Behavioral Finance in Action

Psychological challenges in the financial advisor/client relationship,

and strategies to solve them

By Shlomo Benartzi, Ph.D.

Professor, UCLA Anderson School of Management,
Chief Behavioral Economist, Allianz Global Investors
Center for Behavioral Finance

Contents

Introduction: Behavioral FinanceTwo Minds at Work . . . . . . . . . . . . 3

Overcoming Investor Paralysis: Invest More Tomorrow . . . . . . . . . . . 8

Reining in Lack of Investor Discipline: The Ulysses Strategy . . . . . . 12

Regaining and Maintaining Trust: Competence + Empathy . . . . . . 16

In Development: Addressing the Disinclination to Save

The Behavioral Time Machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
 Preface

Behavioral Finance in Action (BeFi-in-Action) is designed to help

financial advisors better understand the psychology and emotions
underlying their clients decisions and to empower both the advisor
and the client to make better ones.

First, we discuss key concepts from the field of behavioral finance.

We then identify three specific challenges financial advisors face in
working with their clients and propose solutions from our behavioral
finance toolbox. We also present a fourth challenge whose solution
is still in development.

We have written this in a modular format, so that after reviewing

the introduction readers can take the rest of the document as a whole,
or select any of the following sections at will, according to their
specific interests.

As with all Center for Behavioral Finance initiatives, the goal of this
work is to translate academic theory into action. Its the beginning of
a long-term project to help financial advisors incorporate behavioral
finance insights and tools into their practice.

For financial professional use only. Not for use with the public. Behavioral Finance in Action 2
Introduction

Behavioral Finance: Two Minds at Work

Behavioral finance is an extension of behavioral economics, which uses psychological

insights to inform economic theory. When Daniel Kahneman was awarded the Nobel Prize
in economics in 2002 for his contribution to behavioral economics, he was only the second
psychologist to receive the economics prize. Part of Kahnemans insight that led to the prize
was his recognition of the important role of emotion and intuition in peoples decision
making, which in certain circumstances leads to systematic and predictable errors
(Kahneman, 2003).

Kahneman uses the framework of two minds to describe
the way people make decisions (Stanovich and West, 2000).
Each of us behaves as if we have an intuitive mind, which
forms rapid judgments with great ease and with no con-
scious input; knowing that a new acquaintance is going
to become a good friend on first meeting is one such
judgment. We often speak of intuitions as what comes
to mind.
Heres an illustration of what is meant by intuitive mind,
and how it sometimes leads one astray. Take a look at
Diagram 1 below. If you havent seen it before you will im-
mediately see that the bottom line is longer than the
top line.

We also have a reflective mind, which is slow, analytical Diagram 1:

and requires conscious effort. Financial advisors engage
this mind when they sit down with clients and calculate a
retirement framework based on their risk profile, current
circumstances and future goals.

Most decisions that people make are products of the intui-

tive mind, and they are usually accepted as valid by the
reflective mind, unless they are blatantly wrong (Klein and
Kahneman, 2009). Indeed, intuitive decisions are often
correct, some impressively so (Gladwell, 2006). However, it
is the errors of the intuitive mind, along with failures of the
reflective mind, that interest behavioral finance academ-
ics and have practical implications for how financial
advisors work with their clients.

