Behavioral Finance in Action - Allianz Global In…

Behavioral Finance in ActionPsychological challenges in the financial advisor/client relationship, and strategies to solve them

By Shlomo Benartzi, Ph.D.Professor, UCLA Anderson School of Management,Chief Behavioral Economist, Allianz Global Investors Center for Behavioral Finance

Contents

Introduction: Behavioral Finance–Two Minds at Work . . . . . . . . . . . 3

Overcoming Investor Paralysis: Invest More Tomorrow . . . . . . . . . . 8

Reining in Lack of Investor Discipline: The Ulysses Strategy . . . . . 12

Regaining and Maintaining Trust: Competence + Empathy . . . . . 16

In Development: Addressing the Disinclination to Save– The Behavioral Time Machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Behavioral Finance in Action 2For financial professional use only. Not for use with the public.

Preface

Behavioral Finance in Action (BeFi-in-Action) is designed to help

financial advisors better understand the psychology and emotions

underlying their clients’ decisions and to empower both the advisor

and the client to make better ones.

First, we discuss key concepts from the field of behavioral finance.

We then identify three specific challenges financial advisors face in

working with their clients and propose solutions from our behavioral

finance “toolbox.” We also present a fourth challenge whose solution

is still in development.

We have written this in a modular format, so that after reviewing

the introduction readers can take the rest of the document as a whole,

or select any of the following sections at will, according to their

specific interests.

As with all Center for Behavioral Finance initiatives, the goal of this

work is to translate academic theory into action. It’s the beginning of

a long-term project to help financial advisors incorporate behavioral

finance insights and tools into their practice.


Kahneman uses the framework of “two minds” to describe the way people make decisions (Stanovich and West, 2000). Each of us behaves as if we have an “intuitive” mind, which forms rapid judgments with great ease and with no con-scious input; “knowing” that a new acquaintance is going to become a good friend on first meeting is one such judgment. We often speak of intuitions as “what comes to mind.”

We also have a “reflective mind,” which is slow, analytical and requires conscious effort. Financial advisors engage this mind when they sit down with clients and calculate a retirement framework based on their risk profile, current circumstances and future goals.

Most decisions that people make are products of the intui-tive mind, and they are usually accepted as valid by the reflective mind, unless they are blatantly wrong (Klein and Kahneman, 2009). Indeed, intuitive decisions are often correct, some impressively so (Gladwell, 2006). However, it is the errors of the intuitive mind, along with failures of the reflective mind, that interest behavioral finance academ-ics and have practical implications for how financial advisors work with their clients.

Here’s an illustration of what is meant by intuitive mind, and how it sometimes leads one astray. Take a look at Diagram 1 below. If you haven’t seen it before you will im-mediately see that the bottom line is longer than the top line.

Introduction

Behavioral Finance: Two Minds at Work

Behavioral finance is an extension of behavioral economics, which uses psychological insights to inform economic theory. When Daniel Kahneman was awarded the Nobel Prize in economics in 2002 for his contribution to behavioral economics, he was only the second psychologist to receive the economics prize. Part of Kahneman’s insight that led to the prize was his recognition of the important role of emotion and intuition in people’s decision making, which in certain circumstances leads to systematic and predictable errors (Kahneman, 2003).

Diagram 1:


Now take two small pieces of paper – two Post-It Notes will work – and use them to cover the “fins” on the bottom line. As those who are familiar with the diagram already know, you will discover that the lines are in fact the same length.

You are the victim of an optical illusion, the famous Müller-Lyer illusion. The visual perception part of your mind is tricked into seeing something that doesn’t exist, in this case because of the effect of the “fins.”

The remarkable thing about this and other optical illusions is that even when you “know” the truth – that the lines are the same length – you still “see” one as being longer than the other. In the framework of the two minds, your reflec-tive mind knows the lines are the same length, but your intuitive mind sees them as being different. The output of the intuitive mind is so powerful that it overrides any attempt by the reflective mind to see the lines in any other way. You can’t help yourself. Intuitive judgments tend to be held with greater confidence, too – another factor making them hard to override.

One of the insights that earned Kahneman the Nobel Prize1 is that we humans are sometimes as susceptible to “cogni-tive illusions” as we are to optical illusions. These illusions, also known as biases, result from the use of heuristics, or, more simply, mental shortcuts. For instance, people are “supposed” to make decisions based on the logic and

1 Kahneman did all the important work that underpins behavioral economics with his colleague Amos Tversky, who had died before the Nobel Prize was awarded. Nobel Prizes are never awarded posthumously.

substance of transactions, not on how they are superfi-cially described. When faced with a “choice” between having cold cuts that are “ninety percent fat free” or “con-taining ten percent fat,” people overwhelmingly select the first option. Logically, the two are identical of course, but people automatically respond negatively to “containing fat” and positively to “fat free,” and choose accordingly. This ubiquitous and powerful effect, the product of the intuitive mind, is called “framing” (Tversky and Kahneman, 1974).

We can see, then, that intuition is a powerful force. And people typically place a great deal of faith in it. Kahneman’s discovery that under certain circumstances intuition can systematically lead to incorrect decisions and judgments changed psychologists’ understanding of decision making, and, ultimately, economists’, too.

Classical economics held that people are rational, self- interested and have a firm grasp on self-control. Behavioral economics (and common sense) showed instead that we are not as logical as we might think, we do care about others, and we are not as disciplined as we would like to be. It is not that people are irrational in the colloquial sense, but that by the nature of how our intuitive mind works we are susceptible to mental shortcuts that lead to erroneous decisions. Our intuitive mind delivers the products of these mental shortcuts to us, and we accept them. It’s hard to help ourselves.



