How you ask questions can have a profound impact on how your clients respond--and therefore how financial plans are implemented.
This month's article is the seventh in a series called "Behavioral Finance and Retirement," which is intended to provide insight to advisors on the unique needs and financial behaviors of clients who are entering that period of transition called "retirement."
I put retirement in quotation marks because people today are not retiring the way they used to. The days of the retirement party, the gold watch, and sitting out one's years doing crossword puzzles and watching "Wheel of Fortune" are over for most people.
We've all heard the analogy that the baby boomers are like a baseball going through a garden hose. Well, the baseball is getting to the end of the hose, and it's not leaving without a bang! And before it leaves, it will be a financial force to be reckoned with.
To serve retired clients properly, there are some key themes that advisors need to be aware of:
1. People are living longer than ever thanks in part to medical technology and better living habits such as diet and exercise. This is extending the length of time people are in a nonworking phase of life.
2. People's definition of retirement is changing, which is having a major impact on how individuals manage their finances.
3. In some cases, a certain segment of the population will have no choice but to produce some type of income after they leave the traditional workforce.
4. The responsibility of planning and investing for retirement has shifted in large part to the employee/retiree and away from corporations. As a result, behavioral biases significantly affect individuals who are entering or already in this phase of life.
In this article we are going to turn our attention to another, less-known bias that affects the retirement-planning process: framing.
Framing is quite relevant in the retirement realm. This is because people who are saving for retirement, as we noted last month, have self-control issues around saving behavior and can be swayed by how questions are asked.
As an advisor you should be keenly aware that how you present topics and ask questions can have a profound impact on how your clients respond--and therefore how financial plans are implemented.
Let's start by reviewing framing bias and then discuss the investment implications. Framing bias is the tendency of decision-makers to respond to various situations differently based on the context in which a choice is presented (or framed). This can happen in a number of ways, including how word problems are described, how data is presented in tables and charts, and how figures are illustrated.
Framing bias also encompasses a sub-categorical phenomenon known as "narrow framing," which occurs when people focus too restrictively on one or two aspects of a situation, excluding other crucial aspects and thus compromising their decision-making. For example, a consumer working within too narrow a frame of reference might shop for a lawnmower that is fast, while overlooking blade width, fuel economy, and other factors that affect the length of time required to mow a lawn.
In the realm of retirement savings, rational economic agents would never focus on one aspect, like return, while ignoring important considerations, like risk. But what happens in practice is that people tend to answer questions based on how questions are asked (framed).
A common example of this is in the retirement savings realm, specifically enrollment in retirement saving plans. Historically, employees were given an option of whether they would like to participate in a plan; this is also known as making a "positive election" to join, for example, a 401(k) plan. Today, some employers provide automatic enrollment, which involves not a voluntary election but rather the employee being enrolled directly into the 401(k) plan by the employer at a specified contribution rate. The employee retains the right to opt out of the plan at any time.
Changing the scenario from "do you want to participate?" to "you will participate unless you choose not to" results in higher participation. Academic duo Brigitte Madrian and Dennis Shea (2001) demonstrated that when employees are automatically enrolled in a savings plan, the results are dramatic. For example, at one company the plan participation rate increased from 37% to 86% for new hires after automatic enrollment was introduced. You can see how framing bias can have a significant impact on financial behavior!
The example just given is something called "nudge theory" in action. Nudge theory is mainly concerned with the design of choices, which influences the decisions people make. The point is to design questionnaires and other choices based on how people actually think (that is, potentially irrationally), rather than how companies or politicians believe people should think (that is, logically or rationally). Nudge theory was named and popularized by the book, "Nudge: Improving Decisions About Health, Wealth, and Happiness," by Richard H. Thaler and Cass R. Sunstein. The book is based on the Nobel prize-winning work of psychologists Daniel Kahneman and Amos Tversky, who were responsible for Prospect Theory. I would highly recommend this book as it helps to solve many of the issues caused by framing bias.
Putting It Into Practice
Financial markets don't just reflect financial realities. Investors' beliefs, perceptions, and desires exert a tremendous influence on most instruments and indexes. When investor and advisor expectations regarding portfolio performance are misaligned, the advisory relationship can deteriorate quickly.
As such, it's important that a practitioner accurately gauge a client's mind-set; this doesn't just mean listening carefully when the client answers important questions. Sometimes the formulation of the question itself also matters, because framing determines reference points and defines expectations.
Each investor has the right to express his or her personal financial objectives and should expect investment plans to be created relative to these desires. The advisor needs to ask the right questions and to make sure to understand the client's answers.
Assessing investor risk tolerance is a process wherein framing can be particularly influential; so practitioners and clients should make sure to carve out a precise, shared understanding of what constitutes risk and should decide exactly how much risk is tolerable.
Ultimately, question framing can and does determine appropriate information elicitation.