For financial professional use only. Not for use with the public. Behavioral Finance in Action 3
Behavioral Finance: Two Minds at Work
Now take two small pieces of paper two Post-It Notes
will work and use them to cover the fins on the bottom
line. As those who are familiar with the diagram already
know, you will discover that the lines are in fact the
same length.
You are the victim of an optical illusion, the famous Mller-
Lyer illusion. The visual perception part of your mind is
tricked into seeing something that doesnt exist, in this
case because of the effect of the fins.
The remarkable thing about this and other optical illusions
is that even when you know the truth that the lines are
the same length you still see one as being longer than
the other. In the framework of the two minds, your reflec-
tive mind knows the lines are the same length, but your
intuitive mind sees them as being different. The output
of the intuitive mind is so powerful that it overrides any
attempt by the reflective mind to see the lines in any other
way. You cant help yourself. Intuitive judgments tend to be
held with greater confidence, too another factor making
them hard to override.
One of the insights that earned Kahneman the Nobel Prize1
is that we humans are sometimes as susceptible to cogni-
tive illusions as we are to optical illusions. These illusions,
also known as biases, result from the use of heuristics, or,
more simply, mental shortcuts. For instance, people are
supposed to make decisions based on the logic and
1 Kahneman did all the important work that underpins behavioral economics
with his colleague Amos Tversky, who had died before the Nobel Prize was
awarded. Nobel Prizes are never awarded posthumously.
For financial professional use only. Not for use with the public.
substance of transactions, not on how they are superfi-
cially described. When faced with a choice between
having cold cuts that are ninety percent fat free or con-
taining ten percent fat, people overwhelmingly select the
first option. Logically, the two are identical of course, but
people automatically respond negatively to containing
fat and positively to fat free, and choose accordingly.
This ubiquitous and powerful effect, the product of the
intuitive mind, is called framing (Tversky and
Kahneman, 1974).
We can see, then, that intuition is a powerful force. And
people typically place a great deal of faith in it. Kahnemans
discovery that under certain circumstances intuition can
systematically lead to incorrect decisions and judgments
changed psychologists understanding of decision making,
and, ultimately, economists, too.
Classical economics held that people are rational, self-
interested and have a firm grasp on self-control. Behavioral
economics (and common sense) showed instead that we
are not as logical as we might think, we do care about
others, and we are not as disciplined as we would like to be.
It is not that people are irrational in the colloquial sense,
but that by the nature of how our intuitive mind works we
are susceptible to mental shortcuts that lead to erroneous
decisions. Our intuitive mind delivers the products of these
mental shortcuts to us, and we accept them. Its hard to
help ourselves.
Behavioral Finance in Action 4
Behavioral Finance: Two Minds at Work
Loss Aversion Is Fundamental
At the core of many of these powerful but erroneous
intuitions is peoples hyper-negative response to potential
loss, or loss aversion, as described by Prospect Theory
(Kahneman and Tversky, 1979). Simply put, losses loom
larger than equal-sized gains. Psychologically speaking,
the pain of losing $100 is approximately twice as great as
the pleasure of winning the same amount. For this reason,
most people are prepared to enter a 50:50 gamble of losing
$100 on one hand, only if the sum to be won is at least $200.
Loss aversion is a fundamental part of being human, and
we are not alone in that. Yale economist M. Keith Chen did
some ingenious preference experiments with capuchin
monkeys in which they always finished up with one piece
of apple. They got there in different ways, however, which
affected the monkeys preferences. Sometimes the
monkeys started off with two pieces of apple, one of which
was taken away. At other times they started off with none,
and were given one piece. The monkeys strongly preferred
the second scenario, and disliked the first, where one piece
of apple was taken from them (Chen, 2006).
Psychologists speculate that loss aversion makes sense in
terms of evolution and survival: better to be cautious and
give that saber-toothed tiger a wide berth rather than take
the risk of confronting it by yourself. Whatever its origin,
loss aversion affects many of our decisions, including
financial ones.
For financial professional use only. Not for use with the public.
For instance, people have a tendency to hold on to losing
stocks too long. Selling a losing stock is extremely unpalat-
able because it brings the reality of loss very much to mind.
On the other hand, people often sell winning stocks too
soon because the act of selling a winning stock realizes
a gain, and that gives us pleasure. We feel pain when we
realize a loss and pleasure when we realize a gain. The
mistake people are making here is one of mental account-
ing: instead of looking at their portfolio as a whole they
look at each stock separately, and make decisions based on
these separately perceived realities.
Loss aversion also makes people reluctant to make
decisions for change because they focus on what they
could lose more than on what they might gain. This is
called inertia, or the status quo bias (Samuelson and
Zeckhauser, 1988).
Inertia is at play when people know they should be doing
certain things that are in their best interests (saving for
retirement, dieting to lose weight, or exercising), but find it
hard to do today. Procrastination and lack of self-control
rule the day. However, people are usually willing to say they
will do the right thing at some point in the future: Ill start
that exercise program next week, I promise!
We make intuitive judgments
all the time, but its very hard for
us to tell which ones are right and
which ones are wrong.
Nicholas Barberis,
Yale School of Management
Behavioral Finance in Action 5
Behavioral Finance: Two Minds at Work
We make intuitive judgments all the time, says Nicholas
Barberis,2 a behavioral finance researcher at the Yale
School of Management, but its very hard for us to tell
which ones are right and which ones are wrong. (See
Kahneman and Klein, 2009.) Behavioral finance research-
ers have identified many circumstances in which the
intuitive mind leads people to make money-related
mistakes. For this paper, we have worked with these
academic insights to develop techniques grounded in
behavioral finance that financial advisors can use to help
their clients discriminate between wise intuitions and
erroneous judgments.
SMarT: A Powerful Example
Richard Thaler of the University of Chicago and Shlomo
Benartzi of UCLA 3 used some of the above psychological
insights in one of the earliest, and most successful, ap-
plications of behavioral finance, the Save More Tomorrow
program (SMarT). The problem is widespread: An alarm-
ingly large proportion of employees fail to participate in
their companys defined contribution retirement plan,
often forgoing matching funds (free money) from employ-
ers. SMarT effectively removes psychological obstacles to
saving in the short and longer term, and helps people
overcome them with very little effort on their part. SMarT
was designed around the psychological principles of
2 Nicholas Barberis is a member of the Academic Advisory Board of the Allianz
Global Investors Center for Behavioral Finance. decisions which, ultimately, should lead to better
3 Shlomo Benartzi is the Chief Behavioral Economist for the Allianz
Global Investors Center for Behavioral Finance. Richard Thaler is a member
of the Centers Academic Advisory Board.
For financial professional use only. Not for use with the public.
inertia, loss aversion and immediate gratification and
will be described in detail in the following section,
Investor Paralysis.
In the first case study of SMarT, employees at a midsize
manufacturing company increased their contribution
to their retirement fund from 3.5 percent to 13.6 percent
of salary over a three-and-a-half-year period (Thaler and
Benartzi, 2004). This is a remarkable improvement in
saving behavior. As a result, the program is now offered by
more than half of the large employers in the United States,
and a variant of the program was incorporated in the
Pension Protection Act of 2006 (Hewitt, 2010).
The lesson of the experience
with the SMarT programis general
and powerful: the strategic application
of a few key psychological principles
can dramatically improve peoples
financial decisions.
Shlomo Benartzi,
UCLA Anderson School of Management
The lesson of the experience with the SMarT program,
therefore, is general and powerful, says Benartzi, the
strategic application of a few key psychological principles
can dramatically improve peoples financial decisions.
Financial advisors can take advantage of such insights
in their own practices to help their clients make better
financial outcomes.
Behavioral Finance in Action 6
Behavioral Finance: Two Minds at Work

The Path Ahead

In this paper, we present three timely decision challenges

and techniques from the behavioral toolbox to solve
them:
Investor paralysis
Lack of investor discipline
A crisis of trust

We also present a tool in development that is designed

to address a fourth decision challenge:
The disinclination to save.

These four challenges might seem diverse and unrelated at

first glance. But they are united by being, first, the product
of our intuitive minds; and, second, they are susceptible to
solution by the careful application of behavioral finance
tools based on a few simple, psychological principles.

BeFi-in-Action Framework

Two minds:

Intuitive mind Reflective mind

(fast, automatic, effortless): (slow, conscious, effortful):
Can often lead to wise decisions, Can lead to more thoughtful,
but sometimes leads rational decisions. Advisors can
systematically to irrational, engage their clients reflective
poor financial decisions. minds to improve outcomes by
correcting the mistakes of the
intuitive mind.

For financial professional use only. Not for use with the public. Behavioral Finance in Action 7
Overcoming Investor Paralysis:
Invest More Tomorrow

The psychological fallout of the financial crisis that erupted late in 2008 was profound.
As often happens in circumstances like these, investment paralysis has been ubiquitous.
Record amounts of cash are still sitting on the sidelines, with people alternating between
the fear that the bear market has not really gone away and the potential ignominy of missing
out on a new bull market. It is not just investors who are paralyzed. Financial advisors,
being human too, are weighing the risk of being wrong against the chance of being right.
And this sometimes leads to a kind of paralysis of their own.