Loss Aversion Is Fundamental

At the core of many of these powerful but erroneous intuitions is people’s hyper-negative response to potential loss, or “loss aversion,” as described by Prospect Theory (Kahneman and Tversky, 1979). Simply put, losses loom larger than equal-sized gains. Psychologically speaking, the pain of losing $100 is approximately twice as great as the pleasure of winning the same amount. For this reason, most people are prepared to enter a 50:50 gamble of losing $100 on one hand, only if the sum to be won is at least $200.

Loss aversion is a fundamental part of being human, and we are not alone in that. Yale economist M. Keith Chen did some ingenious preference experiments with capuchin monkeys in which they always finished up with one piece of apple. They got there in different ways, however, which affected the monkeys’ preferences. Sometimes the monkeys started off with two pieces of apple, one of which was taken away. At other times they started off with none, and were given one piece. The monkeys strongly preferred the second scenario, and disliked the first, where one piece of apple was taken from them (Chen, 2006).

Psychologists speculate that loss aversion makes sense in terms of evolution and survival: better to be cautious and give that saber-toothed tiger a wide berth rather than take the risk of confronting it by yourself. Whatever its origin, loss aversion affects many of our decisions, including financial ones.

For instance, people have a tendency to hold on to losing stocks too long. Selling a losing stock is extremely unpalat-able because it brings the reality of loss very much to mind. On the other hand, people often sell winning stocks too soon because the act of selling a winning stock realizes a gain, and that gives us pleasure. We feel pain when we realize a loss and pleasure when we realize a gain. The mistake people are making here is one of mental account-ing: instead of looking at their portfolio “as a whole” they look at each stock separately, and make decisions based on these separately perceived realities.

Loss aversion also makes people reluctant to make decisions for change because they focus on what they could lose more than on what they might gain. This is called “inertia,” or the status quo bias (Samuelson and Zeckhauser, 1988).

Inertia is at play when people know they should be doing certain things that are in their best interests (saving for retirement, dieting to lose weight, or exercising), but find it hard to do today. Procrastination and lack of self-control rule the day. However, people are usually willing to say they will do the right thing at some point in the future: “I’ll start that exercise program next week, I promise!”

We make intuitive judgments all the time, but it’s very hard for us to tell which ones are right and which ones are wrong.”Nicholas Barberis,Yale School of Management



“We make intuitive judgments all the time,” says Nicholas Barberis,2 a behavioral finance researcher at the Yale School of Management, “but it’s very hard for us to tell which ones are right and which ones are wrong.” (See Kahneman and Klein, 2009.) Behavioral finance research-ers have identified many circumstances in which the intuitive mind leads people to make money-related mistakes. For this paper, we have worked with these academic insights to develop techniques grounded in behavioral finance that financial advisors can use to help their clients discriminate between wise intuitions and erroneous judgments.

SMarT: A Powerful Example

Richard Thaler of the University of Chicago and Shlomo Benartzi of UCLA3 used some of the above psychological insights in one of the earliest, and most successful, ap-plications of behavioral finance, the Save More Tomorrow™ program (SMarT). The problem is widespread: An alarm-ingly large proportion of employees fail to participate in their company’s defined contribution retirement plan, often forgoing matching funds (free money) from employ-ers. SMarT effectively removes psychological obstacles to saving in the short and longer term, and helps people overcome them with very little effort on their part. SMarT was designed around the psychological principles of

2 Nicholas Barberis is a member of the Academic Advisory Board of the Allianz Global Investors Center for Behavioral Finance. 3 Shlomo Benartzi is the Chief Behavioral Economist for the Allianz Global Investors Center for Behavioral Finance. Richard Thaler is a member of the Center’s Academic Advisory Board.

inertia, loss aversion and immediate gratification and will be described in detail in the following section, Investor Paralysis.

In the first case study of SMarT, employees at a midsize manufacturing company increased their contribution to their retirement fund from 3.5 percent to 13.6 percent of salary over a three-and-a-half-year period (Thaler and Benartzi, 2004). This is a remarkable improvement in saving behavior. As a result, the program is now offered by more than half of the large employers in the United States, and a variant of the program was incorporated in the Pension Protection Act of 2006 (Hewitt, 2010).

“The lesson of the experience with the SMarT program, therefore, is general and powerful,” says Benartzi, “the strategic application of a few key psychological principles can dramatically improve people’s financial decisions.” Financial advisors can take advantage of such insights in their own practices to help their clients make better decisions which, ultimately, should lead to better financial outcomes.

The lesson of the experience with the SMarT program…is general and powerful: the strategic application of a few key psychological principles can dramatically improve people’s financial decisions.”Shlomo Benartzi,UCLA Anderson School of Management



The Path Ahead

In this paper, we present three timely decision challenges and techniques from the “behavioral toolbox” to solve them: • Investor paralysis• Lack of investor discipline• A crisis of trust

We also present a tool in development that is designed to address a fourth decision challenge: • The disinclination to save.

These four challenges might seem diverse and unrelated at first glance. But they are united by being, first, the product of our intuitive minds; and, second, they are susceptible to solution by the careful application of behavioral finance tools based on a few simple, psychological principles.

BeFi-in-Action Framework

Two minds:

Intuitive mind (fast, automatic, effortless):Can often lead to wise decisions, but sometimes leads systematically to irrational, poor financial decisions.

Reflective mind (slow, conscious, effortful):Can lead to more thoughtful, rational decisions. Advisors can engage their clients’ reflective minds to improve outcomes by correcting the mistakes of the intuitive mind.



What is the cure for this paralysis? University of Chicago behavioral economist Richard Thaler prescribes this: “Devise a plan that you will actually be able to implement, even when confronted with the inevitable distractions and temptations.”

The question, of course, is, “What would such a plan look like?” Here we offer a solution based on the success of the Save More Tomorrow™ (SMarT) program. SMarT is a savings enhancement plan that utilizes an understanding of the psychological obstacles people face when trying to save more money. Some of the key psychological hurdles here are also at play in preventing people from getting back into the market. We therefore suggest a relatively simple idea that draws on the principles of SMarT. Let’s call it “Invest More Tomorrow.”

