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There’s no denying that human emotions play a role in managing money. Even someone who’s usually level-headed can get caught up in excitement, fear, or uncertainty.
But what happens when we make choices based on feelings instead of facts and figures? Normally, nothing good. When our clients are caught up in their emotions, is there anything we can do to help them bring logic back into the mix?
That’s where behavioral economics comes in.
This isn’t a novel concept. Back in the 18th century, Adam Smith wrote a book called The Theory of Moral Sentiments, which provided the framework that led to the study of behavioral economics.
In the 1970s, Daniel Kahneman and Amos Tversky used the concepts of cognitive psychology to explain divergences in financial decision-making. They made three conclusions that are relevant to us today.
- The structure of a problem impacts choices;
- Gains are perceived differently than losses; and
- Certainty is weighed more heavily than uncertainty.
What makes these things relevant to the work we do on behalf of our clients? We need to know how they view gains and losses as well as certainty and uncertainty if we want to help them make wise financial decisions.
Meeting clients where they are
When clients trust us with their money, we should do whatever is necessary to meet them where they are – and that includes understanding their emotions. It’s not realistic to think we can always rein in volatile, reactionary feelings and replace them with logic. Even the most well-researched rationale can get pushed aside when a client is scared they’ll lose money or worried about the future.
It’s on us to recognize when one of our clients is ensnared in an emotional trap, and to use what we know about the impact of cognitive biases on rational decision-making to push them back toward the logical side of the fence. That means educating ourselves, using the right tools, and engaging with clients – specifically, acknowledging how they’re feeling and guiding them accordingly.
One way we can get clients back on track when emotions are running high is to use a concept known as nudging.
A nudge, which was articulated by professors Cass Sunstein and Richard Thaler, is not an order or an ultimatum. It’s more like a suggestion.
With a nudge, we can encourage rational, fact-based decisions without mandating them.
An effective nudge might be, “You could put your child’s college fund into a high-yield savings account, but you’ll get better returns with a 529 account.” That’s a statement that gently pushes a client to choose a 529 while still leaving them with the option of going in another direction.
Nudging is useful, but it’s not the only way we can incorporate behavioral economics into the work we do.
Beyond the nudge
We’re all susceptible to cognitive biases such as loss aversion, which tells us that people are more sensitive to losses than they are to gains. The tricky thing about cognitive biases is that simply knowing about them doesn’t mean we can overcome them. In turn, it’s imperative to reinforce awareness through education.
Education is most effective when it’s rolled out slowly, as noted by McKinsey in their newsletter on leadership through change.
So, where do we start?
First, wealth managers must appreciate what can derail decision-making before they can educate clients. Examples include the halo effect (a tendency to make decisions based on overall impressions instead of specific factors) and the sunk costs fallacy (a reluctance to pull out of an unsuccessful endeavor instead of cutting one’s losses).
The next step is learning how to recognize emotional triggers when they’re happening. For example, a client who has read a lot about a particular investment class may be in the thrall of overconfidence bias. Or a family that’s fearful of losing money might allow loss aversion to prevent them from selling when they should.
Don’t be afraid to enlist tools like AI
You don’t need to become an expert in behavioral economics to apply its principles and improve your client relationships. Rather, you can use tools to help analyze your clients’ investment preferences and decision-making styles.
For example, you could use generative AI like ChatGPT to enter a client’s previous financial decisions and request an analysis of their decision-making style. From there, you’d be able to use the style you created to forecast future choices.
We’re not yet at the point where we have Theory of Mind AI, which could potentially understand and respond to human emotions. But what we do have is AI that can analyze choices over time and gain an understanding of what makes clients tick – and how we can nudge them into better decision-making.
At the end of the day, we can’t eliminate emotional triggers. Nobody can. What we can do is learn about them, recognize them, and provide our clients with the best possible framework for making smart and rational decisions about their money.
Matt Reiner is a CFA, CFP®, and partner at Capital Investment Advisors, a $2.8+ billion RIA in Atlanta. Reiner is also CEO of Wela Strategies, a sister company to Capital Investment Advisors, and is the founder and CEO of Benjamin™. Benjamin is an AI technology created by Reiner after seeing the gaps in technology used in his own firm. Reiner’s true passion is using his vast experience to coach other advisors across the country, helping them evaluate their firms’ practices and find the best strategies for future success. To reach Matt Reiner, visit www.MattReiner.com.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.