What is the cure for this paralysis? University of Chicago
behavioral economist Richard Thaler prescribes this:
Devise a plan that you will actually be able to implement,
even when confronted with the inevitable distractions
and temptations.
The question, of course, is, What would such a plan look
like? Here we offer a solution based on the success of the
Save More Tomorrow (SMarT) program. SMarT is a
savings enhancement plan that utilizes an understanding
of the psychological obstacles people face when trying to
save more money. Some of the key psychological hurdles
here are also at play in preventing people from getting back
into the market. We therefore suggest a relatively simple
idea that draws on the principles of SMarT. Lets call it
Invest More Tomorrow.
Here we briefly describe SMarT to illustrate the psycho-
logical factors at play. We then present the Invest More
Tomorrow strategy, outlining the actions financial
advisors can take to implement it.
Save More Tomorrow
The SMarT program is designed to help people achieve
what they say they want to, by working around the psycho-
logical factors (indicated in italics) that stand in their way
(Thaler and Benartzi, 2004). There are four ingredients
to the program:
1. Employees are invited to pre-commit to increase their
saving rate in the future. Because of procrastination,
most people find it easier to imagine doing the right
things in the future, similar to our New Year resolutions
to start exercising and dieting next year.
2. For those employees who do enroll, their first increase
in savings coincides with a pay raise so that their take-
home pay does not go down. This avoids triggering the
minds hypersensitivity to loss, or loss aversion.
3. The contribution rate continues to increase automati-
cally with each successive pay raise until a previously
agreed upon ceiling is reached. Here, inertia is working
in peoples best interest, ensuring that people stay in
the plan and the contribution rate increases.

For financial professional use only. Not for use with the public. Behavioral Finance in Action 8
Overcoming Investor Paralysis
4. Employees may opt out of the plan at any time they
choose, though experience shows that people rarely do.
This provision makes them more comfortable about
joining in the first place.
SMarT has been a striking success, almost quadrupling the
average contribution rate from 3.5 to 13.6 percent of salary
over a three-year period when first applied in 1998. This
illustrates that having the right psychology applied
judiciously in a financial domain can dramatically
improve outcomes.
Invest More Tomorrow
There are sufficient important similarities between the
reluctance to enter the market and the inability to contrib-
ute adequately to defined contribution plans to make a
similar solution feasible. There are two parts to the Invest
More Tomorrow strategy: first, overcoming the fear of
seeing the value of the portfolio decline, or loss aversion;
and second, overcoming the strong tendency to put off
until tomorrow what one should be doing today, or
procrastination.
Overcoming loss aversion
By far the most important psychological factor in investor
paralysis is loss aversion. When people see the value of
their portfolio decline, their intuitive mind reacts nega-
tively, and they experience psychological pain. And, says
Thaler, people are even more averse to the prospect of
future losses when they have experienced loss in the recent
past, as most people did during the 2008 financial crisis.
For financial professional use only. Not for use with the public.
(See Thaler and Johnson, 1990.) Under these circumstanc-
es, people become much more reluctant than usual to take
risks. In other words, investor paralysis now.
How can this be overcome? By means of what we can call
fuzzy mental accounting. Prospect Theory, which recog-
nized the cogency of loss aversion, showed that in judging
gains and losses, people are exquisitely sensitive to what is
called the reference point (Kahneman and Tversky, 1979).
If an investor were to put all their cash into the market in
one single transaction, then that amount of money would
become the reference point. Any movement of the market
that increased or decreased the value of the investment,
above or below the reference point, would then be very
easily calculated. And the intuitive mind would respond
very negatively to losses.
People are even more averse
to the prospect of future losses
when they have experienced loss
in the recent past, as most people
did during the 2008 financial crisis.
Richard Thaler,
University of Chicago,
Graduate School of Business
If, however, a client were to invest a specific proportion of
his portfolio, say 25 percent, at regular intervals, such as
every three months, then there is no readily obvious refer-
ence point. There is no single figure against which to
measure performance. In which case, loss aversion is
much less likely to kick in.
Behavioral Finance in Action 9
Overcoming Investor Paralysis
Suppose the investments made in the first entry into the
market under this strategy were initially to lose value.
The client is likely to say, Oh, I only invested a small
portion of my cash, and now I see an opportunity to buy
cheap with my next purchase. The intuitive mind isnt
spooked, and the reflective mind can be engaged to
consciously turn a potentially aversive situation into
an opportunity.
This investment strategy is well known, of course, as dollar
cost averaging. But people have now seen that dollar cost
averaging cant protect against losses when the entire
market collapses, as it recently did. While they were more
willing to try it in the past they are afraid to do so now.
They may, however, be willing to contemplate doing it in
the future. Which brings us to procrastination, the second
barrier to breaking through investor paralysis.
Invest More Tomorrow
is a simple strategy that provides
an action framework that eases
anxiety for both clients and
financial advisors by attending
to the psychology underlying
investor paralysis.
John Payne,
Fuqua School of Business,
Duke University
For financial professional use only. Not for use with the public.
Overcoming procrastination
SMarT worked around procrastination by asking people
to commit to increasing their contribution rate many
months in advance. Pre-commitment is important,
because it is psychologically palatable, and is linked to
the desired action actually taking place rather than just
a vague promise.
In the same way, a financial advisor could ask his/her client
if he/she is willing to commit to going into the market at
some specific point in the future. If the answer is yes, then
the question becomes, OK, when do you think market con-
ditions will be favorable to take that initial step? This puts
the timing of the strategy in the hands of the client, rather
than having it imposed. As a result, the client feels both in
control and committed to the agreed-upon action. With a
specific answer to that question, the Invest More Tomorrow
strategy becomes an informal agreement between finan-
cial advisor and client.
Pre-commitment to begin investing at a specific point in
the future is the key psychological element here, because it
doesnt trigger the intuitive minds aversion to doing what
is right today. Procrastination is conquered, and the
periodic investment program begins.
Although the strategy as envisaged at present is not on
autopilot like SMarT (the agreed-upon purchases still
have to be made), pre-commitment engages the benefit
of inertia: it is not a question of whether to buy at that point
in time, but rather what to buy. The Invest More Tomorrow
strategy is a relatively simple overlay on the existing
investment plans financial advisors have worked out
with their clients. Its purpose is to overcome investor
paralysis so that those plans can go into effect rather
than remaining stalled.
Behavioral Finance in Action 10
Overcoming Investor Paralysis

Observes Duke University Business School professor John

Payne1: Invest More Tomorrow is a simple strategy that
provides an action framework that eases anxiety for both
clients and financial advisors by attending to the psychol-
ogy underlying investor paralysis.

