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Emotional Decision-Making Can Be Irrational

Is you client willing to pay $28 for a $20 bill?

Justin A. Reckers and Robert A. Simon, 06/17/2010

If we first learn to observe the situations when emotions become entangled in the otherwise rational economic models, we are able to observe how people depart from rational financial decision-making into emotional decision-making. Research shows that there are conditions under which an individual is willing and quite happy to pay $28 for a $20 bill at auction. Some have written about how we can apply Einstein's theory of relativity to human decision-making processes. The technology now exists to help us analyze the neurocognitive effect of receiving expert financial advice.

We believe that there are three distinct parts to the client mind that deserve attention. We call these elements emotions, risk tolerance, and thought processes. These parts become elements of every decision. Sometimes they even contradict one another. They are the building blocks to the financial decision-making process.

Understanding the three elements can help advisors assess what is taking place inside the client's emotional, social, and cognitive worlds. Knowing the right questions to ask and how to use the answers to these questions helps identify each of three elements' contributions to the overall decision-making process. Once the elements have been identified and isolated, the advisor can observe how the client is functioning with regard to each and make an informed decision about whether to adapt an economic decision-making model to the individual financial reality of their client or attempt to change how the client reaches financially related decisions

Research has proven that a majority of decisions are emotionally driven and made based upon emotional cues. In the $20 bill example referred to above, a group of people was asked to participate in an auction to purchase a $20 bill. The highest bidder won the right to take the $20 bill home and the second-highest bidder was required to pay the amount of their losing bid but go home with nothing. This paradigm apparently stimulated the fear of loss: The participants realized they might pay $21 for a $20 bill, and they kept bidding hoping to avoid the perceived loss. The winner paid $28 for a $20 bill and the losing participant paid $27 for nothing. The fear of loss led to the irrational decision a $20 bill was worth $28 because emotions were brought into play.

Emotions often cloud the expected outcomes dictated by economic models. Financial advisors need to ask important questions to prepare themselves as economic modeling is tossed out the window in real-life decisions. Thus, advisors know that it is important to ask questions to find out how the client feels about money. Do they consider it a tool, or means of power, self esteem or even control? Do they generally worry about money? How did their parents manage money? What narratives from this influence the client's current views and emotions about money? Are they frightened of their unknown financial future?

Discussions about risk tolerance can tell the advisor if the client is more likely to be passive or active when making financial decisions. Neuroeconomists have shown simple financial decision making tasks involving risk can be significantly affected by receiving expert financial advice. The researchers found that receiving expert advice may neurobiologically "offload" the responsibility for financial decision-making from the client to the advisor. In other words the client becomes a passive member of the decision-making process, relying upon advice from experts or knowledgeable friends and family, by offloading the burden of the decision. This is important, because a passive client will be predisposed to a different set of biases than an active client. Clients may also make decisions without actually considering the ramifications. A determination of passive or active is often the key in determining whether to attempt to alter a client's decision-making process or adapt to it. Emotional clients are often fueled by fear on the passive end of the spectrum and power on the active end of the spectrum. Understanding how clients arrived at where they are today in their lives, careers, and wealth will help to determine whether a client is likely to be passive or active. Here are a few questions to help start the conversation.

Is the client risk-averse or does he embrace risk, actively considering options? Is the client financially secure? Objectively? Subjectively? What kind of career has the client undertaken? Is it risky and competitive, or safe and comfortable? Has the client risked his own capital in the pursuit of greater wealth?

The flexibility of a client can be determined in various stages, but this is one of the first places in which we will encounter barriers in their thought processes. If the client is actively participating, takes responsibility for his action items, and demonstrates willingness to accept the change inherent in planning, the client probably has good analytical skills and demonstrates accurate and realistic thought processes. If the client has not committed to being an active participant, appears averse to minor changes and seems to subjectively judge one item relative to another, it is likely that the clients' thinking and decision-making is influenced by variables, such as emotions, that lead the decision-making process astray. Applying the theory of relativity to financial decisions may appear ambitious, but we can pick out four words and apply them easily to financial decisions. People often judge the quality of options "relative to one another." If the first option is not available or aspirational in the first place, other options will fail to measure up relatively and ultimately be cast aside.

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