December 12, 2019
December 12, 2019 | Risk Pulse
Harnessing behavioural finance for better client outcomes
You may have heard of Behavioural Finance, but do you wonder how you can apply it to better service your clients? In this article, Mike Daniels from The Behavioural Architects explains what Behavioural Finance is and some of the most important concepts to help you better understand your clients.
Behavioural Finance is a scientific model of behaviour that explains why people can sometimes make sub-optimal decisions due to the influence of cognitive biases. Cognitive biases are inherent in all of us (not just your clients!), and have a huge impact on the way we understand, interact with, and receive information and advice.
Being aware that your clients’ decisions and choices can often be based on emotions and gut feel (‘System 1’ thinking), rather than logic, helps you to deliver more effective advice and communications. Similarly, understanding that certain biases can interfere with your clients achieving their goals in the long term will equip you to develop strategies and plans that they will be able to stick to.
Not all cognitive biases are the same, and in this article, we’ll cover some of the most important concepts.
- First – People have two modes of thinking, System 1 and System 2
- Second – People anchor to specific reference-points when making decisions,
- Third – The way information is presented can noticeably influence the impact it has on decision-making.
Two systems of the mind
System 1 and 2 is based on the idea that there is a dual system of the mind, where System 1 (the mode we’re in most of the time) is emotional and intuitive, but incredibly fast. Think 2 x 2; you can calculate the answer (4) very quickly with little considered thought. By contrast, System 2 is much slower and requires more effort to activate (try answering 74 x 53!). Of course, the brain is not literally divided into two. It’s simply a useful analogy to understand how we think and process information.
Financial products and information can often be complex and confusing and understandably, people struggle to make sense of them, losing concentration and switching off – it requires too much System 2 thought! Sometimes, it’s the sheer amount of information that can be the barrier to action, leading people to become overwhelmed. As we are in System 1 most of the time, it’s important to present information to clients in ways that require minimal effort to understand – things like tables, visual graphics and plain language. It’s techniques like these that promote what we call ‘cognitive ease’ and let people absorb information using System 1 thinking.
People rely heavily on reference points and anchors
When making a decision, people look for reference points or anchors that they are familiar with – and then they adjust from that point. But often we rely too heavily on one piece of information to make a decision. Anchors affect our decision making in a variety of different contexts, and the anchors themselves can vary (e.g., we can anchor to prices, similar products, extremes, rules of thumb, and even to completely random numbers, albeit subconsciously).
To illustrate anchoring, studies have shown that a person's choice of repayment on their credit card can be disproportionately influenced by the minimum repayment amount printed on the statement. When the minimum repayment amount is present, people typically anchor to that minimum amount paying only the necessary amount whereas, when this anchor is removed from the statement, people actually pay more back on their card.
As another example, think about the Australian stock market context. If the share market return has been at around 9% per annum for a number of years, for example, investors may be heavily anchored to that level of return as their reference point. This may set up unrealistic expectations for future returns. Exploring what number your clients might already be anchored to as their ‘reference number’ can greatly assist in managing expectations.
How you frame your advice can impact how it’s received
The way information is presented, ordered or framed, has a significant impact on decision making. Framing influences our behaviour because it activates our System 1 - our automatic gut reactions that help us make quick decisions. How you frame your advice can impact how your client interprets it.
People can make very different decisions depending on how the numerical information is presented to them. For example, people tend to judge risk as greater when it is expressed as a natural frequency (i.e. 1 out of 10), rather than when it is expressed as a percentage (i.e. 10%), even though it’s the exact same information! As Nobel prize winner Daniel Kahneman says “An investment said to have an 80% chance of success sounds far more attractive than one with a 20% chance of failure. The mind can't easily recognise that they are the same".
Equally, the way in which you frame a choice to clients can also influence their likelihood to take action. Research shows that if you frame a financial decision in terms of the present year (e.g. make a decision by December 31st 2019) rather than the future (e.g. make a decision by January 1st 2020) people are more likely to take action, even though the two only differ by a day! Think about ways in which you could frame decision making in terms of the present to encourage action!
3 simple tips for your next meeting with your client
- Think about whether the information you’re providing your client is easy to access and simple to understand. Reduce the total amount of information they have to digest and make the most important information stand out. For example, get people’s attention by including a simple one-page summary.
- Think about the anchors or reference points that your client may have, so you can anticipate their reactions and present additional information or options that reduces the weight of their initial anchor.
- Think about different ways you might frame the same information. Frame information in ways that are more meaningful to your client.