- 3-Minute Article
- Jul 01, 2017
How to Help Your Clients Make More Rational Financial Decisions
Insights from leading behavioral finance expert, Professor Victor Ricciardi
One of the ways people make decisions is using what scientists call “heuristics.” These are mental shortcuts or assumptions that help us reduce the energy and time commitment required to make choices.
Heuristics can be very effective for making quick decisions in daily life, but are generally less successful when it comes to more complex issues, such as choosing financial products.
Here, I look at two heuristics that can have a major effect on the choices your clients make, anchoring and mental accounting, and discuss ways of overcoming them.
Anchoring is a tendency to:
- Give too much significance to one piece of information.
- Use that information as a reference point for developing future decisions.
Possible effects of anchoring
A client who has heard negative stories about, say, annuities, may resist investing in an annuity as part of a diversified portfolio. This negative anchor has consequences in preventing them from buying a product that is potentially beneficial to their needs.
How to manage anchoring
Identify the anchors. In order to overcome anchors, it’s sometimes useful for clients to become aware of them. It’s worthwhile spending time talking to your client and getting to the bottom of their preconceptions about a product or a plan. It may be that they have simply jumped to a conclusion based on a single piece of information that is out of date or incorrect.
Education, education, education. Anchors can be very tenacious and difficult to break down. One strategy is to ensure your client understands their portfolio and their financial context as fully as possible. A client who has heard negative stories about annuities will be more likely to disregard the anchoring effect of those stories if they are knowledgeable about how the product performs and the potential benefits it can bring.
Mental accounting is the tendency to:
- Break a complex problem into separate “buckets.”
- Not take into account how the “buckets” relate to each other in the bigger picture.
Possible effects of mental accounting
Many people divide financial products into separate buckets, for example, into “investments” and “insurance.” This can lead to a situation where a client has substantial savings invested in, say, an annuity, but doesn’t have enough life insurance coverage. This may be because they view the annuity positively for the guaranteed income it provides while deprioritizing the life insurance, assuming that there will only be a small chance they will need to use it.
Mental accounting can have consequences in potentially preventing a client from creating a balanced, diversified portfolio that meets all of their needs.
How to manage mental accounting
Use mental accounting to help. Mental accounting can actually be useful during the financial planning process. Research suggests that, for example, making one product a “bucket” for your client’s retirement savings and another product a “bucket” for their children’s long-term financial security can be successful in ensuring this money remains untouched, meaning your clients are more likely to achieve their financial goals.1
Treat all money as equal. By contrast, mental accounting is unhelpful when trying to encourage clients to change their portfolios. Many people subconsciously think of different dollars doing different jobs— for example the dollars paying off your credit card are different to the dollars going into your savings when in reality all dollars are exactly the same no matter what job they are doing. It may seem obvious to point out that all dollars are the same, but the idea of sameness helps clients take their money out of unhelpful mental “buckets” and focus on the bigger picture, putting their dollars where they can be used most efficiently instead.
Heuristics are part of being human, which means everyone uses them all the time. Improving your clients’ decision making takes time, patience, and commitment. If you want to help them understand their own decision making, it is vital to start by building strong, long-term relationships with your clients based on trust.