Invest More Tomorrow

BeFi-in-Action:

1. Invite clients to pre-commit to begin

investing at a specific time in the
future and ask them to set the date
for that action.

2. Work with clients to agree on the size

and frequency of periodic investments.

3. Decide in advance on the nature of

assets to be purchased.

1 John Payne is a member of the Academic Advisory Board of the Allianz

Global Investors Center for Behavioral Finance.

For financial professional use only. Not for use with the public. Behavioral Finance in Action 11
Reining in Lack of Investor Discipline:
The Ulysses Strategy

In characteristically provocative manner, Warren Buffett had this advice for investors
in his 2004 Chairmans Letter: Investors should remember that excitement and expenses
are their enemies. And if they insist on trying to time their participation in equities, they
should try to be fearful when others are greedy and greedy only when others are fearful.

According to standard economic theory, people make in-
vestment decisions based on a rational analysis of the
present value and future prospects of equities. It is clear
from his advice to investors, however, that the Oracle of
Omaha recognizes that factors other than rational analysis
are sometimes at play.
Buffett understands from his years of experience that in-
vestors often buy high and sell low. They also often buy the
wrong stocks, sell the wrong stocks and, in normal times,
do far too much buying and selling. Academic insights
from Behavioral Finance help explain why people behave
the way they do, and they offer practical solutions to finan-
cial advisors to help their clients make better investment
decisions. The idea is that people are not being stupid,
they are just human.
Here, we introduce The Ulysses Strategy, which engages
the reflective mind for rational short- and long-term
investment strategies, thereby avoiding the errors that
the intuitive mind is otherwise prone to make.
More Than Just Fear and Greed
Financial advisors are well aware of the herd mentality of
humans, which sometimes leads individual investors to
buy high and sell low, by plunging into rising markets and
fleeing when markets fall (Bikhchandani et al., 1992; Gal-
braith, 1993). But there are other psychological issues at
play in the behavior of individual investors, beyond fear
and greed, impulses that flow from the intuitive mind.
Overconfidence is as strong an urge in humans as the herd
instinct. It leads people to believe they can outperform the
market, and seduces them to trade stocks at an irrationally
high rate. Its a costly path to follow. One study of 66,465
individual investors over a six-year period in the United
States found that the average investor turned over 75
percent of his/her portfolio each year. Transaction costs
associated with this excessive trading reduced net perfor-
mance by 3.7 percent compared with the market as a
whole. Investors who traded most (in the top quintile) did
even worse: these people turned over their portfolios more
than twice each year, and as a result suffered a 10.3 percent
reduction in net performance (Barber and Odean, 2000;
see also Daniel et al.,1998). This is the expenses trap that
Buffett mentioned in his letter.

