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The Secret to Why Your Clients May Often Fail to Heed Your Best Advice

As a financial professional, you likely agree that understanding the intricacies of human behavior is as crucial to helping your clients as comprehending market trends and investment strategies when constructing their portfolios. And perhaps there is no better thesis on how behavior influences financial decision-making than the contemporary classic, “Thinking, Fast and Slow.” Written by Nobel Laureate Daniel Kahneman as a summary of a lifetime of research in the field of behavioral economics, Khaneman offers invaluable insights into the psychological underpinnings of decision-making.

This blog explores why investors often make quick, emotional investment decisions, especially during volatile market conditions. We’ll discuss Kahneman’s theory of dual-process thinking—System 1 and System 2—and uncover how various behavioral biases can influence decisions. Finally, we’ll discuss strategies you can employ to help your clients make sound, informed choices when they are most likely to do otherwise.

How We Make Decisions

Thinking, Fast and Slow, introduces us to the concept of two distinct mental processing systems that Kahneman explains have been integral to the survival of the human species since the beginning of time: System 1 and System 2. These systems operate at very different speeds and serve entirely different functions.

System 1

System 1 thinking is fast, automatic, and intuitive. The rapid-fire mode of thinking allows us to make snap judgments and decisions without conscious effort. This system relies on heuristics—mental shortcuts that simplify complex tasks. It’s highly efficient for everyday tasks, such as recognizing a friend’s face or responding to a sudden danger.

It’s been estimated that System 1 thinking represents 98% of our decision-making processes and that, on average, a person will make as many as 35,000 decisions daily. Examples of System 1 thinking include detecting hostility in a voice, answering  2 + 2 = ? reading, or knowing to stop when you see a red traffic light. These actions and thousands of others require very little conscious thinking and happen spontaneously.

Characteristics

• Fast
• Unconscious reasoning
• Judgments based on intuition
• Processes information quickly
• Hypothetical reasoning
• Large capacity
• Prominent in humans and animals
• Unrelated to working memory
• Effortlessly and automatically
• Unintentional thinking
• Influenced by experiences, emotions and memories
• Can be overridden by system 2
• Prominent since human origins
• Includes recognition, perception, orientation, etc.

System 2

System 2 thinking, on the other hand, is deliberate, analytical, and effortful. It’s the mode of thinking we engage when faced with complex problems or when we need to exert self-control. System 2 thinking involves careful consideration, logical reasoning, and a conscious evaluation of information.

Examples of System 2 thinking include completing complex calculations, analyzing a comprehensive financial report focusing on the voice of a particular person in a crowded and noisy room, looking for a woman with white hair, or filling out a tax form. System 2 thinking requires conscious effort.

Characteristics

• Slow
• Conscious reasoning
• Judgements based on examination
• Processes information slowly
• Logical reasoning
• Small capacity
• Prominent only in humans
• Related to working memory
• With effort and control
• Intentional thinking
• Influenced by facts, logic and evidence
• Used when system 1 fails to form a logical/acceptable conclusion
• Developed over time
• Includes rule following, comparisons, weighing of options, etc.

Beware Behavioral Biases

Understanding the differences between System 1 and System 2 thinking is crucial to unraveling why your clients may be inclined to make poorly informed emotional decisions with their investment portfolios when markets are raging or collapsing. In these conditions, System 1 often takes the lead, and this is where behavioral biases come into play.

Kahneman’s research sheds light on many of the behavioral biases that affect our decision-making, several of which include:

Loss Aversion: People tend to feel the pain of losses more intensely than the pleasure of gains. This bias can lead to hasty decisions when clients see their investments in the red.

Example: A client panics and sells their equity holdings during an extended bear market or when the market declines rapidly. Keeping a long-term perspective would have been more beneficial.

Overconfidence Bias: Investors often overestimate their ability to predict market movements, leading to investment decisions that expose them to excessive risk.

Example: A client believes they can consistently outperform the market and invests heavily in speculative assets, exposing themselves to significant risk.

Recency Bias: This bias causes investors to give more weight to recent market or economic events and assume that current trends will continue indefinitely.

Example: During a bull market, a client may become overly optimistic and over-allocate to stocks, assuming the market will keep rising indefinitely.

Confirmation Bias: Investors seek information confirming their beliefs while ignoring contradictory evidence or choosing not to explore alternative perspectives.

Example: A bullish client on a particular market sector only pays attention to news and analysis that supports their viewpoint, ignoring negative indicators.

Anchoring Bias: Clients may fixate on a particular price point or reference point when making investment decisions, even when it’s no longer relevant.

Example: A client purchases a stock at $1000 and refuses to sell it for less than $1000, even though the current market price has dropped to $800, and all indicators point to a further decline.

While your clients–actually while ALL of us–will never be able to completely overcome the behavioral biases that are inherently woven into our duel-thinking brains, there are several strategies and approaches Kahnamen suggests can help us mitigate the impact of these biases on making bad decisions:

Awareness and Recognition: The first step in overcoming behavioral biases is to be aware of their existence. Help educate your clients to recognize when they might fall victim to biases. Simply acknowledging these biases can help clients pause and reconsider their decisions.

Slow Down and Engage System 2: Kahneman emphasizes the importance of engaging System 2 thinking when making important decisions. Encourage clients to slow down and process the information available to them. Encourage them to ask questions like, “What evidence supports this decision?” or “Have I considered all available insights?”

Use Decision Checklists: Kahneman suggests creating decision checklists or guidelines. These checklists can serve as a structured approach to decision-making, helping clients ensure they’ve considered all relevant factors. For instance, when reevaluating portfolio allocations, a checklist might include criteria such as risk tolerance, diversification, and long-term goals.

Seek Diverse Perspectives: Confirmation bias often leads people to seek information that aligns with their beliefs. Encourage clients to actively seek diverse perspectives and dissenting opinions. This can help counteract the tendency to selectively process information that confirms preconceived notions.

Embrace Uncertainty: Many biases stem from a desire to eliminate uncertainty. Kahneman advises clients to become more comfortable with uncertainty and recognize that not all decisions can be made with complete confidence. Encourage clients to accept uncertainty in their investment decisions and focus on managing risk instead of trying to eliminate it entirely.

Consider the Outside View: When making predictions or assessments, Kahneman recommends using the “outside view.” Clients should consider similar situations in a broader context instead of relying solely on personal experiences or intuitions. This can lead to more realistic expectations and decisions.

Implement Cooling-Off Periods: Suggest implementing cooling-off periods in situations where impulsive decisions can be harmful. This means delaying a decision for a set period, allowing emotions to subside and System 2 thinking to take over. For example, if a client wants to make a portfolio change during a market downturn, advise them to wait a day or two before taking action.

Feedback and Evaluation: Regularly review past decisions and their outcomes. This feedback loop can help clients learn from their mistakes and successes. It’s a way to refine decision-making processes over time and reduce the influence of overconfidence bias.

Incorporating these strategies into decision-making processes can help clients better manage their cognitive biases and make more rational, informed choices in various aspects of life, including decisions related to their investment portfolios. By understanding the workings of System 1 and System 2 thinking and actively addressing biases, your clients can improve their decision-making process relative to the long-term financial plans you have developed together.