“Decisions can be easy when [people can] choose from a well-defined set of options,” says Baruch Fischhoff, a specialist in social and decision sciences at Carnegie Mellon University in Pittsburgh.
It’s when options are unlimited and parameters undefined that people become paralyzed by choice. This means advisors must create better decision-making environments. Fischhoff told Advisor’s Edge how to do that.
Help clients make good decisions
Winnow a client’s investment options to a set small enough that they can think seriously about each option. Then, summarize uncertainties, so you’re not making promises you can’t keep.
The right set of options
Advisors are required to give people risk-tolerance tests. But people don’t have deep insights into their risk-related behaviour.
People often mistakenly think of themselves as brave investors, so they make risky investments they later regret. The research finds people’s risk-taking propensity varies by domain—people may take risks in the stock market that they wouldn’t take with their health or careers.
Quizzes about investment make people think too abstractly. Instead, ask direct questions: Has a client lost money but gone on to think he had made a reasonable investment? Has he made money but thought he was just lucky?
By tapping into real investment histories and the associated emotions, you’re better prepared to narrow the number of products to which clients should pay attention.
The role of expectations in decision-making
To create realistic expectations, consider two biases. The first is outcome bias: someone judges the quality of her decision after already knowing the outcome. Protect against this bias by making it clear that investments aren’t sure things. That will better prepare someone to lose money, or at least temper her expectations of returns.
There’s also hindsight bias—seeing events that have already occurred as more predictable than they were before they took place. Discussing potential negative outcomes will help clients cope if things go wrong. They need to remember your telling them investments are vulnerable to the European financial crisis, for example.
If I don’t know realistic rates of return, the first number I hear will serve as my anchor, which may bias how I process further information. So carefully define financial terms for clients and check understanding. If they’re hesitant to admit confusion, they’ll welcome the chance to go over things again.
Inflation, for instance, is a common term. But the inflation that affects food and gasoline prices is different than the inflation that affects my portfolio.
So, illustrate these differences on a chart showing long-term inflation and how it affects expected accumulated rates of return for different investments.
This solves two problems: First, it shows a client the inflation relevant to his investments; second, it does the arithmetic. People aren’t good at computing long-term probabilities in their heads. A good visual does that for them.
Brynna Leslie is an Ottawa-based financial writer.