For financial professional use only. Not for use with the public. Behavioral Finance in Action 12
Reining in Lack of Investor Discipline
A separate study of transactions in 19 major international
stock markets produced equally salutary warnings against
the urge to beat the market by too frequently buying and
selling securities. Between 1973 and 2004, the average
penalty for repeated buying and selling as opposed to a
buy-and-hold strategy in these markets was 1.5 percent
(Dichev, 2007).
Faced with thousands of possibilities, individual investors
are ill-equipped to make rational decisions about which
stocks to buy. Most people simply dont have the time or
expertise to find fairly valued stocks or under-valued
stocks. As a substitute for appropriate analysis, many
people unconsciously fall back on a simple rule of thumb,
or heuristic: What stocks are in the news? Buy them.
Stock markets often move
in response to many factors
unrelated to true value.
Shlomo Benartzi,
UCLA Anderson School of Management
Apparently, it matters not at all why a company happens to
be in the news the launch of a new product, large one-day
moves on the market (up or down), even a scandal involv-
ing the CEO these stocks are bought disproportionately
by individual investors (Barber and Odean, 2008). This is
the intuitive mind taking the easy way to making a choice,
one that, if fully engaged, the reflective mind might reject.
Inevitably, attention-driven buying pushes prices beyond
true value, and investors once again do less well than
they expect.
For financial professional use only. Not for use with the public.
The intuitive mind is at work in the very common mistakes
people make in selling stocks they already own. The
rational investor would sell losers and hold on to winners.
But this is not what individual investors commonly do:
They sell winners too early and losers too late. This error is
called the disposition effect.
This is how it works for investors. An individual who owns a
stock that has appreciated significantly faces a choice: hold
or sell. If they sell, they lock in a gain, and they feel good
about that. But by selling they forfeit any possibility of
further price appreciation and accept the certainty of
paying taxes on their profit. If a stock has lost value,
however, the investor faces the prospect of admitting a loss
if they sell, and that feels very bad. Loss aversion kicks in
and most investors choose instead to hold on to the stock.
They now face the possibility of further deterioration in
price, and the certainty of passing up tax advantages if
they were to sell, which is what they perhaps should do.
The disposition effect is the result of mental accounting.
The rational investor would be interested in the overall
return of their portfolio, and be content to say, You win
some, you lose some, but overall its doing well. Instead,
the typical investor treats the portfolio as a series of invest-
ing episodes. A winning stock offers the opportunity to
sell, and so lock in a gain, and the investor experiences the
pleasure of that gain. They sell. This is a positive investing
episode. A losing stock offers the prospect of incurring a
loss, and experiencing the pain that goes with it. They hold,
and in so doing avoid a negative investing episode
(Barberis and Xiong, 2010).
Behavioral Finance in Action 13
Reining in Lack of Investor Discipline
Stock markets often move in response to many factors
unrelated to true value. For instance, a commercial plane
crash in the United States that kills 75 people or more
typically causes the NYSE briefly to shed around $60 billion
in value. This reduction in market value contrasts with the
actual economic cost of such incidents (incurred by the
airline and insurance companies) of around $1 billion
(Kaplanski and Levy, 2010). In countries where soccer is a
major sport, a loss by the national team leads to a signifi-
cant decline in that countrys stock market (Edmans et al.,
2007). And weather gloom or shine has been found
variously to affect stock markets, too (Laughran and
Schultz, 2004; Hirshleifer and Shumway, 2003).
The evidence that investor
emotions are influencing prices of
securities is becoming overwhelming.
Kent Daniel,
Graduate School of Business,
Columbia University
Investor mood associated with irrational fear of plane
crashes or the ignominy of ones national team losing,
is apparently at work here. The resulting dark mood causes
investors to view future economic conditions more
pessimistically, so they favor selling rather than buying.
As you have seen here, and as Columbia School of Business
professor Kent Daniel1 observes, The evidence that
investor emotions are influencing prices of securities is
1 Kent Daniel is a member of the Academic Advisory Board of the Allianz
Global Investors Center for Behavioral Finance.
For financial professional use only. Not for use with the public.
becoming overwhelming. No less a figure than former
Fed chairman Alan Greenspan admitted as much while
appearing before the House Committee on Oversight and
Government Reform in October 2008. He said of the idea of
self-correcting markets: The whole intellectual edifice
collapsed in the summer last year. The challenge for be-
havioral finance is to find ways to help people not go with
the crowd, and not be susceptible to the errors of the intui-
tive mind. Here we offer such a solution.
The Ulysses Strategy
The phrase Ulysses contract refers to a decision made in
the present to bind oneself to a particular course of action
in the future. It derives from a strategy that Ulysses
adopted on his journey home from the Trojan wars,
which took him and his ships crew close to the Sirenusian
islands. The islands were famous for being home to the
Sirens, whose songs were so irresistibly seductive that
seamen felt impelled to fling themselves into the waters,
in an attempt to reach the Sirens. No seaman ever survived,
so no living human knew the nature of the Sirens songs.
Ulysses wanted to be the first human to hear the songs,
and survive. He instructed his crew to fill their ears with
beeswax, to block out the sound, and then tie him securely
to the mast and to ignore his pleas to be released, should
he do so. The plan worked. Ulysses heard the Sirens songs,
the crewmen ignored his entreaties to be untied and when
they were out of earshot, he gave a pre-arranged signal to
Behavioral Finance in Action 14
Reining in Lack of Investor Discipline
take out the ear plugs and release him. Ulysses had com-
mitted himself to a rational course of action at a neutral
time, that is before he could hear the Sirens songs, and
ensured that he stuck with his decision. This action of
pre-commitment is the work of the reflective mind.
In the same way, financial advisors could invite their
clients to engage their reflective mind to pre-commit to
a rational investment strategy in advance of movements
of the market that might otherwise trigger irrational re-
sponses of the intuitive mind. This kind of Ulysses Strategy
has been shown to work with the Save More Tomorrow
program (Thaler and Benartzi, 2004), in a pilot savings
product in the Philippines (Ashraf et al., 2006) and in a
program to help smokers quit, which involved participants
depositing a sum of money in an account that they would
forfeit if they relapsed (Gin et al., 2008). Pre-commitment
to a rational investment plan is important, because the
intuitive impulse to act otherwise is strong.
The first step in the process is to help your clients under-
stand the psychology of trading by individual investors
that can lead to poor decisions. Help them understand that
these misguided impulses of the intuitive mind are quite
natural, but that there is another, better path to follow, one
that is guided by the reflective mind.
The second step is to agree on an investment strategy,
which would include an acceptable balance between risky
and conservative instruments. As financial advisors, you
are already very familiar with this. What would be novel for
most advisors, however, is to commit to a specific contin-
gency plan. This is an agreement made in advance about
what action will be taken should a certain event or condi-
tion occur: for example, if the market goes up 25 percent or
if the market goes down 25 percent.
For financial professional use only. Not for use with the public.
The third component of the Ulysses Strategy is to formalize
these agreements in a commitment memorandum, to
which both the client and the financial advisor are parties
(see Appendix A for a sample memorandum). Although
research shows that financial professionals are less
affected by the impulses of the intuitive mind, they are not
completely immune to them (Barber and Odean, 2000).
And by being co-signatories to the memorandum, finan-
cial advisors put themselves on the same footing as their
clients. This memorandum is not binding, in the sense of a
legal contract. But the act of writing down the agreements
and putting ones signature to it helps people resist the
siren call of the intuitive mind. It helps clients stick with
the plan when changes in market conditions might tempt
them to go with the herd, and make unwise decisions. And
it helps financial advisors honor the agreement, too.
The Ulysses Strategy
BeFi-in-Action:
1. Help clients understand the sometimes
impulsive nature of investment decisions.
2. Discuss and agree upon what action
would be taken when, for example, the
markets move 25 percent up or down.
3. Draw up a commitment memorandum,
with both client and advisor as signatories.
(See sample memorandum page 26.)
Behavioral Finance in Action 15
Regaining and Maintaining Trust:
Competence + Empathy

Investor paralysis is just one important consequence of the recent financial crisis.
A second, related corollary is its impact on the bond of trust that exists between financial
advisors and their clients. The Nobel laureate economist Kenneth Arrow is often quoted
as saying, Virtually every commercial transaction has within itself an element of trust
(Arrow, 1972). This is especially true of the financial advisor/client relationship
(Guiso et al., 2008).

