Humans believe that they are rational decision-makers—but that’s not really true. Behavioral finance shows that people are more irrational than they think. Savvy financial advisors recognize this and use behavioral-finance skills to help clients avoid emotional decision-making.
When Freud Meets Friedman
Behavioral finance isn’t new. The field has been around for more than 100 years, dating to 1912, when G.C. Selden wrote Psychology of the Stock Market.1
For almost 10 years, we’ve been using insights from behavioral finance to coach financial advisors on how to navigate difficult conversations and how to avoid oversimplifying their own decision-making. Some say that behavioral finance is what happens when Freud meets Friedman, since it gives us a way to examine the impact of human behavior on investment decision-making.
Today, the most recognizable name in the field is Daniel Kahneman, who won the Nobel Prize in Economic Sciences in 2002 for describing vulnerabilities of the central nervous system that he calls heuristics. His book Thinking, Fast and Slow catalogs the natural heuristics that cloud investment decisions: “The technical definition of heuristic is a simple procedure that helps find adequate, though often imperfect, answers to difficult questions.”2
A person uses heuristics when faced with a complicated or challenging decision for which he can’t find an immediate and satisfying answer. Instead, the mind decides to answer an easier question.
What Triggers Heuristics?
Heuristics can befuddle complicated investment decisions.
When faced with a challenging question like “How can I have financial security in the future?”—a question for which there’s no immediate and satisfying answer—the brain uses heuristics. According to Kahneman, “If a satisfactory answer to a hard question is not found quickly, [the brain] will find a related question that is easier and will answer it.”3 In other words, heuristics provide shortcuts that allow the person to answer a simpler question.
Many heuristics work together. For now, let’s focus on how financial advisors can overcome one of these heuristics in decision-making.
It’s All About Your View: Narrow Versus Broad
Where there’s complexity, the brain may become overwhelmed by too much data and miss important information. In behavioral finance, this is called narrow framing, because the mind tries to cope by zooming in on a small portion of the total picture. When clients experience narrow framing, they oversimplify.
For example, investors tend to obsess about the part of their portfolio that isn’t working and may make impulsive decisions about reallocating or abandoning active management. This is narrow framing: focusing on a small element. But while there are usually losers to fret about, frequently there are winners to focus on, too.
The goal is to refocus the investor: instead of looking at asset returns individually, encourage the client to think about the overall portfolio and decide based on a thoughtful, comparative analysis. Kahneman calls this broad framing.
How to Overcome Narrow Framing
Fortunately, it’s possible to recognize many of the common decision-making vulnerabilities that clients are prone to. Becoming aware of these vulnerabilities is the first step to remedying a problem before it affects your business.
Here are some steps to overcome narrow framing:
- Teach clients that narrow framing is a kind of tunnel vision.
- Educate clients to appreciate that some part of their portfolio will always trail, just as some part will always lead.
- Label assets’ weaknesses or strengths as opportunities to rebalance the portfolio.
- Show clients other ways you add value to the relationship, such as you offer more than just investment advice and how active management is more valuable than a passive approach.
By learning how humans make decisions and how heuristics work, we can understand their effects on clients’ decision-making. This awareness can improve the quality of the advice we provide to our clients.
1 Mwaymire, “A Brief History of Behavioral Finance,” Finworx.com, August 11, 2016
2 Daniel Kahneman, Thinking, Fast and Slow (2011): 98
3 Daniel Kahneman, Thinking, Fast and Slow (2011): 98