As financial planners, we work with our clients to make the most of their finances, aligning their money to be in integrity with their diverse wants, needs, ambitions, fears, and behaviors.
When it comes to truly understanding our clients, behavioral psychologist and Nobel laureate Daniel Kahneman has made an indelible impact on our field.
Kahneman passed away on March 27th at the age of 90.
In a remembrance of Kahneman and his impact, we’ve compiled nine of his timeless insights that will continue guiding us through the complex psychological terrain of financial decision-making.
1. Loss Aversion: Kahneman revealed that we feel the pain of loss more intensely than the pleasure of profit.
This is why we spend the time making sure clients are properly insured and invested in alignment with their risk tolerance.
2. Overconfidence Bias: It’s not uncommon to have a client who has picked some individual stocks that turned out to be winners.
However, recognizing how statistically difficult this is to do with any degree of consistency, we coach clients to rely on empirical evidence > overconfidence.
For those that want to keep trading, we designate a % of their invested assets as “fun money.” This allows them to engage in stock selection without losing the farm.
As planners, our overconfidence bias is that a low-fee, globally diversified approach will beat out individual stock-picking 99.5% of the time. We believe alpha (i.e. outperformance) is best achieved via long-term planning + patience > gut feelings + speculative moves.
3. Anchoring Effect: This cognitive bias describes our tendency to give disproportionate weight to the first piece of information we receive when making decisions.
Consider a scenario in salary negotiations:
A hiring manager shares that the salary for a position is $250,000.
This number sets an anchor in the mind of the interviewee.
When an offer of $260,000 follows, it appears attractive because it surpasses the initial anchor of $250,000.
However, imagine if the interviewee had not been influenced by this anchor and they discovered similar roles in the same industry paying $300,000.
The $260,000 might be viewed differently.
The anchoring effect goes beyond just salary negotiations. It affects how we perceive the value in everything from real estate, to automobiles, to investment opportunities and beyond.
4. Planning Fallacy: This is when individuals underestimate the time, costs, and risks involved in a project while simultaneously overestimating the benefits.
Thinking of investing in that timeshare that promises endless family vacations?
Convinced that your brother-in-law’s mobile back waxing startup will be the next big thing?
About to back that friend’s idea of starting a chain of left-handed stores?
In each of these examples, emotions can cloud our better judgement, leaving us to overestimating the upside while ignoring the real costs and risks.
As planners, we try to help clients zoom out of the present moment and view circumstances + opportunities from 30,000ft.
Similarly, when it comes to tax + retirement projections – we err on the side of being conservative.
We’d rather a slight overestimation of your taxes and an underestimation of your investment returns to help:
- build buffers for the unexpected
- prepare for a wider range of outcomes
- avoid disappointment
5. Endowment Effect: This bias causes individuals to overvalue assets simply because they own them, potentially leading to poor financial decisions.
However, it also applies to areas of life beyond the portfolio:
- Real Estate: Homeowners may overestimate the value of their home because of their emotional attachment, leading to unrealistic listing prices or reluctance to accept fair market offers.
- Personal Items: People often demand a higher price than buyers are willing to pay for used personal items like cars, furniture, or electronics, simply because they own them and have personal histories with them.
- Business Decisions: Business owners might overvalue their own company or business ideas, making it difficult to make objective decisions about selling, investing further, or changing business strategies.
- Career Choices: Employees might overvalue their current job position or role due to familiarity and comfort, leading them to pass up new opportunities that could offer better growth potential.
6. Availability Heuristic: This is the tendency to overvalue information that comes to mind easily, examples can include:
- recent market fluctuations
- personal experiences with investing/real estate
- media coverage of the economy
- a friend’s investment success
Relying on these examples can skew planning decisions, often for the worse.
As planners, we navigate this heuristic by seeking and sharing diversified sources of news, information, and data.
7. Sunk Cost Fallacy: This is the classic case of when an individual doesn’t know when to cut their losses.
Clients may be inclined to continue investing in a failing investment/business simply because they’ve already invested considerable resources.
Educating clients about this fallacy and encouraging them to consider current and future costs + benefits, rather than past investments, can guide them towards more rational decision-making.
8. Halo Effect: This bias occurs when overall impressions of a person or company influence specific judgments.
In investing, it may cause clients to overvalue stocks based on admiration for a CEO (hello, Tesla!) or strong brand reputation (hi, Apple!), leading to overlooked risks.
To mitigate this, we work with clients to ensure that their “fun money” investment decisions don’t derail the broader, long-term investment plan.
IMAGE: Photo of Daniel Kahneman used with permission from Wikimedia Commons. This work by NRKbeta.no is licensed under a Creative Commons Attribution-Share Alike 3.0 Norway License. Permissions beyond the scope of this license may be available at http://nrkbeta.no/cc/