A July 2010 Gallup Poll ranks financial institutions 11th out
of 16 institutions in the United States in terms of public
trust. Only television news, Labor, Big Business, HMOs
and Congress score lower, in that order. According to the
Chicago Booth/Kellogg School Financial Trust Index, at the
beginning of 2009 only 34 percent of Americans expressed
trust in financial institutions.
Financial advisors are often tarred by the same brush and
many now face clients whose confidence in them has been
undermined.
The bruised psychological state of investors has been
likened to the feelings of betrayal following the discovery
of a partners affair. Just as in repairing such a relationship,
regaining trust with clients in the aftermath of the finan-
cial crisis requires humility, patience and hard work.
Regaining trust is a top priority for financial advisors, even
if their strategies did not lead directly to clients losses
(Gounaris and Prout, 2009).
1 Noah Goldstein is a member of the Academic Advisory Board of the Allianz
Global Investors Center for Behavioral Finance.
As financial advisors know very well, their client relation-
ships have two components: the technical and the
personal. Active demonstrations of professional compe-
tence and personal empathy have been identified as key
to building and maintaining trust, notes Noah Goldstein,1
of the UCLA Anderson School of Management (see Grling
et al., 2009). The following BeFi-in-Action strategies are
applicable not just to regaining trust in current circum-
stances, but also to maintaining trust in the ongoing
financial advisor/client relationship. Some of these
strategies might at first seem commonplace, but we
add a unique angle on them, often backed up by social
science research.
Active demonstrations of
professional competence and personal
empathy have been identified as key
to building and maintaining trust.
Noah Goldstein,
UCLA Anderson School of Management

For financial professional use only. Not for use with the public. Behavioral Finance in Action 16
Regaining and Maintaining Trust
Demonstrating Competence
Clients understand that financial advisors are profession-
als with a demonstrated level of competence. Nevertheless,
research shows that clients perception of their financial
advisors competence can, and should, be constantly bol-
stered in many ways. Some of these actions seem basic and
perhaps obvious, while others are even counterintuitive.
Many financial advisors know intuitively that acknowledg-
ing shortcomings engenders trust in their client. And
social science research shows this to be the correct thing
to do (Lee et al., 2004). Moreover, a 2010 Golin/Harris survey
revealed that the most effective action a company can
take to restore broken trust is to be open and honest.
The same holds true for individuals. Honesty resonates
strongly, and enhances trust. Less intuitively obvious is
that admitting luck has the same effect. We will start
with this suggested action.
Admit luck. When performance meets or exceeds expecta-
tions it is only human nature to want to take full credit.
However, according to social science research, it is unwise
to do so. Warren Buffett shows himself to be a student of
psychology in understanding this.
For financial professional use only. Not for use with the public.
In Berkshire Hathaway Inc.s annual report for 2006, Buffett
said the following: all that said, a confession about our
2006 gain is in order. Our most important business, insur-
ance, benefited from a large dose of luck. Mother Nature,
bless her heart, went on vacation. After hammering us with
hurricanes in 2004 and 2005 she just vanished. Last year
the red ink from this activity turned black, very black.
Why would Buffett do that, rather than claim all the credit
for himself? Just as admitting shortcomings triggers a
willingness to trust by the intuitive mind, so too does
admitting that luck has played a part in a favorable
outcome (Williams et al., 1993). In Buffetts case, he went
on to claim credit for the successes in the rest of Berkshire
Hathaways portfolio. No doubt the shareholders were
nodding in agreement.
Talk about the downside before presenting the upside.
As we all know, nothing is perfect in this world, except
perhaps Moms apple pie. In the world of financial products
and strategies, however, potential pluses (high returns)
usually come with potential minuses (high risk). Of course,
financial advisors already understand the necessity of
offering a balanced presentation of benefits and risks.
Research, however, shows that the sequence in which the
Behavioral Finance in Action 17
Regaining and Maintaining Trust
downside and upside are presented is crucial to how the
whole is perceived. In this case, clients will be more
trusting of positive claims about a product or service if the
positive claims are preceded by one or two negative claims.
These are known to social scientists as two-sided
messages (Bohner et al., 2003). By talking about the
downside first, the financial advisor is displaying honesty
that elicits a greater willingness in the listener to trust
what is then said about the upside.
Note that this does not mean that the very first thing you say
about the product needs to be negative. Ideally, you could
mention one positive argument for the product, followed by
a potential downside, followed immediately by the strongest
argument for the product. The reason for this narrative struc-
ture is that social science research shows that people are
more likely to remember the first and last things you say
about something (Atkinson and Shiffrin, 1968).
Display evidence of competence. Heres a story of a physicians
practice that struggled with the common problem of patient
non-compliance with exercise therapy designed to speed
recuperation. No amount of explaining to patients the impor-
tance of the exercises made for a significant improvement in
compliance. The physicians assistants engaged a consultant
to find a solution. On visiting the practices offices, the con-
sultant noticed that there were no professional credentials to
be seen. The consultant advised the physicians assistants to
prominently display all relevant certificates and diplomas.
Patient compliance immediately leapt by more than 20
percent (Goldstein, 2011).
For financial professional use only. Not for use with the public.
This dramatically improved outcome is hardly rational.
If asked, the patients would have surely acknowledged that
they knew the physicians assistants would not be able to
practice without the required certification. Yet when these
credentials were clearly visible, patients compliance soared.
From a psychological perspective, this improved outcome
was not a matter of patients reflective minds thinking,
Hm, look at all those diplomas. These people must really
know what they are doing. I had better do as they tell me.
Rather, making evidence of competence salient in the profes-
sional environment triggered an unconscious response in
the intuitive mind, in this case in a positive direction.
If you dont do so already, know that displaying professional
credentials is not a sin of ostentation. Rather, it helps your
clients more readily see who you are, professionally, and what
you have achieved.
Exhibiting Empathy
Most financial advisors know very well that there is more to
the advisor/client relationship than just shaping an invest-
ment portfolio: there is the human side of the relationship,
too. Those financial advisors who place great value on this
aspect of their interaction with clients should know that
their intuition to do so is strongly supported by research.
This research shows that paying genuine attention to the
human element in business transactions improves all
bottom-line measures (Pfeffer, 1998). Putting value on the
human side of business has been described as relational
intelligence (Saccone, 2009).
Behavioral Finance in Action 18
Regaining and Maintaining Trust

