I have been preaching the virtues of behavioral economics for over 15 years, since the Dotcom bust confirmed to me that markets and financial decisions are, in fact, driven by emotions just as much as the fundamentals. Therefore, I was absolutely thrilled in October when I learned that Behavioral Economist Richard Thaler had won the Nobel Prize in economics. Thaler, who teaches at the University of Chicago, is a best-selling author by way of one of my favorite behavioral books, Nudge, which I would encourage you to read.
Even though Thaler is the most recent, he is not the only behavioral economist to win the Nobel Prize. The first was Daniel Kahneman. Kahneman is an Israeli-American psychologist who won the Nobel Prize in economics in 2002. He also wrote a best-selling book and another one of my favorites on behavior and decision making called . As the title suggests, humans have two ways of thinking that play into our decision making; we have the “fast way” of thinking, which is our emotional and instinctual cave man way of thinking, and we also have our “slow way” of thinking, which is our analytical, problem solving way of thinking. There are positives and negatives to both. The key is understanding and managing the process the brain goes through when making decisions, whether those decisions are fast or slow.
Another behavioral economist that won the Nobel Prize was Robert Shiller, who many of you know by the “Case-Shiller Index” in real estate. Shiller is an economics professor at Yale who received his Nobel Prize in economics in 2013 for his studies that actually began 40 years ago by challenging the Efficient Markets Hypothesis. The Efficient Markets Hypothesis, which is the notion that the price of a given security is an accurate reflection of the value of the underlying property, was widely embraced by many pundits in finance at the time. Thus, questioning this theory was very bold and groundbreaking. Shiller has since argued that emotions and irrationality are involved in the investors decisions to buy and sell, which can create booms and busts in markets.
The reason for pointing out the above is: If you are not yet a disciple of behavioral finance and do not spend a good amount of time reading up on this topic, three Nobel prizes should convince you that there is legitimacy to this discipline. Don’t know what behavioral finance is? Behavioral finance is a subset of behavioral economics, and it’s defined as “The study of how finance is affected by psychology. This study attempts to understand and explain how human emotions influence consumers in their decision making process.”
Although behavioral finance can appear to be most prominent in the securities business, it is actually very applicable in all areas of finance. Whether you are an insurance producer, an investment advisory representative (IAR), a registered representative, or all of the above, I believe the study of behavioral finance is one of the disciplines that separates you from your peers. Financial professionals that understand behavioral finance also understand how to tell stories, handle objections, and navigate and handle irrational client emotions. Furthermore, financial professionals that understand behavioral finance also understand one of the most important components of behavioral finance—navigating consumer biases!
There are well over 100 documented biases1 that we humans can fall victim to. Financial professionals witness many of these biases every day. What is a bias? A bias can be a preconceived notion, a prejudice, a thought process, etc. Basically, a bias is a block the brain may have in processing information in a rational way. So, as you are feeding information into the consumer’s brain, if that consumer has one of these 100 biases there is a possibility that your important information is being blocked before the client can even have that information processed by the left side of the brain (i.e. the analytical side). Many times, even if the information you are communicating to that client is mathematically and scientifically perfect, if there is a bias present you will get nowhere with that client unless you know how to identify and handle their bias.
Examples of biases are:
Confirmation Bias: The tendency to search for, interpret, favor, and recall information in a way that confirms one’s preexisting beliefs or hypotheses.
Herd Bias: This is people’s tendency to feel comfortable in doing what other people are doing. Hence, following the herd. There is a great amount of discomfort that people feel in going their own way when everybody else is going another way.
Recency Bias: This is the tendency for people to put a significant amount of weight and consideration on events that have happened recently, while ignoring what may have happened in prior times. People tend to then assume that what happened recently will happen in the future because that recent experience is fresh in their minds.
Home Bias: This is the tendency for people to not want to purchase or experience anything new because it is outside of what they have always been accustomed to and what is mainstream.
Loss Aversion Bias: People are averse to loss. Many studies2 show that people prefer avoiding a loss of a certain dollar amount more than they prefer gaining that certain dollar amount. Even more interesting, there are studies that show that the negative feelings associated with losing one dollar is equivalent to the positive feelings of gaining two. In other words, the negative feeling of loss is twice as powerful as the positive feeling of gain.
Regret Aversion Bias: This is one of my favorite biases to discuss. People obviously don’t like to be wrong, and they don’t like to admit they were wrong. This can lead to regret. Thus, Regret Aversion Bias is when consumers refuse to admit to themselves that they’ve made a poor buying decision. By refusing to fess up, they don’t have to face the unpleasant feelings associated with that decision. As a result, these consumers can hold on to a product or position for too long instead of facing the cold hard truth!
Before the days of GPS apps on cellphones, my wife and I were going to dinner to a restaurant that we had never been to before. I was driving, and once I got to the location where I thought the restaurant was, it was not there! So, because I am stubborn, I circled the block five times searching every plot of land on that block for any sign of the restaurant. After a while it was obvious to my wife and me that I was lost! What did my wife say at that point? She said, “Why don’t you just stop and get directions?” At which point I said, “No, I got this!” I wandered around aimlessly for another 15 minutes and finally said to my wife, “I am going to stop and get directions.” This was very hard for me to do! Why? Because I was basically admitting defeat, which led to regret, which was further exacerbated by her saying, “I told you so.” The reason for me not stopping earlier for directions was because I suffered from regret aversion bias.
When I was just starting my career, I worked for one of the large carrier companies. In my branch office there was a peer of mine that was always out to prove to his potential clients that they were wrong and stupid for making the choices they have made, and that they needed to listen to his great advice in order to get on the path to financial success. In his mind he thought this was the way to convince his clients to follow his advice. When they did not follow his advice, he would be the first to tell them, “I told you so” in hindsight. Very prideful. Do you think he lasted long in the business? No! All of his clients were merely potential clients and never became actual clients.
In other words, you cannot tell the client to make a decision that will be contrary to what they originally thought unless you position it appropriately. Why? Because by the client listening to you and taking action they would be admitting defeat, which would then lead to regret. This is regret aversion bias. Furthermore, if you were to position your recommendation as a change in strategy versus righting a wrong, the chances of you getting the sale would be much greater. An example of a conversation like this may be the example of a client who bought a term policy 15 years ago and may now have a need for permanent coverage. This may be an effective statement for that client: “Mr. Client, when you purchased your term policy 15 years ago you made a very prudent decision given the resources you had at the time. However, your financial situation is much brighter than it was back then and now may be the time to reexamine whether or not you should stick with the term insurance or consider permanent coverage.”
In short, in order to navigate regret aversion, it is much better to compliment the client on prior efforts and point out how the world has changed around them, which may warrant a change of strategy, which is much better than pointing out a significant mistake the client had made.
By the way, the example of the 15-year-old term policy was my real life example. If an agent were to point out that I made a serious blunder, and therefore I should listen to his new recommendation of permanent coverage, I would tell him to hit the road. However, the above verbiage would sell me on learning more about his new strategy! By the way, I don’t regret buying the term insurance because I understand my resources were limited relative to today. The only regret that I will never get over is the fact that I bought the policy from a company that is now a competitor of mine!
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The opinions and ideas expressed by Charlie Gipple are his own and not necessarily those of North American Company for Life and Health Insurance or its affiliates. North American Company does not endorse or promote these opinions and ideas.