Here we briefly describe SMarT to illustrate the psycho-logical factors at play. We then present the Invest More Tomorrow strategy, outlining the actions financial advisors can take to implement it.

Save More Tomorrow

The SMarT program is designed to help people achieve what they say they want to, by working around the psycho-logical factors (indicated in italics) that stand in their way (Thaler and Benartzi, 2004). There are four ingredients to the program:

1. Employees are invited to pre-commit to increase their saving rate in the future. Because of procrastination, most people find it easier to imagine doing the right things in the future, similar to our New Year resolutions to start exercising and dieting next year.

2. For those employees who do enroll, their first increase in savings coincides with a pay raise so that their take-home pay does not go down. This avoids triggering the mind’s hypersensitivity to loss, or loss aversion.

3. The contribution rate continues to increase automati-cally with each successive pay raise until a previously agreed upon ceiling is reached. Here, inertia is working in people’s best interest, ensuring that people stay in the plan and the contribution rate increases.

Overcoming Investor Paralysis: Invest More Tomorrow

The psychological fallout of the financial crisis that erupted late in 2008 was profound. As often happens in circumstances like these, investment paralysis has been ubiquitous. Record amounts of cash are still sitting on the sidelines, with people alternating between the fear that the bear market has not really gone away and the potential ignominy of missing out on a new bull market. It is not just investors who are paralyzed. Financial advisors, being human too, are weighing the risk of being wrong against the chance of being right. And this sometimes leads to a kind of paralysis of their own.


4. Employees may opt out of the plan at any time they choose, though experience shows that people rarely do. This provision makes them more comfortable about joining in the first place.

SMarT has been a striking success, almost quadrupling the average contribution rate from 3.5 to 13.6 percent of salary over a three-year period when first applied in 1998. This illustrates that having the right psychology applied judiciously in a financial domain can dramatically improve outcomes.

Invest More Tomorrow

There are sufficient important similarities between the reluctance to enter the market and the inability to contrib-ute adequately to defined contribution plans to make a similar solution feasible. There are two parts to the Invest More Tomorrow strategy: first, overcoming the fear of seeing the value of the portfolio decline, or loss aversion; and second, overcoming the strong tendency to put off until tomorrow what one should be doing today, or procrastination.

Overcoming loss aversionBy far the most important psychological factor in investor paralysis is loss aversion. When people see the value of their portfolio decline, their intuitive mind reacts nega-tively, and they experience psychological pain. And, says Thaler, “people are even more averse to the prospect of future losses when they have experienced loss in the recent past, as most people did during the 2008 financial crisis.”

(See Thaler and Johnson, 1990.) Under these circumstanc-es, people become much more reluctant than usual to take risks. In other words, investor paralysis now.

How can this be overcome? By means of what we can call “fuzzy mental accounting.” Prospect Theory, which recog-nized the cogency of loss aversion, showed that in judging gains and losses, people are exquisitely sensitive to what is called the “reference point” (Kahneman and Tversky, 1979). If an investor were to put all their cash into the market in one single transaction, then that amount of money would become the reference point. Any movement of the market that increased or decreased the value of the investment, above or below the reference point, would then be very easily calculated. And the intuitive mind would respond very negatively to losses.

If, however, a client were to invest a specific proportion of his portfolio, say 25 percent, at regular intervals, such as every three months, then there is no readily obvious refer-ence point. There is no single figure against which to measure performance. In which case, loss aversion is much less likely to kick in.

People are even more averse to the prospect of future losses when they have experienced loss in the recent past, as most people did during the 2008 financial crisis.”Richard Thaler,University of Chicago,Graduate School of Business

Overcoming Investor Paralysis


Suppose the investments made in the first entry into the market under this strategy were initially to lose value. The client is likely to say, “Oh, I only invested a small portion of my cash, and now I see an opportunity to buy cheap with my next purchase.” The intuitive mind isn’t spooked, and the reflective mind can be engaged to consciously turn a potentially aversive situation into an opportunity.

This investment strategy is well known, of course, as dollar cost averaging. But people have now seen that dollar cost averaging can’t protect against losses when the entire market collapses, as it recently did. While they were more willing to try it in the past they are afraid to do so now. They may, however, be willing to contemplate doing it in the future. Which brings us to procrastination, the second barrier to breaking through investor paralysis.

Overcoming procrastinationSMarT worked around procrastination by asking people to commit to increasing their contribution rate many months in advance. Pre-commitment is important, because it is psychologically palatable, and is linked to the desired action actually taking place rather than just a vague promise.

In the same way, a financial advisor could ask his/her client if he/she is willing to commit to going into the market at some specific point in the future. If the answer is yes, then the question becomes, “OK, when do you think market con-ditions will be favorable to take that initial step?” This puts the timing of the strategy in the hands of the client, rather than having it imposed. As a result, the client feels both in control and committed to the agreed-upon action. With a specific answer to that question, the Invest More Tomorrow strategy becomes an informal agreement between finan-cial advisor and client.

Pre-commitment to begin investing at a specific point in the future is the key psychological element here, because it doesn’t trigger the intuitive mind’s aversion to doing what is right today. Procrastination is conquered, and the periodic investment program begins.

Although the strategy as envisaged at present is not on autopilot like SMarT (the agreed-upon purchases still have to be made), pre-commitment engages the benefit of inertia: it is not a question of whether to buy at that point in time, but rather what to buy. The Invest More Tomorrow strategy is a relatively simple overlay on the existing investment plans financial advisors have worked out with their clients. Its purpose is to overcome investor paralysis so that those plans can go into effect rather than remaining stalled.

