What goes in your client's head when making financial decisions

In module 2 of this 3-part series, Neil Bage, director of behavioural insights at BE-IQ, a UK-based fintech company, focuses on how we process information and our capacity for thinking.

Our capacity for thinking

When we engage in deliberate thought, we are severely limited in terms of capacity and the mental operations we can apply. So, how can clients make complex financial decisions that require deliberate thought? As financial planners, you have to simplify the decision-making process so it is not cognitively overloading and not overload clients with too much information.

How we process information

When we make a decision, we adopt two modes of thinking – system 1 and system 2 thinking. System 1 thinking is the dominant system. It is intuitive, extremely fast and happens automatically within our subconscious, without us being overloaded cognitively. System 2 thinking is similar to rational decision making or thinking. It’s a lot slower and more deliberate and is where we make a conscious effort to really think about something. The downside to system 2 thinking is that it takes a great deal of physical and mental effort, which can be exhausting. While it should be a decision gate-keeper, we often defer to system 1 thinking, which is less taxing and allows us to make a decision more quickly. It is, however, problematic when making important financial decisions with a long-term impact on your financial wellbeing. Financial planners therefore need to get clients into system 2 thinking so they can be more deliberate and thoughtful about the decisions they need to make.

The role of shortcuts or heuristics in decision making

System 1 thinking can result in clients taking shortcuts or heuristics in order to make a quick decision, which may not necessarily be the right decision for their financial plan. The availability heuristic is a mental shortcut that helps us make a decision based on how easy it is to bring something to mind and is one of the more dominant shortcuts we taken when reaching a decision. The representativeness heuristic is a mental shortcut that helps us make a decision by comparing information to our mental prototypes. The affect heuristic is when we make a decision based on what we feel about something as well as our current mood or state of mind.  These three heuristics are always present.

Behavioural biases

If we can’t make a decision based on these quick simple rules of thumb and need to dig more into detail, then our behavioural biases kick in. These biases are essentially filters and are split into two groups. Cognitive bias is when we make a decision based on the way information is presented to us and where there is room for misinterpretation. Affective bias is where we make a decision based on our mood or emotions. Confirmation bias is when we interpret information that only aligns to our existing beliefs or views and ignore anything that could prove we’re wrong. Confirmation bias is a dominant and powerful behavioural bias so, when dealing with clients, you need to make sure that you don’t play to their confirmation bias. The salience or attentional bias is when clients focus on information that is more prominent and ignore information that is less prominent, regardless of its importance. This is important to bear in mind in terms of how you present information to your clients. The under/overconfidence bias is a person’ subjective confidence in his or her judgements or abilities. Planners should therefore not ask clients financial planning questions that are subjective, but rather ask them to explain their answer to eradicate any under or overconfidence and get a proper understanding of what the client understands.

Knowledge

Knowledge underpins many behavioural biases and can be split into subjective knowledge (what you think you know) and objective knowledge (what you do know) and is one of the most crucial areas that impacts decision making. People who have low subjective knowledge and high objective knowledge tend to be risk seeking while people with high subjective knowledge and low objective knowledge tend to be risk averse. People should not be making financial decisions based on subjective knowledge, but rather on objective knowledge. The role of the financial planner is therefore to ensure that every piece of information you present is objective based information. When clients make decisions, you need to eliminate as much subjectivity as you can.

To listen to this conversation, go to Nedgroup Investments Insights on Apple Podcast, Google Podcast and Spotify.