The ABCs of Behavioral Economics: This article was originally published in NAPFA Advisor magazine.
Behavioral economics, with its long lexicon of “biases,” has enjoyed great popularity for a couple of decades. However, it’s also one area where financial planning students feel the least prepared. Experienced advisors, too, find this relatively new field fascinating, but yearn for practical ways to apply it, especially amid the market volatility of the past couple of years.
Sometimes it’s helpful to boil things down to basics. At the risk of oversimplifying, here are three reminders, A-B-C style, of what behavioral economics is about, how it works, and how advisors can use it.
A—What is behavioral economics about? A: Actors (economic ones) are not always rational.
Economists used to assume that actors (people and companies) always act rationally to increase their profit, wealth, or “utility.” The father of behavioral economics, Daniel Kahneman, won a 2002 Nobel Prize for proving they actually don’t. However, even today, both clients and advisors still tend to assume finance is about facts, not feelings.
Throughout my early banking career, I made this assumption. For example, when the estate tax exemption was $675,000, I reveled in suggesting ways that nearly every client could save on estate taxes. One husband, whom I knew liked to argue, pushed back when I brought this up. “Why do you automatically assume I want to save taxes?” he blurted.
His wife looked at my jaw hanging open. I answered, meekly, “Because nearly everyone I talk to wants to save taxes?”
“Well, maybe I don’t!” he said. “The government has a lot of good programs.”
Before that day, I had never asked how anyone felt about paying taxes (who would ask such a stupid question?), or what the idea of legacy meant to someone (too personal, I might upset them). My job, before that day, was like Sergeant Joe Friday, “Nothin’ but the facts, ma’am.”
Now I know all facts, especially anything with the word “estate” in it, for goodness’ sake, come with feelings. It’s far better to get to the feelings first if we want any chance of rational decision making.
B- Why Does This Happen? B: Brains have powerful primitive parts.
In his 2011 best seller, Thinking: Fast and Slow, Kahneman divides the brain into two systems: System 1 and System 2. To oversimplify, System 1 is the older, primitive part, and it generates emotional responses. System 2 is the newer, intellectual part.
Most of the time we’re quite aware of what’s going on with System 2 (intellectual), and quite unaware of System 1 (emotional). We fail to remember how much more powerful System 1 is than System 2. To make matters worse, System 2 falsely believes it can override System 1 anytime it wants.
For example, have you ever been sitting at a traffic light and suddenly heard a honk from the car behind you? My System 1’s initial thought is, “Who the !@#$ is honking?” as I glare in the rear-view mirror. A fraction of a second later, it occurs to System 2 to, duh, see if the light turned green. System 1’s embarrassment kicks in with a little wave in the mirror, “Sorry!”
One of the signs of a true professional is the ability to override System 1 through experience and practice. Kahneman uses firefighters as an example. After many fires, they learn that fear doesn’t go away. They accept it as part of the job, then, with experience, use it to make split-second but measured decisions.
In the last couple of years, have you not been a little scared, at least once? A study from the Journal of Behavioral Finance showed financial professionals are just as prone to emotional errors as retail investors. Knowing and accepting this should make us even more cautious. Younger advisors know from their training not to act irrationally based on fear. Senior advisors know from experience not to act irrationally after seeing advisors who did.
Our System 2 can try saying, “I won’t be scared the next time the market falls 10%,” but your System 1 will decide that involuntarily, not you.
System 1 beats System 2 to the punch nearly every time because System 2 is wired to conserve energy. So, it allows System 1 to do most of the work, which mainly involves scanning for threats. Fear isn’t wrong. It’s unavoidable. Whether and how we handle it is our hallmark.
C—What can we do about it? C: Curiosity can help.
How do we foster conversations in which System 2 creates a measured response to System 1 impulses? One way is to concentrate on being curious. This means to expect our own emotional response but not react to it. Accept whatever the client brings up. Focus on better understanding the client’s responses.
Here is an example:
Client: “I think we should buy/sell/do something different than what we’ve been doing.”
Advisors’ thoughts under the influence of System 1:
Fear: “Are you leaving?”
Guilt: “I should have called you sooner.”
Contempt: “You stupid idiot!”
Impatience: “No. You are acting irrationally. I don’t have time for this. Here’s my advice. Take it or leave it.”
Advisors under System 2 (with System 1 emotions in the background):
“I understand, and I would like to hear more about what you’re thinking.” (Fear: Yikes! No! You might blame me for this.)
“It sounds like you are really concerned. Tell me more.” (Contempt: After all our meetings, why can’t you just be calm?)
“I’d be happy to talk about that further. Help me understand how you are feeling.” (Impatience: Do I really have to listen to this?)
We can help the client discover their emotions themselves, simply by creating a safe space for it. Upon reaching that point of self-discovery, ironically, they feel more understood by us. Once someone feels understood, only then will System 1 sometimes step aside and make them ready for System 2-based factual advice.
Sometimes Advisors Need to Hold the Advice
In a 2016 article for The Journal of Financial Planning, Brad Klontz wrote,
Klontz, Van Sutphen, and Fries, “Financial Planner as Healer: the Role of Financial Health Physician,” Journal of Financial Planning, December 2016
The secret is this: when we are doing our best work, we are bringing little or nothing new to the exchange. We are asking no questions. We are offering no advice. We are making no recommendations. We are providing no analysis or insights. We are abandoning our goals and agendas and are just bringing ourselves. Sure, we are facilitating a process, but we have learned that our effectiveness grows as our ability to be present grows. In our best moments, we are engaged in exquisite listening, which is the best therapy.
Behavioral economics can feel counterintuitive: Expect irrational responses, and accept that feelings are more powerful than facts. By not immediately reacting with advice, we become the best advisors.
For more on applying behavioral economics principles to real-life financial planning, see The Mindful Money Mentality: How To Find Balance in Your Financial Future.