Invest More Tomorrow is a simple strategy that provides an action framework that eases anxiety for both clients and financial advisors by attending to the psychology underlying investor paralysis.”John Payne,Fuqua School of Business,Duke University



Observes Duke University Business School professor John Payne1: “Invest More Tomorrow is a simple strategy that provides an action framework that eases anxiety for both clients and financial advisors by attending to the psychol-ogy underlying investor paralysis.”

1 John Payne is a member of the Academic Advisory Board of the Allianz Global Investors Center for Behavioral Finance.

Invest More Tomorrow BeFi-in-Action:

1. Invite clients to pre-commit to begin investing at a specific time in the future and ask them to set the date for that action.

2. Work with clients to agree on the size and frequency of periodic investments.

3. Decide in advance on the nature of assets to be purchased.



According to standard economic theory, people make in-vestment decisions based on a rational analysis of the present value and future prospects of equities. It is clear from his advice to investors, however, that the Oracle of Omaha recognizes that factors other than rational analysis are sometimes at play.

Buffett understands from his years of experience that in-vestors often buy high and sell low. They also often buy the wrong stocks, sell the wrong stocks and, in normal times, do far too much buying and selling. Academic insights from Behavioral Finance help explain why people behave the way they do, and they offer practical solutions to finan-cial advisors to help their clients make better investment decisions. The idea is that people are not being stupid, they are just human.

Here, we introduce The Ulysses Strategy, which engages the reflective mind for rational short- and long-term investment strategies, thereby avoiding the errors that the intuitive mind is otherwise prone to make.

More Than Just Fear and Greed

Financial advisors are well aware of the herd mentality of humans, which sometimes leads individual investors to buy high and sell low, by plunging into rising markets and fleeing when markets fall (Bikhchandani et al., 1992; Gal-braith, 1993). But there are other psychological issues at play in the behavior of individual investors, beyond fear and greed, impulses that flow from the intuitive mind.

Overconfidence is as strong an urge in humans as the herd instinct. It leads people to believe they can outperform the market, and seduces them to trade stocks at an irrationally high rate. It’s a costly path to follow. One study of 66,465 individual investors over a six-year period in the United States found that the average investor turned over 75 percent of his/her portfolio each year. Transaction costs associated with this excessive trading reduced net perfor-mance by 3.7 percent compared with the market as a whole. Investors who traded most (in the top quintile) did even worse: these people turned over their portfolios more than twice each year, and as a result suffered a 10.3 percent reduction in net performance (Barber and Odean, 2000; see also Daniel et al.,1998). This is the expenses trap that Buffett mentioned in his letter.

Reining in Lack of Investor Discipline: The Ulysses Strategy

In characteristically provocative manner, Warren Buffett had this advice for investors in his 2004 Chairman’s Letter: “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”


A separate study of transactions in 19 major international stock markets produced equally salutary warnings against the urge to beat the market by too frequently buying and selling securities. Between 1973 and 2004, the average “penalty” for repeated buying and selling as opposed to a buy-and-hold strategy in these markets was 1.5 percent (Dichev, 2007).

Faced with thousands of possibilities, individual investors are ill-equipped to make rational decisions about which stocks to buy. Most people simply don’t have the time or expertise to find fairly valued stocks or under-valued stocks. As a substitute for appropriate analysis, many people unconsciously fall back on a simple rule of thumb, or heuristic: What stocks are in the news? Buy them.

Apparently, it matters not at all why a company happens to be in the news – the launch of a new product, large one-day moves on the market (up or down), even a scandal involv-ing the CEO – these stocks are bought disproportionately by individual investors (Barber and Odean, 2008). This is the intuitive mind taking the easy way to making a choice, one that, if fully engaged, the reflective mind might reject. Inevitably, attention-driven buying pushes prices beyond true value, and investors once again do less well than they expect.

The intuitive mind is at work in the very common mistakes people make in selling stocks they already own. The rational investor would sell losers and hold on to winners. But this is not what individual investors commonly do: They sell winners too early and losers too late. This error is called the disposition effect.

This is how it works for investors. An individual who owns a stock that has appreciated significantly faces a choice: hold or sell. If they sell, they lock in a gain, and they feel good about that. But by selling they forfeit any possibility of further price appreciation and accept the certainty of paying taxes on their profit. If a stock has lost value, however, the investor faces the prospect of admitting a loss if they sell, and that feels very bad. Loss aversion kicks in and most investors choose instead to hold on to the stock. They now face the possibility of further deterioration in price, and the certainty of passing up tax advantages if they were to sell, which is what they perhaps should do.

The disposition effect is the result of mental accounting. The rational investor would be interested in the overall return of their portfolio, and be content to say, “You win some, you lose some, but overall it’s doing well.” Instead, the typical investor treats the portfolio as a series of invest-ing “episodes.” A winning stock offers the opportunity to sell, and so lock in a gain, and the investor experiences the pleasure of that gain. They sell. This is a positive investing episode. A losing stock offers the prospect of incurring a loss, and experiencing the pain that goes with it. They hold, and in so doing avoid a negative investing episode (Barberis and Xiong, 2010).

Stock markets often move in response to many factors unrelated to true value.”Shlomo Benartzi,UCLA Anderson School of Management

Reining in Lack of Investor Discipline


Stock markets often move in response to many factors unrelated to true value. For instance, a commercial plane crash in the United States that kills 75 people or more typically causes the NYSE briefly to shed around $60 billion in value. This reduction in market value contrasts with the actual economic cost of such incidents (incurred by the airline and insurance companies) of around $1 billion (Kaplanski and Levy, 2010). In countries where soccer is a major sport, a loss by the national team leads to a signifi-cant decline in that country’s stock market (Edmans et al., 2007). And weather – gloom or shine – has been found variously to affect stock markets, too (Laughran and Schultz, 2004; Hirshleifer and Shumway, 2003).

