A recent ad sponsored by the CFP Board shows a car swerving out of control, the steering wheel being pulled in different directions just as clients are pulled in different directions by varying financial issues. The announcer then advises consumers to seek out the help of the one person, a certified financial planner, who can help them get all their finances working in the same direction.
According to this ad, our job as planners is to get our clients’ finances working together toward a common goal. I think this is a good starting point, but if you drill down just a bit further you realize that financial planning is about making decisions. And that leads us to the question, “How can we make better ones?”
One theory suggests people make decisions (or, at least should make decisions) by carefully and cognitively weighing all the options and choosing the one that maximizes their wealth. But there are two problems with this.
First, people do not optimize, they “satisfice.” This term, introduced by Nobel prize winning economist, sociologist and psychologist Herbert Simon in 1956, combines the words “satisfy” and “suffice” to explain the behavior of a decision-maker who can’t find an optimal solution. Researchers started using the term when they discovered that people often work toward a solution that’s satisfying but not optimal. Since cognitive thinking requires considerable effort, most of our clients will stop when they find a satisfactory solution.
The second problem is that most decisions are made at a non-cognitive, subconscious level. Brian Knutson and George Loewenstein at Columbia University gave students a generous amount of money to spend and showed them images of items they could buy. After looking at the items for a few seconds, the students were shown the price. If they decided to buy, the money was deducted from their pile of cash. To make this interesting, the researchers had the students inside an fMRI machine so they could see what parts of the brain were active during the decision-making process.
When the students saw an item they wanted, the nucleus accumbens lit up. This part of the brain is associated with pleasure. When the price was revealed, the insula lit up and, to a small degree, the prefrontal cortex showed activity. The insula produces negative feelings and is especially sensitive to spending money. What the researchers discovered is that the nucleus accumbens and the insula essentially engaged in a tug-of-war and the winner determined whether the student made the purchase. Once the decision was made, the prefrontal cortex got busy creating a rational explanation.
The nucleus accumbens and the insula both operate on a subconscious level, so Knutson and Loewenstein were able to conclude that these buying decisions were subconscious decisions. This leaves us to wonder what else might be going on that we are not aware of that influences our decisions.
In the early 1970s, Daniel Kahneman and Amos Tversky introduced the idea of cognitive heuristics and used this to develop “prospect theory” in 1979. This theory deals with the way people make decisions when faced with risk. The researchers showed that people often use cognitive heuristics (mental shortcuts) to make decisions.
Such thinking tools are very valuable, but as Kahneman, Tversky, Richard Thaler and many other researchers have shown, the shortcuts can lead us astray from time to time. Thaler, a noted behavioral economist at the University of Chicago’s Booth School of Business, asked people to write down the last three digits of their phone number. Then he asked them if the year Attila the Hun was defeated was before or after the number they’d written down. Finally, he asked them to guess the specific year Attila was defeated.
What this illustrates is that having the last three digits of someone’s phone number in mind can cause people to guess either too high or too low. This is a particular cognitive heuristic called “anchoring,” and the illustration is used to show us how these heuristics lead us astray in our decision-making.
The popular press has picked up on this idea, and a number of books have been published that paint a very discouraging picture. Consider this brief list of titles:
• Sway: The Irresistible Pull of Irrational Behavior by Ori and Rom Brafman (2008)
• Blind Spots: Why Smart People Do Dumb Things by Madeleine Van Hecke (2007)
• Predictably Irrational: The Hidden Forces That Shape Our Decisions by Dan Ariely (2008)
• Decision Traps: The Ten Barriers to Brilliant Decision-Making and How To Overcome Them by J. Edward Russo & Paul J.H. Schoemaker (1990)
• Everyday Irrationality: How Pseudo-Scientists, Lunatics, and the Rest of Us Systematically Fail to Think Rationally by Robyn Dawes (2001)
Clearly we are hopelessly irrational decision makers. Or are we?
Gary Klein, a well-known research psychologist who pioneered the field of naturalistic decision making, says, “What really happened is that Kahneman and Tversky designed their studies to demonstrate the limits of classical decision theory, not the limits of their subjects.”
Consider that we are talking about thinking systems that are hardwired into our brains. And any system will have limitations. Klein illustrates the point with a toaster, which typically has a thermostat that causes the toast to pop up when it reaches the desired temperature. If the toaster has already been used recently, the toast will likely pop up before it’s done because the coils have been preheated. Does this mean the toaster is irrational or in some way defective? No. It just means the toaster has a limitation that has to be worked around if you know it has recently been used.
In the same way, our mental heuristics have limitations that have to be worked around when we know we may be prone to make a mistake. Take another look at the Attila exercise. We are being asked to guess at a number and are given a totally unrelated number that forms an anchor. If you were on Craigslist trying to decide how much to ask for the wing chair that has been sitting in your living room for the past 30 years, you would not start by writing down the last three digits of your phone number. Instead, you would look for a similar item on Craigslist and use that number as your anchor. It’s a shortcut, but you are choosing an appropriate anchor.
The first step in helping our clients make better decisions is to realize that they, too, are using mental shortcuts. This will be easier for you to see than it is for them. As Kahneman points out, it is easier to spot the mental shortcuts others are using than it is to spot your own.
The next step is to learn to name the shortcut. If you can tell a client they are going to be using anchoring when making a decision, then you can help them set a proper anchor. One problem is the client’s focus on “recency” (a tendency to give disproportionally more weight to current events than to more distant events) and when you identify it you can help the clients put the current events into a broader historical perspective.
The real key is to be aware that we naturally employ cognitive heuristics—in other words, to think about our thinking and about our clients’ thinking.
Thom Allison, CFP, founded Allison Spielman Advisors, based in Bellevue, Wash., in 1997.