In the context of regaining and maintaining trust, there- Have frequent contact with clients, especially in difficult
fore, exhibiting empathy with a client is not just being times. As we all know, maintaining relationships requires
nice: it is good business practice. And most financial frequent interactions. When those contacts are made are,
advisors know that exhibiting individualized care to their however, even more important. Financial advisors find
clients is an integral part of the way they need to work, talking with clients during prosperous times to be easy,
in order to serve their clients most effectively. Here are and even rewarding, notes Goldstein. But clients need
a few actions around exhibiting empathy that may be contact with their financial advisors most urgently during
less obvious. difficult economic times, when they are facing uncertainty
and worry. These difficult times offer an opportunity to
strengthen the relationship. Good financial advisors push
aside the inclination to avoid contact at these times, and
Financial advisors find call their clients more frequently than before, thus provid-
ing emotional support. They are regarded not only as
talking with clients during competent, but also as trustworthy. Their example is
prosperous times to be easy, worth emulating.
and even rewarding. But clients
Allay embarrassment. Have you ever asked a client, Is
need contact with their financial there anything about our strategy you dont understand?
advisors most urgently during It is a perfectly valid, and very professional, question
difficult economic times, when because it comes from a desire to ensure that the financial
advisor/client relationship is on a sound footing. After all,
they are facing uncertainty no financial advisor wants a client to be going along with
and worry. a strategy that he/she doesnt fully grasp. However, the
Noah Goldstein,
wording of the question might not elicit the truth. Many
UCLA Anderson School of Management people dont like to admit ignorance. A client might not
understand everything, but will nevertheless answer,
No, there isnt, rather than face that embarrassment.
A slightly different wording of the same question, such
as Is there anything about our strategy that I can clarify?
allows the client to admit ignorance without it being so
labeled. The same goal is achieved.

For financial professional use only. Not for use with the public. Behavioral Finance in Action 19
Regaining and Maintaining Trust

Seek feedback. Seeking feedback from clients is a standard
part of the financial advisor/client relationship. But, once
again, this is especially important in challenging
economic times. A financial advisor might therefore ask,
Is there anything I can do to improve my service to you in
this difficult climate? This is a win-win question, for
several reasons. To begin with, the financial advisor is
showing concern to be doing better for his/her client. If the
answer is Yes, then an opportunity has been opened to
improve the professional relationship. If the answer is No,
then the financial advisor can be content with what he/she
is offering. At the same time, something psychologically
quite interesting happens in the clients mind.
By publicly stating that the financial advisor is providing
excellent service, that notion is reinforced in the clients
mind, as described by the theory of self-perception. This
theory says that peoples attitudes and beliefs may be
shaped by observing their actions (in this case, by making
a particular statement). The theory is counterintuitive,
because it would seem more natural if actions were shaped
by beliefs (Bem, 1972).

Regaining and Maintaining Trust

BeFi-in-Action:

Competence Empathy

1. Admit luck. 1. Have frequent contact

with clients, especially
2. Precede the greatest in difficult times.
upside of a product with
a potential downside. 2. Allay embarrassment.

3. Display evidence 3. Seek feedback, especially

of competence. in difficult times.

For financial professional use only. Not for use with the public. Behavioral Finance in Action 20
In Development:
Addressing the Disinclination to Save
The Behavioral Time Machine

Many people were caught off guard in the recent financial crisis as they watched with alarm
the value of their 401(k) accounts plummet, the price of their house decline and their job
security threatened or even lost entirely. Most people imagined these three pillars of future
financial stability to be separate: if one pillar started to crumble, the other two would
compensate. The fact that under a confluence of certain financial circumstances their fates
might be closely correlated was a timely reminder of the interconnectedness of things in
our financial worlds. It also exposed a chronic problem: inadequate savings, not just for
retirement but also for a source of stability in blustery financial climates in the future.

As financial advisors know, people find the task of saving
adequately to be very challenging. Standard economic
theory of saving assumes that people will be able to grasp
how much they need to save, for retirement and for other
contingencies; and then have the self-control to forgo
current rewards in favor of later benefits.
Even those people who can do the math (it isnt easy) often
find their best intentions derailed by the lure of immediate
gratification leading to poor financial decisions that the
mind, if given time to reflect, would reject.
It may be difficult to focus on the benefits of financial
rewards that will be available at retirement, because the
present self may be psychologically disconnected from the
distant future self. With extreme psychological discon-
nection, says Hal Ersner-Hershfield, of the Kellogg School
of Management, Northwestern University, saving for re-
tirement may feel to the present self like giving money to a
stranger years in the future. That is a strong disincentive
to saving now.
The Behavioral Time Machine currently under develop-
ment offers the prospect of a simple tool that effectively
reduces the gap between present and future selves. It will
assist peoples imagination to understand the impact of
present decisions on the future self, thereby enhancing
peoples willingness to save now (Ersner-Hershfield et al.,
in press).

