A number of years ago I read Richard Thaler and Cass Sunstein’s book, Nudge: Improving Decisions About Health, Wealth, and Happiness.  The book, first published in 2009, argues that individuals often make poor, sub-optimal decisions due to cognitive and behavioral biases.  A real-world example cited by the authors is low-enrollment in employer-sponsored retirement savings plans (401(k)).  Administrative barriers make it difficult to enroll and so people do as they always have (status-quo bias).  The brave souls that do saunter forward and prevail over the HR enrollment process must still navigate the labyrinthian plan administrator website.  What do confusing terms like “fund prospectus,” “target portfolio allocation,” and “automatic rebalance” mean?  Armed with nothing but their hard-earned savings, employees young and old question whether their financial future is secure.  Studies have shown that in the face of such risk and uncertainty individuals assign greater value to certainty and seek to avoid ambiguity and uncertainty.  They tend to under-allocate to riskier assets and over-allocate to safe assets despite the risk capacity to do the opposite (risk aversion bias).  Consequently, the 25-year-old with a bright future and significant capacity for risk ends up allocating 100% of their contributions to cash.

How did the authors propose to solve these problems? Reconfigure the choice architecture.  Nudge people in a different direction.  First, automatically enroll eligible employees in employer-sponsored retirement plans; employees must opt-out, as opposed to opt-in.  Second, have a default election option.  The proposal has been so widely successful that Congress made it part of the Secure Act 2.0 and employers will be required to abide by it starting in 2025.

I bring up Nudge because it emphasizes the importance of investor behavior and investor psychology to financial planning and investment returns.  Here are two of our favorites and some suggestions for limiting their negative impacts. 

• Herd Mentality: our desire to belong to a group and mimic the actions of others has played a significant role in our survival as a species for thousands of years.  In financial markets, bypassing this circuitry can be exceptionally difficult.  When we see stocks going up, we don’t want to miss the gains, so we buy.  When we see stocks going down, we don’t want to be the only one holding losses, so we sell.  We abandon our own judgment for the judgment of others.  We buy high, we sell low.  We focus on noise.  Our advice?  Turn off the financial news media.  Go outside, read a book, visit friends, visit family.  Embrace and enjoy the peace of mind that comes with adherence to a sound investment process.  

• Endowment Effect / Bias: we place a higher value on an item we own, than the same item we do not.  Example: you own a 6ft Werner ladder and will not sell it to me for less than $75 but you’re willing to pay no more than $60 to purchase a new one.  Our advice?  Frame the transaction differently.  Try not to think of the item as constitutive of your identity.  When my brother died, my family wanted to keep all his personal items: t-shirts, pants, gym equipment, car keys, even his car.  These things reminded us of him and that memory was hard to let go.  We were finally able to let many of these items go by reframing their loss.  For instance, we donated his car to a volunteer firefighter department so they could practice live burn scenarios.  While we ‘lost’ the car, the donation was a way for my brother to positively impact the world, to exist in it, even after he was gone. 

Advisors should talk openly with their clients about cognitive and behavioral biases.  How is the advisor limiting their impact on investment returns?  Does the financial plan capture the actual habits of the individual or family?  Or is the plan best suited for the fictitious ‘rational agent’ of the university economics department?  Is the couple being honest about how much they spend and what they spend it on?  Talking about what makes us uncomfortable isn’t always a comfortable conversation, but a good advisor knows this.  And they will always handle these conversations with the patience, empathy, and care their client deserves.