At IMCA’s 2017 Annual Conference Experience, we heard from some of the premier voices in finance, psychology, marketing and business on how new disciplines and emerging trends can affect the investments and wealth management sector. One of those voices was Richard Thaler, Ph.D., a professor at the University of Chicago’s Booth School of Business, on the history of behavioral economics and its impact on financial services professionals.
There has been much chatter in recent years about behavioral economics—in fact, on a macro level, governments have turned to the field as a key driver of policy decisions—but what exactly is it? In short, according to Thaler, it’s the humanization of economics. Rather than theories and assumptions based on markets that exist in a vacuum (which they never do), behavioral economics focuses on human behavior and what real people respond to.
Behavioral economics exposes some of the faulty thinking underlying classical economics: That people (for our purposes, investors) seek to optimize their results; always act out of self-interest; can control their impulse for reward today versus greater reward tomorrow; and do not maintain biased beliefs. But if we look at the bigger picture, these attributes are remarkably inhuman. We may be able to exhibit some of these behaviors from time to time, but people are ultimately fickle and , and they do not cease to exist because of these mistakes—they adjust course and continue to make decisions and, often, more mistakes. The key point Thaler made on this front is that most economic decisions are made by amateurs, and we have to have explanations for the way everyone behaves—not just the smartest people in the room.
So what does this mean for investments and wealth professionals? How can they tailor their advice and education to best cater to their very real, very human clients? Take, for example, a financial professional advising a client on retirement savings. A classical economic model would assume that the client is highly rational and will seek to optimize their savings: They’ll forecast what they earn over their lifetime, determine how long they’re likely to live, decide what consumption profile they’ll have over their lifetime, and from there, identify the returns they want from their retirement savings. But your average investor simply doesn’t think this way.
Instead of embracing this highly theoretical model, investments and wealth professionals need to consider how their clients actually think and behave. Supposedly irrelevant factors under a standard model—such as sunk costs, the framing of a problem or piece of advice, the options presented as defaults, etc.—have a very real impact on investor decision-making. Continuing with the retirement savings example, advisors can work with plan sponsors to instead encourage an individual investor to kick-start their savings by offering automatic enrollment in their employer’s 401k plan. In addition, plan sponsors and their advisors can nudge investors towards increasing savings by offering a “Save More Tomorrow” plan, in which the investor can increase contributions in tandem with pay raises.
The key takeaway for investment and wealth professionals, then, is that their clients are human, and part of their job is to anticipate the way the client thinks and guide them towards making sound financial decisions. The world of finance is difficult and complex, and maximizing outcomes can be hard for even the most sophisticated of investors. Investment and wealth professionals are ultimately here to help their clients navigate these occasionally murky waters.