For financial professional use only. Not for use with the public. Behavioral Finance in Action 21
Addressing the Disinclination to Save
Two Selves
The notion of a disconnection between present and future
selves has fascinated philosophers since the time of Plato.
Many young people view their older selves heading into
retirement as strangers. The British philosopher Derek
Parfit famously described this lack of comprehension of
future selves as a failure of imagination, or some false
belief (Parfit, 1971). It is a failure to identify with oneself in
the future.
This unconscious assumption of a different self in the
future is demonstrated graphically by brain scans. Re-
searchers at Northwestern University and elsewhere find
that when people think about their future selves, the same
brain region lights up as when they think about strangers.
This neurological response to thinking about future selves
is stronger in some people than in others. And those in
whom the brain region is activated most when looking at
future selves also show the steepest discounting of the
future (Ersner-Hershfield et al., 2009). The degree of psy-
chological disconnection is reflected in an unwillingness
to save.
To a failure of imagination we might add many young
peoples seeming sense of immortality, or denial that one
day they, too, will be old.
In any case, the disconnection between present and future
selves is well recognized, and it correlates with a reluc-
tance to save. The question is, can the psychological gap
between the two selves be closed, and would this affect
willingness to save?
For financial professional use only. Not for use with the public.
Having people imagine their future selves in a substantive
way is very challenging, for several reasons. For a start, it is
not something people ordinarily do, and so it is a foreign
exercise for them. And for anyone, imagining themselves at
the age of retirement conjures up many possibilities, with
different contingencies (losing ones hair, winning the
lottery, moving to another town or country, having a
facelift), which leads to multiple different outcomes. Under
this spate of different potential future selves, people find it
very hard to bring a single future self into focus.
The Behavioral Time Machine will provide a means of
creating a single, salient future self to which the intuitive
self reacts strongly. The reflective mind endorses that
reaction, and makes rational decisions about saving.
Enter Virtual Worlds
When people are confronted with vivid visual images of
themselves that have been digitally aged, they take notice.
Hal Ersner-Hershfield and six colleagues performed such
an experiment on young volunteers, using age-progression
software in a virtual reality environment. These algo-
rithms use a framework of key facial features to build an
image of what that person will look like in, say, thirty years
time. Some of the comments on seeing age-rendered
future selves included: Wow, I look just like Grandma,
Oooh, I dont know if I want to see this and Whoa, this
is freaky (Ersner-Hershfield, 2011). But more pertinently,
the volunteers in the experiment who see their future
selves more than double the amount of money they say
they would allocate to retirement savings.
Behavioral Finance in Action 22
Addressing the Disinclination to Save
This was not a simple priming effect. When the volunteers
see similarly age-processed images of other people, it does
not affect their allocation to savings. Only when they see
images of their own future selves do they do the right thing
with savings.
Seeing our future selves boosts savings
Seeing a happy future self further boosts savings
(Ersner-Hershfield and Goldstein, in progress)
For financial professional use only. Not for use with the public.
These experimental results are the first demonstration of
a new kind of intervention that shifts participants willing-
ness to forgo present rewards in favor of future benefits.
The age-progression exercise helps people recognize that
the future self is indeed the same person as the present
self. It repairs the disconnection
between the two selves and leads to
far-sighted decisions that take care
of the future self by making adequate
contributions to a retirement plan.
In other words, says Daniel Goldstein,1
a professor at London Business School,
The Behavioral Time Machine helps
people to imagine their future selves
by presenting them with a striking
visual image of that self.
In a second study these same experi-
menters added an emotional dimen-
sion to the future selves. They first
took three photographs of each
participant, one with a very happy
expression, another with a very sad
expression and a third one with a
neutral face. These three images were
then digitally processed to form a
series of about a dozen expressions in
a future self-image, progressing from
very happy to very sad. The experi-
menters then linked this sliding
emotional scale to a sliding financial
scale, going from minimal allocation
of savings for retirement on the left to
optimal allocation on the right.
1 Daniel Goldstein is a member of the Academic Advisory Board of the Allianz
Global Investors Center for Behavioral Finance.
Behavioral Finance in Action 23
Addressing the Disinclination to Save
Participants could then see the emotional reaction of their
future selves to different rates of saving for retirement by
the present self: pushing the slider toward the left (low
allocation) end of the scale evokes an ever sadder future
face; when participants move the slider toward the right
(high allocation) end of the scale, the smile on their future
selves faces gets ever broader.
The results of the procedure are clear-cut: Participants
who see these emotional reactions in their future selves
allocate significantly more to saving for retirement as
compared with others who encounter only happy or sad
images of their present selves.
The Behavioral Time Machine
helps people to imagine their future
selves, by presenting them with a
striking visual image of that self.
Daniel Goldstein,
London School of Business
For financial professional use only. Not for use with the public.
The virtual reality environment that these experimenters
used in their laboratory studies is very high tech and
sophisticated. Ersner-Hershfield and one of his colleagues,
Daniel Goldstein, are working with Allianz Global Investors
to scale down the technology to a level that would be
practicable for financial advisors to use with their clients.
This is the Behavioral Time Machine currently under
development.2
The Behavioral Time Machine will be complementary to
other savings-enhancement strategies, which focus on
present and future rewards rather than present and future
selves. One of these is Save More Tomorrow, which
effectively reduces the lure of the present (Thaler and
Benartzi, 2004). Another strategy is to heighten peoples
awareness of the benefits of future uses of money: trips
to Europe, for instance, or spoiling the grandchildren.
Research shows that this second strategy increases
peoples patience, and enhances their willingness to save
more now (Bartels and Rips, 2010). Financial advisors
might use the Behavioral Time Machine on its own, or
in combination with one of these strategies.
2 The Behavioral Time Machine tool is projected to become available
in the fall of 2011.
Behavioral Finance in Action 24
 Postscript

This work presents potential solutions to some of the key challenges

that financial advisors are facing with their clients. As the title of the
paper implies, its goal is to transform academic theory into action
by financial advisors.

This venture is, in a sense, a work in progress. Our goal is to build on

what we have begun, to improve and expand upon the contents of
the behavioral finance toolbox. We can do this most effectively in
partnership with you. We therefore invite you to give us your feedback,
based on your initial reading of the paper and, when appropriate,
on your experience in implementing the proposed solutions.

To do so, please email contactus@AllianzBeFi.com.

For financial professional use only. Not for use with the public. Behavioral Finance in Action 25
Appendix A

Sample Commitment Memorandum

A commitment memorandum drawn up between

a financial advisor and his/her client can help the
client avoid making unwise investment decisions.
A sample memorandum might read something
like this:

For financial professional use only. Not for use with the public. Behavioral Finance in Action 26
Acknowledgements
We would like to thank the following experts in behavioral finance for
their input to the intellectual content of this white paper. Each of them is
a member of the Academic Advisory Board of the Allianz Global Investors
Center for Behavioral Finance.

Richard H. Thaler Daniel G. Goldstein

The University of Chicago Yahoo Research, Research Scientist
Booth School of Business London Business School,
Ralph and Dorothy Keller Assistant Professor of Marketing
Distinguished Service Professor of http://www.dangoldstein.com/
Behavioral Science and Economics http://www.london.edu/facultyandresearch/
http://www.chicagobooth.edu/faculty/bio. faculty/search. do?uid=dgoldstein
aspx?person_id=12825835520

Nicholas Barberis Noah Goldstein

Yale School of Management UCLA Anderson School of Management
Stephen & Camille Schramm Assistant Professor of Human Resources
Professor of Finance and Organizational Behavior
http://www.som.yale.edu/faculty/ncb25/ http://www.anderson.ucla.edu/x20524.xml

Kent Daniel John Payne

Graduate School of Business, Duke University, The Fuqua School
Columbia University of Business, Joseph J. Ruvane, Jr.
Professor of Finance Professor of Business Administration
http://www.columbia.edu/~kd2371/ Director, Center for Decision Studies,
Fuqua School of Business
http://faculty.fuqua.duke.edu/~jpayne/bio/

We would also like to thank the financial advisors who provided feedback on this white paper.
And we welcome further comments from our readers. Email us at contactus@AllianzBeFi.com.

For financial professional use only. Not for use with the public. Behavioral Finance in Action 27
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In Development:
Addressing the Disinclination to Save

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