Investor mood associated with irrational fear of plane crashes or the ignominy of one’s national team losing, is apparently at work here. The resulting dark mood causes investors to view future economic conditions more pessimistically, so they favor selling rather than buying.

As you have seen here, and as Columbia School of Business professor Kent Daniel1 observes, “The evidence that investor emotions are influencing prices of securities is

1 Kent Daniel is a member of the Academic Advisory Board of the Allianz Global Investors Center for Behavioral Finance.

becoming overwhelming.” No less a figure than former Fed chairman Alan Greenspan admitted as much while appearing before the House Committee on Oversight and Government Reform in October 2008. He said of the idea of self-correcting markets: “The whole intellectual edifice …collapsed in the summer last year.” The challenge for be-havioral finance is to find ways to help people not go with the crowd, and not be susceptible to the errors of the intui-tive mind. Here we offer such a solution.

The Ulysses Strategy

The phrase “Ulysses contract” refers to a decision made in the present to bind oneself to a particular course of action in the future. It derives from a strategy that Ulysses adopted on his journey home from the Trojan wars, which took him and his ship’s crew close to the Sirenusian islands. The islands were famous for being home to the Sirens, whose songs were so irresistibly seductive that seamen felt impelled to fling themselves into the waters, in an attempt to reach the Sirens. No seaman ever survived, so no living human knew the nature of the Sirens’ songs.

Ulysses wanted to be the first human to hear the songs, and survive. He instructed his crew to fill their ears with beeswax, to block out the sound, and then tie him securely to the mast and to ignore his pleas to be released, should he do so. The plan worked. Ulysses heard the Sirens’ songs, the crewmen ignored his entreaties to be untied and when they were out of earshot, he gave a pre-arranged signal to

The evidence that investor emotions are influencing prices of securities is becoming overwhelming.”Kent Daniel,Graduate School of Business,Columbia University



take out the ear plugs and release him. Ulysses had com-mitted himself to a rational course of action at a neutral time, that is before he could hear the Sirens’ songs, and ensured that he stuck with his decision. This action of pre-commitment is the work of the reflective mind.

In the same way, financial advisors could invite their clients to engage their reflective mind to pre-commit to a rational investment strategy in advance of movements of the market that might otherwise trigger irrational re-sponses of the intuitive mind. This kind of Ulysses Strategy has been shown to work with the Save More Tomorrow program (Thaler and Benartzi, 2004), in a pilot savings product in the Philippines (Ashraf et al., 2006) and in a program to help smokers quit, which involved participants depositing a sum of money in an account that they would forfeit if they relapsed (Giné et al., 2008). Pre-commitment to a rational investment plan is important, because the intuitive impulse to act otherwise is strong.

The first step in the process is to help your clients under-stand the psychology of trading by individual investors that can lead to poor decisions. Help them understand that these misguided impulses of the intuitive mind are quite natural, but that there is another, better path to follow, one that is guided by the reflective mind.

The second step is to agree on an investment strategy, which would include an acceptable balance between risky and conservative instruments. As financial advisors, you are already very familiar with this. What would be novel for most advisors, however, is to commit to a specific contin-gency plan. This is an agreement made in advance about what action will be taken should a certain event or condi-tion occur: for example, if the market goes up 25 percent or if the market goes down 25 percent.

The third component of the Ulysses Strategy is to formalize these agreements in a commitment memorandum, to which both the client and the financial advisor are parties (see Appendix A for a sample memorandum). Although research shows that financial professionals are less affected by the impulses of the intuitive mind, they are not completely immune to them (Barber and Odean, 2000). And by being co-signatories to the memorandum, finan-cial advisors put themselves on the same footing as their clients. This memorandum is not binding, in the sense of a legal contract. But the act of writing down the agreements and putting one’s signature to it helps people resist the siren call of the intuitive mind. It helps clients stick with the plan when changes in market conditions might tempt them to go with the herd, and make unwise decisions. And it helps financial advisors honor the agreement, too.

The Ulysses Strategy BeFi-in-Action:

1. Help clients understand the sometimes impulsive nature of investment decisions.

2. Discuss and agree upon what action would be taken when, for example, the markets move 25 percent up or down.

3. Draw up a commitment memorandum, with both client and advisor as signatories. (See sample memorandum page 26.)



A July 2010 Gallup Poll ranks financial institutions 11th out of 16 institutions in the United States in terms of public trust. Only television news, Labor, Big Business, HMOs and Congress score lower, in that order. According to the Chicago Booth/Kellogg School Financial Trust Index, at the beginning of 2009 only 34 percent of Americans expressed trust in financial institutions.

Financial advisors are often tarred by the same brush and many now face clients whose confidence in them has been undermined.

The bruised psychological state of investors has been likened to the feelings of betrayal following the discovery of a partner’s affair. Just as in repairing such a relationship, regaining trust with clients in the aftermath of the finan-cial crisis requires humility, patience and hard work. Regaining trust is a top priority for financial advisors, even if their strategies did not lead directly to clients’ losses (Gounaris and Prout, 2009).

1 Noah Goldstein is a member of the Academic Advisory Board of the Allianz Global Investors Center for Behavioral Finance.

As financial advisors know very well, their client relation-ships have two components: the technical and the personal. “Active demonstrations of professional compe-tence and personal empathy have been identified as key to building and maintaining trust,” notes Noah Goldstein,1 of the UCLA Anderson School of Management (see Gärling et al., 2009). The following BeFi-in-Action strategies are applicable not just to regaining trust in current circum-stances, but also to maintaining trust in the ongoing financial advisor/client relationship. Some of these strategies might at first seem commonplace, but we add a unique angle on them, often backed up by social science research.

Regaining and Maintaining Trust:Competence + Empathy

Investor paralysis is just one important consequence of the recent financial crisis. A second, related corollary is its impact on the bond of trust that exists between financial advisors and their clients. The Nobel laureate economist Kenneth Arrow is often quoted as saying, “Virtually every commercial transaction has within itself an element of trust” (Arrow, 1972). This is especially true of the financial advisor/client relationship (Guiso et al., 2008).

