- 3-Minute Article
- Jun 01, 2017
How Science Can Help You Understand Your Clients’ Decision Making
Professor Victor Ricciardi introduces key behavioral finance concepts.
There are many ‘hidden’ human factors that influence how people make financial decisions. These factors are a natural product of the way the human mind works and we typically use them without ever realizing.
Behavioral finance is the study of how we make financial decisions. It’s a relatively new field, but it has already generated major insights that can help you, as a financial advisor, to deepen your understanding of your clients and potentially lead to more productive conversations.
I’m going to introduce you to this fascinating subject with three concepts that form the foundations of behavioral finance: biases, heuristics and emotional finance. In a series of articles for Brighthouse Financial, I will be writing about insights and findings that are built on these concepts, so this is a great starting point for developing your knowledge of the subject."
Over the coming weeks, I will be going into much more depth on these and related subjects, discussing how you can learn to identify and manage key behaviors in your clients so you can have even more productive conversations.
What is a bias?
A ‘bias’ is a tendency to unconsciously favor one approach over another when making financial judgments. Bias in this context means a ‘built in’ tendency and shouldn’t be taken in the perhaps more familiar, negative sense of deliberately favoring one group over another.
What sort of biases might I encounter?
Common biases you are likely to have seen before are the tendency towards either ‘active’ or ‘passive’ decision making.
Active decision makers may have what we call an overconfidence bias. This could, for example, lead to making financial decisions without looking at all the options.
Passive decision makers may have what we call a status quo bias, perhaps leading to a tendency to leave things as they are, such as putting off saving for retirement.
What is a heuristic?
Another way human beings make decisions is using what scientists call ‘heuristics’. These are mental shortcuts or assumptions that we use when we’re asked to deal with complex information or a range of choices, like choosing financial products.
Heuristics help us reduce the mental energy and time commitment required to make decisions. They can be very effective for making quick decisions in daily life, but are generally less successful when it comes to financial matters.
What sort of heuristics might I encounter?
One common heuristic is mental accounting, which is a tendency to break complex problems into separate ‘boxes.’ Separating out problems in this way can make it harder to understand how they relate to each other in the bigger picture.
For example, this may be the reason some clients keep expensive credit card debts when it would make better financial sense to use savings to clear them.
What is emotional finance?
Emotions are one of the ways our brains work out what is important to us. Many of the decisions we make every day are the result of ‘gut feeling’ or intuition, which are simply different ways of describing an emotional response. The emotional aspects of our relationship with money are sometimes referred to as ‘emotional finance.’
What sort of emotional responses might I encounter?
The way in which information is presented can provoke an emotional reaction that influences our decision-making. This is called ‘framing’ and is a technique that will be familiar from advertising, where emotional storytelling is often used to make a product more engaging.
How you ‘frame’ your conversations with your clients can have a major impact on whether or not they choose to accept your advice.