Although so many financial and economic models take as a fundamental assumption the idea that we are all rational human beings, the emerging research from the field of behavioral finance clearly illustrates this is a false assumption. In reality, we have some pretty strange financial behaviors, that do not appear to be at all consistent with a purely rational decision-making process. Fortunately, the world of behavioral finance is showing us that at least some of our irrational behavior occurs in a consistent manner that we can predict, so while our actions may not be rational at least they can be anticipated. But that in turn begs a fundamental question: when faced with a client making an irrational financial decision, is the rational (for the planner) solution to try to change the client to be more rational as well, or to change the recommendation to fit the client’s irrational behavior?
The inspiration for today’s blog post comes from some ongoing discussions I’ve been having with other planners about how to develop financial planning recommendations for irrational clients. But it’s not just about what the emerging research on behavioral finance tells us that people do; it’s also about what YOU are supposed to do ABOUT it. In general, I’m finding that planners seem to fall into one of two camps: either the "proper" way to deal with irrational clients is to show them how they are being irrational and help them to see the error of their ways so that they will self-correct the behavior, or you are supposed to adapt your financial planning recommendations to arrive at a solution that will work in spite of the client’s irrational behaviors.
It’s actually a pretty difficult challenge for the client-centric financial planner. The idea of following the latter path – to adapt your recommendations to the client’s irrational behavior – just feels… "icky" to many, and is outright anathema to some. How could you, the professional financial planner, possibly make a deliberate decision to offer a recommendation that is not the "optimal" one based on all the analysis and data available? For instance, would you ever recommend an illiquid investment to someone, simply because you wanted it to be harder for them to make a hasty irrational decision to sell it in a panic? After all, almost by definition, if the client is acting irrational, they are making "sub-optimal" decisions that are not in their best interests, and recommending a sub-optimal solution would seem to just exacerbate the problem. How can you be a professional and cater to such client tendencies? How could it be responsible as a planner to deliberately recommend a solution that takes a client down a less-than-optimal path? Or simply put, if you’re a rational professional, how can you NOT give rational-based recommendations?
If you’re going to go down such a path, though, you’ll have to convince the irrational client to stop being irrational, for which the best prescription right now seems to be "show the client how he/she is behaving irrationally, and let them self-correct the behavior." To say the least, this can be far more difficult in practice than it sounds, though. For instance, if there’s one thing I’ve learned in my brief time being married, it’s that if I think my beloved wife is acting in an irrational manner, it rarely improves the situation to point this "fact" out to her at the time the "problem" is occurring. Perhaps, maybe, we can have a conversation to reflect on how one of us was behaving irrationally, long after the fact, but even then it still doesn’t necessarily mean the same thing won’t happen next time. And in a client situation, your time is far more limited; the time that you meet with your client to try to "fix" their irrational behavior is the same meeting at which you’re trying to get them to adopt a rationally recommended solution at the end. In other words, you’re trying to package together re-education, re-training, and a rational recommendation into a pretty small window of time.
But once again, if you don’t think you can convince the client to just stop being irrational by pointing out their irrationality to them, what else is a planner to do? The next step would seem to be right back where we started; if you can’t change the client, you have to change the recommendation to fit them, instead. In some cases, this may not be too difficult; for instance, the emerging field of choice architecture has a great focus on looking at how we can better guide client behavior (in finance and many other areas) to the outcome we want them to select, simply by being cognizant of how the decisions are presented in the first place. A classic example is changing savings plans to occur automatically and let people opt out, instead of not-saving by default and asking them to opt in; as a result, savings behaviors come out dramatically improved. In other words, it’s a way to use a client’s irrational behavior to their own advantage. So maybe catering to a client’s irrational tendencies isn’t always bad, and sometimes you can take advantage of predictably irrational behaviors for a client’s own good?
So what do you think? How do you handle these challenges in your own life and with your own clients? Do you try to "fix" the irrational behavior, or "fix" the recommendation to fix an irrational world? Is one solution more "professional" than the other?