Active demonstrations of professional competence and personal empathy have been identified as key to building and maintaining trust.”Noah Goldstein,UCLA Anderson School of Management


Demonstrating Competence

Clients understand that financial advisors are profession-als with a demonstrated level of competence. Nevertheless, research shows that clients’ perception of their financial advisors’ competence can, and should, be constantly bol-stered in many ways. Some of these actions seem basic and perhaps obvious, while others are even counterintuitive.

Many financial advisors know intuitively that acknowledg-ing shortcomings engenders trust in their client. And social science research shows this to be the correct thing to do (Lee et al., 2004). Moreover, a 2010 Golin/Harris survey revealed that the most effective action a company can take to restore broken trust is to be “open and honest.” The same holds true for individuals. Honesty resonates strongly, and enhances trust. Less intuitively obvious is that admitting luck has the same effect. We will start with this suggested action.

Admit luck. When performance meets or exceeds expecta-tions it is only human nature to want to take full credit. However, according to social science research, it is unwise to do so. Warren Buffett shows himself to be a student of psychology in understanding this.

In Berkshire Hathaway Inc.’s annual report for 2006, Buffett said the following: “… all that said, a confession about our 2006 gain is in order. Our most important business, insur-ance, benefited from a large dose of luck. Mother Nature, bless her heart, went on vacation. After hammering us with hurricanes in 2004 and 2005 … she just vanished. Last year the red ink from this activity turned black, very black.”

Why would Buffett do that, rather than claim all the credit for himself? Just as admitting shortcomings triggers a willingness to trust by the intuitive mind, so too does admitting that luck has played a part in a favorable outcome (Williams et al., 1993). In Buffett’s case, he went on to claim credit for the successes in the rest of Berkshire Hathaway’s portfolio. No doubt the shareholders were nodding in agreement.

Talk about the downside before presenting the upside. As we all know, nothing is perfect in this world, except perhaps Mom’s apple pie. In the world of financial products and strategies, however, potential pluses (high returns) usually come with potential minuses (high risk). Of course, financial advisors already understand the necessity of offering a balanced presentation of benefits and risks. Research, however, shows that the sequence in which the

Regaining and Maintaining Trust


downside and upside are presented is crucial to how the whole is perceived. In this case, clients will be more trusting of positive claims about a product or service if the positive claims are preceded by one or two negative claims. These are known to social scientists as “two-sided messages” (Bohner et al., 2003). By talking about the downside first, the financial advisor is displaying honesty that elicits a greater willingness in the listener to trust what is then said about the upside.

Note that this does not mean that the very first thing you say about the product needs to be negative. Ideally, you could mention one positive argument for the product, followed by a potential downside, followed immediately by the strongest argument for the product. The reason for this narrative struc-ture is that social science research shows that people are more likely to remember the first and last things you say about something (Atkinson and Shiffrin, 1968).

Display evidence of competence. Here’s a story of a physicians’ practice that struggled with the common problem of patient non-compliance with exercise therapy designed to speed recuperation. No amount of explaining to patients the impor-tance of the exercises made for a significant improvement in compliance. The physicians’ assistants engaged a consultant to find a solution. On visiting the practice’s offices, the con-sultant noticed that there were no professional credentials to be seen. The consultant advised the physicians’ assistants to prominently display all relevant certificates and diplomas. Patient compliance immediately leapt by more than 20 percent (Goldstein, 2011).

This dramatically improved outcome is hardly rational. If asked, the patients would have surely acknowledged that they knew the physicians’ assistants would not be able to practice without the required certification. Yet when these credentials were clearly visible, patients’ compliance soared. From a psychological perspective, this improved outcome was not a matter of patients’ reflective minds thinking, “Hm, look at all those diplomas. These people must really know what they are doing. I had better do as they tell me.” Rather, making evidence of competence salient in the profes-sional environment triggered an unconscious response in the intuitive mind, in this case in a positive direction.

If you don’t do so already, know that displaying professional credentials is not a sin of ostentation. Rather, it helps your clients more readily see who you are, professionally, and what you have achieved.

Exhibiting Empathy

Most financial advisors know very well that there is more to the advisor/client relationship than just shaping an invest-ment portfolio: there is the human side of the relationship, too. Those financial advisors who place great value on this aspect of their interaction with clients should know that their intuition to do so is strongly supported by research. This research shows that paying genuine attention to the human element in business transactions improves all bottom-line measures (Pfeffer, 1998). Putting value on the human side of business has been described as “relational intelligence” (Saccone, 2009).



In the context of regaining and maintaining trust, there-fore, exhibiting empathy with a client is not just “being nice”: it is good business practice. And most financial advisors know that exhibiting individualized care to their clients is an integral part of the way they need to work, in order to serve their clients most effectively. Here are a few actions around exhibiting empathy that may be less obvious.

Have frequent contact with clients, especially in difficult times. As we all know, maintaining relationships requires frequent interactions. When those contacts are made are, however, even more important. “Financial advisors find talking with clients during prosperous times to be easy, and even rewarding,” notes Goldstein. “But clients need contact with their financial advisors most urgently during difficult economic times, when they are facing uncertainty and worry.” These difficult times offer an opportunity to strengthen the relationship. Good financial advisors push aside the inclination to avoid contact at these times, and call their clients more frequently than before, thus provid-ing emotional support. They are regarded not only as competent, but also as trustworthy. Their example is worth emulating.

