Clients will go to great lengths to rationalize a past decision, even when a better solution is needed.
This month's article is the 16th 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 exploring another bias that affects the retirement-planning process: cognitive dissonance bias. When presented with information that conflicts with pre-existing beliefs, people often experience mental discomfort--a psychological phenomenon known as cognitive dissonance.
This is a belief perseverance bias, because humans tend to stick with ideas they already believe to be true. For example, a consumer might purchase a certain brand of mobile phone, initially believing that it is the best mobile phone available. However, when a new cognition that favors a substitute mobile phone is introduced--representing an imbalance--cognitive dissonance occurs in an attempt to relieve the discomfort that comes with the notion that perhaps the buyer did not purchase the right mobile phone.
Imagine Bill buys phone X because it has the exact specifications that he wants. He is very happy with his purchase. However, his friend Sally buys phone Y. She loves her purchase and proceeds to tell Bill why he should have bought a phone like hers, making a case that phone Y fits Bill's needs better than phone X. Bill spent time researching phones to make his decision. But Sally's idea that phone Y is better makes him feel mental discomfort. In fact, he will probably argue with Sally that phone X is better simply because he wants to convince himself that he made the right decision.
People will go to great lengths to convince themselves that a purchase or decision they have already made is better than an option they just learned about to avoid mental discomfort associated with their initial action. We pursue the belief that we are correct, when, in fact, we may not be.
Investment Implications for Retirement Planning
Let's consider a specific investment example of cognitive dissonance bias in the retirement context. Suppose you have a client who is 78 years old and insists on having a large percentage of his portfolio in safe tax-free bonds. "I need income so I should have a lot in safe municipal bonds," he says.
You try to convince him to take a "total return" approach to investing--one that involves owning not just bonds but stocks and other assets--a diversified portfolio. He has declined. Over the past 10 years of working with this client, you have noticed that his portfolio hasn't grown that much. Finally, he notices the same thing. Your moment has arrived! You present him with information that a diversified portfolio would have returned a much higher number than safe tax-free holdings. Unfortunately, he refuses to acknowledge the evidence and decides not to take action. This is classic cognitive dissonance in action.
The driving force behind most of the irrational behavior discussed is the tendency of individuals to adopt certain detrimental responses when cognitive dissonance occurs in an effort to alleviate their mental discomfort. Therefore, the first step in overcoming the negative effects of cognitive dissonance is to recognize and attempt to abandon such counterproductive coping techniques. People who can recognize this behavior in themselves become much better investors.
I have a three-pronged process for getting clients to acknowledge a belief perseverance bias like cognitive dissonance:
> First, acknowledge that you have a disciplined process in managing investment decisions. In this case, discuss the risk of outliving one's assets.
> Second, use facts to explain a more rational alternative to the decision. Don't make it personal (e.g., they made a bad decision, so they are at fault).
> Third, tell a story. Storytelling often reinforces learning. In this case you could tell the story of a person who outlived their assets and the detrimental effect it had on their family.
If you take this approach, investors will often heed your advice and take the appropriate action.