Behavioral economics has opened advisors’ eyes to how feelings about risk and return weigh on decisions, but some financial choices are made quickly and randomly.
Daniel Kahneman, the Nobel-laureate author of “Thinking Fast and Slow,” told attendees at the Morningstar Investment Conference in Chicago on Tuesday that he wants to find out why.
“I’ve become convinced that there’s something more important than systematic error, and that is unsystematic error,” said Kahneman. “There is a random element to decision making that is very significant.”
Kahneman described a study conducted in conjunction with an insurance company. Fifty underwriters were presented with five to six realistic cases and asked to put a dollar value on them.
Going into the study, Kahneman expected to find an average variance between underwriters of 10 percent or less.
“When you actually compute the statistics and the average difference in dollar value, you get 50 percent,” said Kahneman. “There is a lot of variability and a lot more noise in underwriting than anybody was aware of. The company was unaware that it had that problem. When underwriters can differ on average by 50 percent, they may not be worth having.”
Kahneman suggested that underwriting could be automated by algorithms to reduce the unsystematic “noise” that causes such a high level of variability between individual underwriters.
Advisors may deal with “noisy” clients who are unreliable sources of information about crucial planning topics like their financial goals. Kahneman suggested that advisors employ a lengthier and more intimate onboarding process to determine if clients are speaking realistically about their feelings and goals.
“If you can, probe gently into what the history of these people was,” said Kahneman. “What they have done in the past is important—find out whether they have different accounts or a history of engaging with one advisor after another. Then the conversation would have to be fairly detailed. You’d have to discuss many different scenarios and opportunities in detail and get a sense from the interaction about how the clients react—for example, how regret prone they are. Instruments are needed that go well beyond standard measures of risk tolerance.”
Kahneman said that a fiduciary’s aim need not be return or wealth maximization, but “regret minimization.” Though Kahneman admitted to being more focused on loss aversion, regret minimization also involves addressing investors fear of missing out.