It’s no surprise that people often struggle to act responsibly, even when they know better. They charge too much on their credit cards, eat ice cream for breakfast and skip the gym. Many of these self-control issues are driven by present bias, which is the tendency to make choices that are distorted by the prospect of an immediate reward. Here are two sample questions from a behavioral test capable of measuring an individual’s level of present bias:
Question 1: You just learned that you are due a tax refund. If you’d like, you can get the $1,000 refund right away. Alternatively, you can get a $1,100 refund in 10 months. Which do you prefer?
Question 2: You just learned that you are due a tax refund. If you’d like, you can get a $1,000 refund in 18 months. Alternatively, you can get a $1,100 refund in 28 months? Which do you prefer?
The two questions are nearly identical. However, the second question postpones the two options by 18 months, while the first offers an option for an immediate reward. Someone at low risk of present bias should answer both questions the same way: choosing the early option both times, or the delayed option both times. In contrast, those at high risk of present bias choose inconsistently. They will take the larger tax refund if both refunds require a delay, as in the second question. But they choose to accept the smaller amount when it is available immediately, as it is in the first question. For these people, the prospect of getting an immediate reward is simply too difficult to resist.
Present bias can shape many of our most important financial decisions. Just look at the timing of retirement. Research has shown that the extent of present bias predicts an individual’s risk of retiring too early and regretting that decision. Fortunately, investors and professionals can use this present bias test to minimize the risk of future regret. While early retirement might be tempting, it is important to understand the dangers of retiring too early and regretting it, whether it’s because investors haven’t saved enough or because they’ll get bored playing golf. In addition, investors high in present bias can be encouraged to save at a slightly higher rate during their working years. That way, if these investors are tempted to retire early, they will at least have sufficient resources. One of the jobs of a financial planner is to help clients avoid major financial mistakes. The best way to do that is to anticipate their future regrets and make sure they never happen.
NARROW FRAMING TEST
Many of the financial mistakes people make are caused by a fundamental shortcoming: They can’t see the big picture. In behavioral economics, this is known as “narrow framing.” When it comes to asset allocation, narrow framing means that many investors will make investment decisions without considering the context of their overall portfolios or relevant time horizons. This test measures whether or not investors display an inconsistency in responding to a series of monetary outcomes when they are framed narrowly or broadly. Those who display the inconsistency are at higher risk of narrow framing, which can lead to serious investing mistakes, especially when it comes to the assessment of risk. Here’s a sample mistake caused by narrow framing: Some investors tend to myopically focus on short-term losses. Instead of considering how an investment fits with their long-term goals (for example, a comfortable retirement), investors get scared by the daily swings of the market. As a result, they opt for an excessively conservative portfolio or keep too much of their assets in cash. In this case, a financial planner can tailor the communication strategy to highlight an investor’s long-term returns and the minimal impact of short-term fluctuations.
In other cases, narrow framing can lead people to take on too much risk. This is typically because they don’t realize they have similar investment risks in different investment accounts. One solution to this problem is to encourage account aggregation. The problem with having multiple accounts at different firms is that it can make it harder for investors to think holistically about their finances and properly assess their overall risk exposure. By engaging investors with the narrow framing test, financial planners can help them understand the benefits of having a single view of all of their accounts. If investors or professionals want to truly understand their financial reality, then it needs to be easy for them to see the big picture.
If you don’t have a good plan in place, it may be time just to give you a little more confidence and conviction so you too can avoid some of these common issues investors face. As always, we appreciate our relationship with you, and we are here to help.