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The Difference Between Cognitive and Emotional Biases

There are broad implications for either kind of client.

Justin A. Reckers and Robert A. Simon, 08/19/2010

Our last article introduced concepts that help advisors determine whether their clients may have emotional biases related to financial decision-making or cognitive biases governed by their tolerance for risk and/or beliefs about money. We also discussed whether the person tends to take an active or a passive approach toward decision-making and provided a few examples of how these characteristics extend to financial decision-making. These are important distinctions, because the more an advisor understands the client's approach toward financial decision-making, the better an advisor can assist the client in a fashion that is consistent with the client's "mind" and in a manner that fosters a trusting relationship.

Let's look first at the broad implications of emotional biases versus cognitive biases. Clients who primarily manifest emotional biases will need their advisor to adapt to those biases and attempt to moderate their affects rather than try to remove them completely. Clients who primarily manifest cognitive biases will be helped more efficiently and effectively by the advisor's attempt to remove the bias.

Now, let's look at the continuum of active versus passive style and the implications for the advisor. Passive clients tend to be followers. They tend to take advice from friends and family without forming their own opinions. In divorce situations, these clients often make statements like "My friend said they got $2,000 a month in spousal support and I deserve the same". We call this the "Greek chorus effect." In ancient Greek plays, the chorus often served a dramatic purpose to provide background and summary information to help the audience follow a performance. In many of the plays the chorus was used to express hidden fears and secrets the main characters could not just say to the audience. The Greek theaters of the day were large and required exaggerated voices to ensure that all could hear. This led to the communications taking a larger and more noticeable effect on the audience. The impact of the communication to a passively oriented client may take on such great power that they will rely implicitly upon it for decision-making, whether they consciously realize it or not. The underlying bias may be emotional, cognitive or both.

As an example, an emotionally biased client with passive tendencies may have a status quo bias affecting their ability to make changes. The status quo bias is the tendency to prefer that things remain the same because the disadvantages of the change loom larger than the advantages. This is one of the most common biases encountered in divorce financial planning. This is an emotional roadblock that may be better moderated or removed through collaboration with a mental-health professional. These clients may have an aversion to even hearing the options available and become reclusive rather than facing the decision at hand. On the other hand, a cognitively biased client with passive tendencies is more likely to have an aversion to ambiguity bias. An aversion to ambiguity bias simply denotes the client's avoidance of options with missing information. The missing information makes the outcome of the decision seem unknown. The client will choose the option with a more certain outcome in order to avoid the ambiguity. This cognitive roadblock can be removed or moderated by brainstorming options and investigating the outcomes of each option through modeling and analysis.

Active clients are usually assertive and tend to be leaders. They are often the first in their family to create wealth and probably have entrepreneurial spirits or that stereotypical salesperson vibe. They make quick decisions on most items and like to be very hands on. In divorce situations, these clients may try to avoid seeking legal help. They believe that they can read about divorce and read some law and then do everything an attorney does. The success of books such as "The Complete Idiot's Guide to Divorce" is testimony to such active individuals. A recent American Bar Association survey of American judges showed that the majority believe their court-rooms are negatively affected by self-represented litigants. A full 62% believe that not having an attorney negatively impacted the outcomes for self-represented parties. The underlying bias for these active decision-makers may be emotional, cognitive or both. Whatever the underlying motivation is, the bias is affecting the client decision-making and has a heightened potential of leading to negative outcomes.

An emotionally biased client with active tendencies may have an overconfidence bias as depicted in the previous paragraph. Such individuals have a tendency to overestimate their own ability to analyze factors and the accuracy of their assessment of those factors. The emotionally biased active client is also the most likely type to exhibit excessive spending due to self-control bias that lends them to a tendency to consume today with no regard for tomorrow. The emotional element appears to be connected more directly with unfettered optimism that they can make it work. Advisors must stand their ground with these clients--they are likely to be the most challenging clients you will encounter.

A cognitively biased client with active tendencies may have a selective perception or confirmation bias. They search for or interpret information in a way that confirms their preconceptions or allows their expectations to affect their perception. We see this in divorce negotiations when spouses begin making settlement offers. One party will make an offer that is doomed from the first word because their spouse is unable to believe the offer could be good for them. The statement is usually "It cannot possibly be a good deal for me if my ex offered it because they are out for themselves." In reality, these offers are sometimes great and the inability to consider the option can have a negative effect on the ultimate outcome.

Next month we will delve further into how advisors can overcome behavioral finance biases looking closer at the intervention game plan. How and when do advisors decide to adapt to a clients biases or attempt to moderate or remove them? Does the client's wealth play a role?

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