Dan Ariely

From a behavioral economics point of view, the field of financial advice is quite strange and not very useful. For the most part, professional financial services rely on clients’ answers to two questions:

1. How much of your current salary will you need in retirement?
2. What is your risk attitude on a seven-point scale?

From my perspective, these are remarkably useless questions — but we’ll get to that in a minute. First, let’s think about the financial advisor’s business model. An advisor will optimize your portfolio based on the answers to these two questions. For this service, the advisor typically will take one percent of assets under management – and he will get this every year!

Not to be offensive, but I think that a simple algorithm can do this, and probably with fewer errors. Moving money around from stocks to bonds or vice versa is just not something for which we should pay one percent of assets under management.

Actually, strike that. It’s not something we should do anyway, because making any decisions based on answers to those two questions don’t yield the right answers in the first place.

To this point, we’ve run a number of experiments. In one study, we asked people the same question that financial advisors ask: How much of your final salary will you need in retirement? The common answer was 75 percent. But when we asked how they came up with this figure, the most common refrain turned out to be that that’s what they thought they should answer. And when we probed further and asked where they got this advice, we found that most people heard this from the financial industry. Sort of like two months salary for an engagement ring and one-third of your income for housing, 75 percent was the rule of thumb that they had heard from financial advisors. You see the circularity and the inanity: Financial advisors are asking a question that their customers rely on them for the answer. So what’s the point of the question?!

In our study, we then took a different approach and instead asked people: How do you want to live in retirement? Where do you want to live? What activities you want to engage in? And similar questions geared to assess the quality of life that people expected in retirement. We then took these answers and itemized them, pricing out their retirement based on the things that people said they’d want to do and have in their retirement. Using these calculations, we found that these people (who told us that they will need 75% of their salary) would actually need 135 percent of their final income to live in the way that they want to in retirement. If you think about it, this should not be very surprising: If you add 8 hours (or more) of free time to someone’s day, they will probably not want to spend this extra time by going for long walks on the beach and watching TV – instead they may want to engage in activities that cost money.

You can see why I’m confused about the one-percent-of-assets-under-management business model: Why pay someone to create a portfolio that’s 60 percent too low in its estimation?

And 60% is if you get the risk calculation right. But it turns out the second question is equally problematic. To show this, we also asked people to tell us how much risk they were willing to take with their money, on a ten-point scale.  For some people we gave a scale that ranges from 100% in cash on the low end of the risk scale and 85% in stocks and 15% in bonds on the high end of the risk scale. For other people we gave a scale that ranges from 100% in bonds on the low end of the risk scale and buying only derivatives on the high end of the risk scale.  And what did we find?  People basically looked at the scale and said to themselves “I am a slightly above the mean risk-taker, so let me mark the scale at 6 or 7.” Or they said to themselves “I am a slightly below the mean risk-taker, so let me mark the scale at 4 or 5.” In essence, people have no idea what their risk attitude is, and if they are given different types of scales they end up reporting their risk attitude to be very different.

So we have an industry that asks one question it’s giving the answer to, and a second question that assumes that people can accurately describe their risk attitude (which they can’t). This saddens me because, while I think that financial advisors are overpaid for the service they provide, in principle they could contribute much more, and they could even deserve their salary. But only if they start offering a more useful service, one that they are in the perfect position to provide. Money, it turns out, is incredibly hard to reason about in a systematic and rational way (even for highly educated individuals). Risk is even harder.

Financial advisors should be helping their clients with these tough decisions! Money is about opportunity cost. Every time we think about buying a car or going on vacation we should be asking ourselves what we won’t be able to afford in the future if we go ahead and make this purchase. And that’s where the financial advisor should come in.

It’s possible that the best financial advisors already do help in this way, but the industry as a whole does not. It’s still centered on the rather facile service of balancing portfolios, probably because that’s a lot easier to do than to help someone understand what’s worthwhile and how to use their money to maximize their current and long-term happiness.