Allay embarrassment. Have you ever asked a client, “Is there anything about our strategy you don’t understand?” It is a perfectly valid, and very professional, question because it comes from a desire to ensure that the financial advisor/client relationship is on a sound footing. After all, no financial advisor wants a client to be going along with a strategy that he/she doesn’t fully grasp. However, the wording of the question might not elicit the truth. Many people don’t like to admit ignorance. A client might not understand everything, but will nevertheless answer, “No, there isn’t,” rather than face that embarrassment. A slightly different wording of the same question, such as “Is there anything about our strategy that I can clarify?” allows the client to admit ignorance without it being so labeled. The same goal is achieved.

Financial advisors find talking with clients during prosperous times to be easy,and even rewarding. But clients need contact with their financial advisors most urgently during difficult economic times, when they are facing uncertainty and worry.”Noah Goldstein,UCLA Anderson School of Management



Seek feedback. Seeking feedback from clients is a standard part of the financial advisor/client relationship. But, once again, this is especially important in challenging economic times. A financial advisor might therefore ask, “Is there anything I can do to improve my service to you in this difficult climate?” This is a win-win question, for several reasons. To begin with, the financial advisor is showing concern to be doing better for his/her client. If the answer is “Yes,” then an opportunity has been opened to improve the professional relationship. If the answer is “No,” then the financial advisor can be content with what he/she is offering. At the same time, something psychologically quite interesting happens in the client’s mind.

By publicly stating that the financial advisor is providing excellent service, that notion is reinforced in the client’s mind, as described by the theory of self-perception. This theory says that people’s attitudes and beliefs may be shaped by observing their actions (in this case, by making a particular statement). The theory is counterintuitive, because it would seem more natural if actions were shaped by beliefs (Bem, 1972).

Regaining and Maintaining Trust BeFi-in-Action:

Competence

1. Admit luck.

2. Precede the greatest upside of a product with

a potential downside.

3. Display evidence of competence.

Empathy

1. Have frequent contactwith clients, especially

in difficult times.

2. Allay embarrassment.

3. Seek feedback, especially in difficult times.



As financial advisors know, people find the task of saving adequately to be very challenging. Standard economic theory of saving assumes that people will be able to grasp how much they need to save, for retirement and for other contingencies; and then have the self-control to forgo current rewards in favor of later benefits.

Even those people who can do the math (it isn’t easy) often find their best intentions derailed by the lure of immediate gratification leading to poor financial decisions that the mind, if given time to reflect, would reject.

It may be difficult to focus on the benefits of financial rewards that will be available at retirement, because the present self may be psychologically disconnected from the distant future self. “With extreme psychological discon-nection,” says Hal Ersner-Hershfield, of the Kellogg School

of Management, Northwestern University, “saving for re-tirement may feel to the present self like giving money to a stranger years in the future.” That is a strong disincentive to saving now.

The Behavioral Time Machine currently under develop-ment offers the prospect of a simple tool that effectively reduces the gap between present and future selves. It will assist people’s imagination to understand the impact of present decisions on the future self, thereby enhancing people’s willingness to save now (Ersner-Hershfield et al., in press).

In Development: Addressing the Disinclination to Save–The Behavioral Time Machine

Many people were caught off guard in the recent financial crisis as they watched with alarm the value of their 401(k) accounts plummet, the price of their house decline and their job security threatened or even lost entirely. Most people imagined these three pillars of future financial stability to be separate: if one pillar started to crumble, the other two would compensate. The fact that under a confluence of certain financial circumstances their fates might be closely correlated was a timely reminder of the interconnectedness of things in our financial worlds. It also exposed a chronic problem: inadequate savings, not just for retirement but also for a source of stability in blustery financial climates in the future.


Two Selves

The notion of a disconnection between present and future selves has fascinated philosophers since the time of Plato. Many young people view their older selves heading into retirement as strangers. The British philosopher Derek Parfit famously described this lack of comprehension of future selves as “a failure of imagination, or some false belief” (Parfit, 1971). It is a failure to identify with oneself in the future.

This unconscious assumption of a different self in the future is demonstrated graphically by brain scans. Re-searchers at Northwestern University and elsewhere find that when people think about their future selves, the same brain region lights up as when they think about strangers. This neurological response to thinking about future selves is stronger in some people than in others. And those in whom the brain region is activated most when looking at future selves also show the steepest discounting of the future (Ersner-Hershfield et al., 2009). The degree of psy-chological disconnection is reflected in an unwillingness to save.

To a failure of imagination we might add many young people’s seeming sense of immortality, or denial that one day they, too, will be old.

In any case, the disconnection between present and future selves is well recognized, and it correlates with a reluc-tance to save. The question is, can the psychological gap between the two selves be closed, and would this affect willingness to save?

Having people imagine their future selves in a substantive way is very challenging, for several reasons. For a start, it is not something people ordinarily do, and so it is a foreign exercise for them. And for anyone, imagining themselves at the age of retirement conjures up many possibilities, with different contingencies (losing one’s hair, winning the lottery, moving to another town or country, having a facelift), which leads to multiple different outcomes. Under this spate of different potential future selves, people find it very hard to bring a single future self into focus.

The Behavioral Time Machine will provide a means of creating a single, salient future self to which the intuitive self reacts strongly. The reflective mind endorses that reaction, and makes rational decisions about saving.

Enter Virtual Worlds

When people are confronted with vivid visual images of themselves that have been digitally aged, they take notice. Hal Ersner-Hershfield and six colleagues performed such an experiment on young volunteers, using age-progression software in a virtual reality environment. These algo-rithms use a framework of key facial features to build an image of what that person will look like in, say, thirty years’ time. Some of the comments on seeing age-rendered future selves included: “Wow, I look just like Grandma,” “Oooh, I don’t know if I want to see this” and “Whoa, this is freaky” (Ersner-Hershfield, 2011). But more pertinently, the volunteers in the experiment who see their future selves more than double the amount of money they say they would allocate to retirement savings.

Addressing the Disinclination to Save


This was not a simple priming effect. When the volunteers see similarly age-processed images of other people, it does not affect their allocation to savings. Only when they see images of their own future selves do they do the right thing with savings.

