Lack of short-term discipline can wreak havoc long-term goals.
This is the sixth article in the Behavioral Finance and Macroeconomics series. We will explore the effect that behavior has on markets and the economy as a whole, and how advisors who understand this relationship can work more effectively with their clients. (Access past articles here.)
In the last article, we discussed the details of a bias called framing. In this article, we will discuss self-control bias.
Simply put, self-control bias is an emotional human-behavioral tendency that causes people to fail to act in pursuit of their long-term overarching goals because of a lack of self-discipline in the short term. In the macro sense, this phenomenon can multiply across many individuals, and the results can be catastrophic.
Attitudes toward eating and dieting provide a simple example of self-control. We know, for example, that eating lots of carbohydrates is not a good tactic for weight loss. But when the large bowl of tortilla chips arrives at the table in the restaurant, it can be very difficult to muster self-control to resist the urge to eat them.
In the world of personal finance, self-control can take many forms, such as spending too high a percentage of income or, worse, taking on too much debt. In today's world, it is culturally acceptable to take on debt. And how did this happen?
For decades and centuries, there has been a powerful notion we call "keeping up with the Joneses." People make social comparisons, which results in the desire to possess what others have. When people have fewer financial assets with which to buy goods or services they see others possess, they borrow the money to get what they want. It's not uncommon to see a neighbor with a massive mortgage, a leased car, and high credit card bills. Feeding this craving are the myriad of companies that make vast amounts of credit available. People tend increase borrowing when credit is made possible.
The crash of 2008-2009 provides a clear example of massive borrowing gone wrong. In their book House of Debt, Princeton University professor Atif Mian and University of Chicago Booth School of Business professor Amir Sufi argued that the Great Recession was the result of a sharp falloff in consumption due to the unevenly accumulated household debt in the first six years of the 21st century. During that period, mortgage credit grew more than twice as fast in neighborhoods with low credit scores than in neighborhoods with high credit scores--a marked departure from the experience of previous decades. When the housing bubble popped, the economic consequences were sharply magnified by the way debt was distributed across households and communities. In essence, so much credit was available that people couldn't resist taking it on. And the result was one of the largest financial crises in history.
As we have seen, self-control bias can cause people to take on too much debt. This behavior can be hazardous to one's wealth, because leverage magnifies risk. There are two things you can do as an advisor when you encounter self-control bias behavior in your clients: discuss spending control and build a financial plan that includes limits on debt.
In addition, I find that showing Monte Carlo simulations to clients can be an effective method to illustrate both the risks of not saving and taking on too much debt.
Self-control bias can sabotage a client's financial plans. Advisors have an opportunity to step in and make a considerable difference in the lives of your clients if you can help solve this issue.
Michael M. Pompian, CFA, CAIA, CFP, is the chief investment officer of Sunpointe Investments, an investment advisor to ultra-affluent clients and family offices and is based in St. Louis. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients.