal counsel should be consulted to ensure compliance with the law. Any adoption of these general recommendations must be considered in light of the particular facts and circumstances of each retirement plan and its participants, and the authors of the program and Allianz Global Investors provide no advice regarding, and are not responsible for, implementation of these concepts by any particular plan. AGI Behavioral Finance in Action

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