The fact is that money is hard to think about and we do need help with making financial decisions. The financial consulting profession has an opportunity to reinvent itself to service this need. And if they do, it will be beneficial for both financial advisors and their clients.

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A shorter version of this appeared at hbr.org

Here are a few suggestions I gave for eating less on thanksgiving:
1) “Move to chopsticks!” Or, barring that, smaller plates and utensils.

2) Place the food “far away,” so people have to work (i.e., walk to the kitchen) to get another serving.

3) Start with a soup course, and serve other foods that are filling but low in calories.

4) Limit the number of courses.

Variety stimulates appetite. As evidence, consider a study conducted on mice. A male mouse and a female mouse will soon tire of mating with each other. But put new partners into the cage, and it turns out they weren’t tired at all. They were just bored. So, too, with food. “Imagine you only had one dish,” he says. “How much could you eat?”
5) Make the food yourself. That way you know what’s in it.

6) “Wear a very tight shirt.”

Enjoy

This advice also appeared here

A few days ago Dan wrote about Don Moore’s research on how we accept advice from others. A lab experiment showed that subjects adhered to advice from confident, not necessarily accurate, sources. The findings of another research, led by Prof. Gregory Berns of Emory University, show another aspect of our reaction to advice.

Berns recorded his subjects’ brain activity with an fMRI machine while they made simulated financial decisions. Each round subjects had to choose between receiving a risk-free payment and trying their chances at a lottery. In some rounds they were presented with an advice from an “expert economist” as to which alternative they consider to be better.

The results are surprising. Expert advice attenuated activity in areas of the brain that correlate with valuation and probability weighting. Simply put, the advice made the brain switch off (at least to a great extent) processes required for financial decision-making. This response, supported by subjects’ actual decisions in the task, are troublesome, perhaps even frightening. The expert advice given in the experiment was suboptimal – meaning the subjects could have done better had they weighted their options themselves. But how could they? Their brains were somewhat dormant.

References:
Jan B. Engelmann, C. Monica Capra, Charles Noussair, Gregory S. Berns (2009). Expert Financial Advice Neurobiologically “Offloads” Financial Decision-Making under Risk.

“For the great majority of mankind are satisfied with appearances, as though they were realities, and are more often influenced by the things that ‘seem’ than by those that ‘are.’”
-16th-century Italian politician Niccolo Machiavelli

It’s something we come across regularly: presentation trumps content. Often what matters is not what we know, or what we have done, but rather how we spin it. It’s why cover letters are so important, and why the peripheral route to persuasion – one of advertising’s biggest weapons – works.

Now, Don Moore of Carnegie Mellon University demonstrated yet another way that we are heavily influenced by delivery — We tend to seek advice from experts who exhibit the most confidence – even when we know they haven’t been particularly accurate in the past.

In his experiment, Don had volunteers guess the weight of people in photographs, and paid them for their correct answers. But before each guess, the volunteers were asked to choose one of four advice-givers (also volunteers) from whom to buy advice. Each advice-giver submitted their weight guess in percentage form, with some advisers spreading out their advice over multiple weight ranges. So, one advisor might have said that there was a 70% chance that the person’s weight was 170-179 pounds, a 15% chance that it was 160-169, and a 15% chance that it was 180-189. A more confident advisor, however, would have put all his eggs in one basket and said there was a 100% chance that the weight was within the 170-179 range.

Now here’s the really important part: in each round, before they chose their adviser, volunteers got to see each adviser’s percentage spread, but not the associated weight ranges. (See this really handy chart for more on the set-up.)

What did Moore find? Volunteers were more likely to buy advice from confident advisers (such as the 100% adviser from above) than those who spread out their percentages. What’s more, this tendency led advisors to make their advice more and more precise in subsequent rounds – but not more accurate.

These findings are troublesome. Because though confidence and accuracy sometimes go hand-in-hand, they don’t necessarily do so. And when we want confident advisors, some will exaggerate to give us what we want.  Maybe this is why so many pundits on TV for example exaggerate their certainty?