Behaviour that costs clients money

There's growing research that demonstrates that investors aren't rational and that their irrational behavior costs them big money over time.

One of the leaders in this area is Duke economist Dan Areily, author of the bestselling book Predictably Irrational - last week we talked just before his kickoff speech at the CFA Institute annual meeting in Boston.  Our conversation can be viewed on today's email.

Advisors who understand the natural biases in individual behavior can frame questions and provide advice that will steer client decision-making process in a more rational - and economically better - direction.

The following is drawn from an article by Bob Huebscher, publisher of online newsletter Advisor Perspectives, reporting on a talk that Ariely delivered last fall. (If you want to receive Advisor Perspectives, you can sign up at no cost at www.advisorperspectives.com.)

Setting up automatic behavior

One example is understanding the power of having inertia work for you by automatically setting up desired behavior.

Ariely showed why organ donor participation rates are strikingly different among European countries that on the surface look similar - Belgium and the Netherlands for example.

Those countries that present an opt-out choice (e.g., "check this box if you don't want to participate in the program") have far higher participation rates than those countries where participants have to check a box to opt-in; Canada falls into this latter category.

What advisors can do:

Advisors can take advantage of default decision making by setting up an automatic savings plan, where a certain amount is contributed from a client's account every month unless they do something to change this.

Or another example is getting clients to buy into automatic rebalancing, so the default decision is the one that will serve clients well.

Presenting a manageable number of choices

Ariely also points to an experiment to illustrate the impact of the number of choices that clients are presented with.

Shoppers in a supermarket were offered the chance to try different jams at a table set up when they entered a supermarket.

In one scenario there were six different jams on the display table; in the other there were 24.

The researchers recorded the percentages of people that approached the tables, tried the jams, and purchased a jam. Where there were six jams on the table, 40% of people approached a table and 30% ended up purchasing a jam, so 75% of those who tried the jams bought a jam.

Where there were 24 jars of jam, 60% of people approached the table, but only 3% purchased a jar of jam - so only 5% of those who tried the jams purchased.

By limiting choice, you ended up with ten times more purchases. Overwhelming shoppers with 24 options totally negated the enticing effect of offering a free sample.

What advisors can do:

The conclusion for advisors is clear. We generally think more choice is good - in fact, past a certain point, more choice causes paralysis.

So we need to be selective about the number of choices that we present to clients - enough so that clients feel they're being presented with a range of options, but not so many that they're overwhelmed.

Dealing with emotions

"When it comes to emotions, we have two sides to ourselves," Ariely says.

While we may have good intentions, for example when it comes to healthy eating, those intentions are often compromised in the face of temptation.

Give people a choice of a half box of Godiva chocolates immediately or a full box in a week and most will choose the half box right now.

But given the choice of half a box of chocolates in a year, or a full box in a year and a week, almost everyone chooses to wait the extra week for a full box.

Ariely calls this bias hyperbolic discounting. When decisions affect events further in the future, people act more rationally. As time frames shorten, temptation plays a greater role and decisions become more irrational.

Hyperbolic discounting explains why people don't save, diet or exercise - the rewards of

immediate temptations are valued too greatly.

What advisors can do:

There are a couple of ways advisors help clients overcome this.

First, help clients build in shorter term rewards as part of their plans - for example, budget for quarterly vacations or plan a weekly or semi-weekly dinner out.

 If the reward is too far in the future without short-term reinforcement, many clients will get discouraged and give up on their long term plans.

Second, to counteract temptation, clients can create binding contracts with themselves or with their advisor to avoid it.

Those contracts need to be drawn up before the temptation arises, and must specify exactly how the investor plans to behave in certain circumstances. For example, a contract might specify how the portfolio will be rebalanced if the market goes down by a certain percentage.

"Advisors need to see if they can be this bridge between their clients' long-term goals and short-term impulses," Ariely said.

On Thursday, I'll present more of Dan Ariely's ideas about what advisors can do to help clients stay on track.