Client Psychology
Good to Know
Client decisions, including financial ones, may be driven more by psychology than just cold, hard, rational facts. The chart below identifies four powerful psychological influences.
| Client Psychology—Influences | |
| Values | Fundamental personal beliefs |
| Attitude | The tendency to view an investment positively or negatively based on our beliefs and experience |
| Bias | A behavioral tendency |
| Heuristic | A “mental shortcut” used to make decisions quickly |
We will now explore each influence in more detail, beginning with values.
Values
A person’s values are those character traits and core beliefs that define them. Personal values form the foundation of how we view ourselves, others, and even financial decisions. Indeed, our very sense of right and wrong is closely tied to our values. For example, an individual may simultaneously believe that it is right for the government to incarcerate convicted violent criminals but wrong to impose the death penalty.
An individual’s values are highly personal and are based on upbringing, life experiences, religious beliefs, culture, and a host of other factors. Specific values are commonly regarded highly, such as honesty, integrity, and loyalty. Yet, individual values frequently differ. For example, one individual may value consistency over creativity while another may feel the opposite. Values permeate us through and through. They inform our very attitudes, as our next psychological influence will address.
Attitudes
Attitudes can be thought of as expressions of our values. For example, a client who values predictability and dislikes surprises may exhibit a strong negative attitude toward an emerging market stock or a high-yield (junk) bond. A negative attitude is more likely when a financial recommendation conflicts with our values. The opposite is also true; we are likely to have a positive attitude when a financial recommendation resonates with our values.
For example:
- A client whose parent died because of liver failure from alcoholism may have an implacably negative attitude toward alcohol stocks,
- An individual who lost a spouse to lung cancer could feel so emotionally negative about tobacco that they vow never to own such stock, even if the stock is grossly undervalued, and
- An environmentally conscious client would tend to view a “clean energy” stock positively while having a negative attitude toward stocks of highly polluting foreign “dirty energy” companies.
So far, we’ve seen how our values define us in many ways and how our values affect our attitudes. Next, we’ll discuss an interesting psychological influence referred to as bias.
Bias
Our psychological bias can be described as our internal, instinctive reaction to an external stimulus such as another person, event, or idea. For example, consider a stock market correction (an external event). A client who reacts immediately by liquidating their portfolio may have been driven by great fear (an internal reaction) that the market would continue to slide, resulting in an even larger loss in the future.
The sequence of events in this example describes the loss aversion bias.
Loss aversion describes our tendency to feel the pain of a financial loss more than the joy of a financial gain. In an experiment conducted by Kahneman and Tversky, people were asked if they would bet on a coin toss. They would lose $100 if the toss came up “heads” but would win $200 if the toss came up “tails.” The result? Survey participants needed a potential gain of about twice the potential loss to take the bet.
Let’s not be too quick to judge the client in the above example who panics, sells, and seeks the “safety” of cash. No one is immune from the subconscious power of our biases. However, we can help clients recognize these biases and counsel them to better financial decisions. Behavioral psychologists have identified well over 100 biases, and the scope of this blog does not permit discussion of each one. Our next psychological influence is heuristics—mental shortcuts.
Heuristics
Heuristics are simplification strategies or “mental shortcuts” used to make decisions when time is of the essence or accuracy is not paramount. Types of heuristics include “Rules of Thumb,” “Educated Guesses,” and “Ballpark Estimates.” For example, one life insurance rule of thumb recommends a death benefit equal to ten times compensation. But be careful! A young, early-career couple with small children and a large mortgage could need more than 10 x earnings. In contrast, a couple in retirement with no debt, a well-funded retirement portfolio, and a large emergency cash reserve could need less than 10 x their retirement income in life insurance coverage.
Summary
According to Modern Portfolio Theory, investors are rational in that they desire gains equally as much as they fear losses. However, it turns out that our species responds to powerful subconscious psychological influences that can drive us to “irrational” decisions based upon, for example, feeling the pain of a loss twice as acutely as feeling pleasure from a gain.
Disclaimer
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide tax, legal, compliance or financial advice. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.
