A new breed of financial adviser is emerging: Using the principles of behavioural economics in your financial planning

Behavioural economics, the intersection of economics and psychology, is the study of the predictable irrationalities in human decision-making –errors in judgement that are often the underlying cause of poor financial planning. An understanding of these irrationalities, or errors, can therefore be an extremely powerful tool in nudging customers to make informed decisions throughout their financial planning journey.

In this article, I highlight a number of techniques from the field of behavioural economics that have been found to influence the effectiveness of financial advice.

1. Be aware of your customers’ psychological and emotional state

A study conducted by Gino, et al., (2012) uncovered that people who are prone to anxiety are more likely to seek advice (90% vs 72% in the control group) and follow through on financial advice (68% vs 41% in the control group). This is not surprising as it is one’s anxiety about the future that drives one to save.

In the same vein, however, many customers are prone to react emotionally to macroeconomics shocks, instinctively withdrawing from their investments in response to a market drop when they should, in fact, stay the course.

What you can do: Being aware of, and planning for, future market fluctuations with your customer from the start of the relationship is one way of managing their psychological and emotional state when the market is down.

2. Agree on specific feedback times

Research shows that the extent to which a customer overreacts in response to market fluctuations is closely linked to the frequency with which they check their portfolio performance.

Customers who check regularly become more sensitive to each short-term up and down, exacerbating their anxieties.

What you can do: Control your customer’s anxiety by carefully choosing when they receive updates on their portfolio. To make this even more effective, discuss and set specific times with your customer to share feedback. Setting up these rules for your engagement also acts as a commitment device, helping your customers to meet their goals.

3. Encourage a long-term state of mind

Numerous studies have found that people are inherently present biased, placing more weight on the here and now rather than the future. This bias has developed over thousands of years as a survival mechanism to help us react quickly to immediate dangers, but falls short when we need to develop plans for the future, such as saving for retirement.

Present bias: People tend to place more weight on events occurring in the present, focusing on immediate benefits over long term gains.

What you can do: Prime customers to think about their future selves prior to making a decision. This will help influence customers to re-focus their attention on their future.

For example, retirement contribution rates were increased by showing people a picture of an aged version of themselves.

4. Get your customers to write down their goals and commitments

As the old adage goes, you can lead a horse to water, but you can’t make it drink.

Bhattacharya et al., (2011) found that very few customers follow through on the advice they receive from an adviser (about 5%).

People typically have good intentions and aim to stick to their long-term strategy, but when the market experiences short-term fluctuations, they sell or withdraw their savings on a whim. This ‘emotional pull’ people feel when faced with the possibility of losing investment value is called loss aversion, and is perpetuated by our inherent present bias.

Loss aversion: The tendency for people to be more attuned to losses than gains. Humans feel a loss about twice as much as they do a gain of the same amount.

For example, Martin et al., (2012) found that by simply asking patients to write down their doctor’s appointment date and time (as opposed to the nurse doing this for them) decreased no-shows by 18%.

What you can do: A simple yet highly effective behavioural tactic to use is the Self-generation effect. This involves working with the customer to build a long-term strategy and getting them to pre-commit to the goals by physically writing them down.

This has two positive outcomes:

I. People like to be consistent with the things they have previously said or done. Writing down their goals and commitments creates a solidified social contract between you and your customer, which they are more likely to honour.

2. When the market experiences turbulence, this contract reminds them of their original reason for starting their investment, placing them back into a long-term strategy state of mind, and counteracting the effects of loss aversion.

5. Frame your customers’ investment options with their benefit in mind

The tendency for people to draw different conclusions depending on how something is described is known as framing. Therefore, the way in which investment options are positioned influences how these products are perceived by the customer.

For example, an influential paper by Brown et al., (2008) found that people find an annuity product more attractive when a “consumption frame” was used rather than an “investment frame”.

More explicitly, people prefer an annuity when their attention is shifted towards thinking about it as a product that supports their future consumption, rather than a product focused on risk and return.

In contrast, people find a savings account more attractive when an investment frame is used.

Additional behavioural principles for you to use

1. Research has found that customers typically give higher ratings to advisers that use less technical jargon. Being overly technical can be detrimental to your relationship with your customers.
2. In times of decision uncertainty, people tend to follow the crowd as an indicator of the commonly accepted (and therefore most correct) course of action. Social influence can be extremely powerful, therefore statements such as “most people in your situation follow this strategy” are, when true, likely to be more influential than offering a personal opinion.
3. People prefer to say “yes” to those that they like. This universal truth has resounding behavioural consequences, particularly for those advisers who want to make a positive impact on their customers’ financial decisions. Likeability can be increased by expressing similarity, cooperation towards mutual goals, and giving compliments.

IMPORTANT: Apply behavioural economics ethically, or risk losing your credibility

Embedding behavioural economics into your financial advice conversation can be used to influence your customers for both positive and negative motives.

Studies have found that the misuse of behavioural techniques can lead to an “irreversible erosion of trust”, which will negatively impact the advisers reputation.

Therefore, it is important to determine whether the influence you have over your customer is in their own best interests.

Richard Thaler and Cass Sunstein, authors of the book “Nudge” and advocates for the use of applying behavioural economics principles for good, propose three essential rules for using behavioural nudges to influence human behaviour:

1) Nudges should be transparent and not misleading

2) It should be easy to opt out of nudges

3) Nudges should improve the welfare of those being nudged.

Uber, for example, came under scrutiny in 2017 for using behavioural nudges to influence its driver’s to pick up more fares, sometimes with little consideration for the drivers’ wellbeing. The backlash they received forced Uber to change its ways or lose its dominant market share.

In conclusion, using the above behavioural principles will help you to improve your advice conversation, assist your customers to develop and stick to their long-term investment strategy and foster a relationship of trust and mutual benefit.

Keeping in mind the ethics of applying these techniques, nudging can help to bring about a new generation of financial advisers, with a new set of tools, to help your customers reach their financial goals.