Behavioral Economics is about examining the biases in decision-making that result in less than optimal decisions. When used appropriately, it helps to remove biases so an individual can see more clearly and make a better decision. However, it can also be used inappropriately to mislead.
When it comes to pricing a two liter bottle of Coca Cola we have a pretty good idea of the cost—it’s going to come in somewhere between 99 cents and $2.50 depending on the store and whether it’s on sale. Okay, what should the price be of a bottle of Beringer Private Reserve Cabernet Sauvignon 2012? Unless you are a connoisseur, you probably don’t have a clue. What do you think a fair price would be if I told you I felt it was comparable in taste to the Dancing Hares Vineyard Napa Valley Red Wine 2013 that typically runs about $160? What if I instead asked what would be a fair price saying it was much better than the Beringer Napa Valley Cabernet Sauvignon 2012 that cost $38? The odds are your price estimate of the Beringer Private Reserve is higher if you were told about the $160 alternative than if you were told about the $38 one (the actual price ranges between $110 and $130).
When determining the value of something that is new to us we often rely on the first value we hear as an anchor to set a price in our mind that we then use to evaluate other choices. In this example, both the high and low priced wines are honest anchors because the prices and my opinions are real. Misleading anchors are those that intentionally distort value. Examples of this would be if I said this Dancing Hares wine cost $700 or I personally felt the two Beringer wines tasted the same, but said the more expensive one tasted much better.
Excellent examples of misleading anchors are found on late night television where the audience is told that the suggested retail price for the electronic gizmo is $79.95, “But we’ll sell it to you not for $79, not for $39, but for $19.95.” Of course, the reality is that the “suggested retail price” in no way reflects the actual market value. Or, the commercial opens with a picture of gold bars saying the price of gold has skyrocketed to over $1300 an ounce, but you can have this gold-plated coin for $12 (even though the actual gold content is worth 65 cents). Gold bars are a misleading anchor.
Fixed index annuities are often new to consumers, so they are looking for an anchor; this is especially true when the index is unfamiliar. One possible anchor would be to use an index that is familiar, but caution is needed. Saying only “The Acme Stock Market Index increased 20 percent last year” gives the impression that this return is also possible for the annuity, although that is seldom the case. A less misleading anchor could mention that although the Acme Index increased 20 percent, that due to the design this fixed index annuity would have credited five percent interest. However, although the return is accurate, it places the fixed index annuity in the same sphere as stock market investments, which also creates a misleading anchor.
We need an anchor that reflects the fixed annuity character of the fixed index annuity; a good one would be saying something like, “The fixed rate annuity yields two percent next year, while the fixed index annuity could realistically credit somewhere between zero and five percent depending upon how the index performed.” Not only is the anchor honest, but it makes the fixed index annuity more attractive because the value is better—just as mentioning the higher price of the Dancing Hares wine makes the value of the proffered wine more attractive.
Understanding behavioral economics helps us understand the decision-making biases that can result in poor decisions. Knowing that the first words you speak will anchor the expectations of the consumer may help you in determining the best way to begin a presentation.