These experimental results are the first demonstration of a new kind of intervention that shifts participants’ willing-ness to forgo present rewards in favor of future benefits. The age-progression exercise helps people recognize that the future self is indeed the same person as the present

self. It repairs the disconnection between the two selves and leads to far-sighted decisions that take care of the future self by making adequate contributions to a retirement plan. In other words, says Daniel Goldstein,1 a professor at London Business School, “The Behavioral Time Machine helps people to imagine their future selves by presenting them with a striking visual image of that self.”

In a second study these same experi-menters added an emotional dimen-sion to the future selves. They first took three photographs of each participant, one with a very happy expression, another with a very sad expression and a third one with a neutral face. These three images were then digitally processed to form a series of about a dozen expressions in a future self-image, progressing from very happy to very sad. The experi-menters then linked this sliding emotional scale to a sliding financial scale, going from minimal allocation of savings for retirement on the left to optimal allocation on the right.

1 Daniel Goldstein is a member of the Academic Advisory Board of the Allianz Global Investors Center for Behavioral Finance.

Seeing our future selves boosts savings

Seeing a happy future self further boosts savings

(Ersner-Hershfield and Goldstein, in progress)



Participants could then see the emotional reaction of their future selves to different rates of saving for retirement by the present self: pushing the slider toward the left (low allocation) end of the scale evokes an ever sadder future face; when participants move the slider toward the right (high allocation) end of the scale, the smile on their future selves’ faces gets ever broader.

The results of the procedure are clear-cut: Participants who see these emotional reactions in their future selves allocate significantly more to saving for retirement as compared with others who encounter only happy or sad images of their present selves.

The virtual reality environment that these experimenters used in their laboratory studies is very high tech and sophisticated. Ersner-Hershfield and one of his colleagues, Daniel Goldstein, are working with Allianz Global Investors to scale down the technology to a level that would be practicable for financial advisors to use with their clients. This is the Behavioral Time Machine currently under development.2

The Behavioral Time Machine will be complementary to other savings-enhancement strategies, which focus on present and future rewards rather than present and future selves. One of these is Save More Tomorrow, which effectively reduces the lure of the present (Thaler and Benartzi, 2004). Another strategy is to heighten people’s awareness of the benefits of future uses of money: trips to Europe, for instance, or spoiling the grandchildren. Research shows that this second strategy increases people’s patience, and enhances their willingness to save more now (Bartels and Rips, 2010). Financial advisors might use the Behavioral Time Machine on its own, or in combination with one of these strategies.

2 The Behavioral Time Machine tool is projected to become available in the fall of 2011.

The Behavioral Time Machine helps people to imagine their future selves, by presenting them with a striking visual image of that self.” Daniel Goldstein,London School of Business



Postscript

This work presents potential solutions to some of the key challenges

that financial advisors are facing with their clients. As the title of the

paper implies, its goal is to transform academic theory into action

by financial advisors.

This venture is, in a sense, a work in progress. Our goal is to build on

what we have begun, to improve and expand upon the contents of

the behavioral finance “toolbox.” We can do this most effectively in

partnership with you. We therefore invite you to give us your feedback,

based on your initial reading of the paper and, when appropriate,

on your experience in implementing the proposed solutions.

To do so, please email [email protected].


Appendix A

Sample Commitment Memorandum

A commitment memorandum drawn up between

a financial advisor and his/her client can help the

client avoid making unwise investment decisions.

A sample memorandum might read something

like this:


Richard H. ThalerThe University of Chicago Booth School of BusinessRalph and Dorothy Keller Distinguished Service Professor of Behavioral Science and Economicshttp://www.chicagobooth.edu/faculty/bio.aspx?person_id=12825835520

Nicholas BarberisYale School of ManagementStephen & Camille Schramm Professor of Financehttp://www.som.yale.edu/faculty/ncb25/

Kent DanielGraduate School of Business, Columbia UniversityProfessor of Finance http://www.columbia.edu/~kd2371/

Daniel G. GoldsteinYahoo Research, Research Scientist London Business School, Assistant Professor of Marketing http://www.dangoldstein.com/http://www.london.edu/facultyandresearch/faculty/search. do?uid=dgoldstein

Noah GoldsteinUCLA Anderson School of ManagementAssistant Professor of Human Resources and Organizational Behaviorhttp://www.anderson.ucla.edu/x20524.xml

John PayneDuke University, The Fuqua School of Business, Joseph J. Ruvane, Jr.Professor of Business Administration Director, Center for Decision Studies, Fuqua School of Business http://faculty.fuqua.duke.edu/~jpayne/bio/

Acknowledgements

We would also like to thank the financial advisors who provided feedback on this white paper. And we welcome further comments from our readers. Email us at [email protected].

We would like to thank the following experts in behavioral finance for their input to the intellectual content of this white paper. Each of them is a member of the Academic Advisory Board of the Allianz Global Investors Center for Behavioral Finance.


Introduction

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1. Overcoming Investor Paralysis: Invest More Tomorrow™


Richard Thaler and Shlomo Benartzi, “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving,” Journal of Political Economy, vol 112, no. 1, pt 2, pp S164 – S187 (2004).

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2. Reining in Lack of Investor Discipline: The Ulysses Strategy

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3. Regaining and Maintaining Trust: Competence + Empathy

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References


In Development:Addressing the Disinclination to Save

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References

For financial professional use only. Not for use with the public.

The Allianz Global Investors Center for Behavioral Finance is committed

to empowering clients to make better financial decisions by delivering

actionable insights, tools and techniques.

For more information, visit

www.AllianzBeFi.com

Allianz Global Investors is the asset management arm of Allianz SE.The Center for Behavioral Finance is sponsored by Allianz Global Investors Capitaland Allianz Global Investors Distributors LLC.

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