in Life Health Pro writes about some of the cognitive errors that lead to bad financial decisions. It looks like a 2-part series, so look for more of her at the above link.

1: Loyalty to an Underperforming Financial Advisor

This is an investment mistake that I have mentioned in the past – Status Quo Bias. Kerry provides the following study that illustrates the potency of this error:

William Samuelson of Boston University showed clients three investment options: one stock with a 50 percent chance of staying the same, another stock with 40 percent of staying the same, a U.S. treasury with a 9 percent return and a municipal bond with a 6 percent tax-free return. Which to choose?

Forty-seven percent of those who were told they already owned an investment stuck with the investment they already had. This study showed that people are inclined to stay with what they have no matter how bad the performance. This also explains why some seniors will stay with a bad advisor.

2:  Reluctance to Reallocate After Losses

Rational individuals who realize that they have made an investment that is costing them money would dump the investment for a better one, right?  Actually, no. There is a documented tendency to stubbornly hold on to the bad investment because “I’ve put so much into this that I can’t just give up on it so easily.”

So people tend to throw good money after bad, like gamblers on a losing streak. It’s a form of denial, driven by the pain of loss. This is the “Sunk Cost Fallacy.” The You Are Not So Smart Blog offers some illustrations:

Have you ever gone to see a movie only to realize within 15 minutes or so you are watching one of the worst films ever made, but you sat through it anyway? You didn’t want to waste the money, so you slid back in your chair and suffered.

Maybe you once bought non-refundable tickets to a concert, and when the night arrived you felt sick, or tired, or hung over. Perhaps something more appealing was happening at the same time. You still went, even though you didn’t want to, in order to justify spending money you knew you could never get back.

What about that time you made it back home with a bag of tacos, and after the first bite you suspected they might have been filled with salsa-infused dog food, but you ate them anyway not wanting to waste both money and food?

If you’ve experienced a version of any of these, congratulations, you fell victim to the sunk cost fallacy.

Sunk costs are payments, investments or costs that can never be recovered. A rational thinker would understand that sunk costs can’t be recovered by seeing a thing through to the end, and would not take sunk costs into account in making a decision. The rational investor would cut their losses and move on. However, since loss aversion is one of the strongest human drives,  many people stubbornly go down with the ship rather than face up to the fact of loss.

Studies Show The Power of Emotion Over Reason

The Bad Ski Trip Test: An experiment conducted by Hal Arkes and Catehrine Blumer  in 1985 demonstrates the power of this illogic. They asked subjects to assume they had spent $100 on a ticket for a ski trip in Michigan, but soon after found a better ski trip in Wisconsin for $50 and bought a ticket for this trip too. They were asked the following question: If the two trips overlapped and the tickets couldn’t be refunded or resold, which trip would you choose, the $100 good vacation, or the $50 great one?

The result: over half of the subjects chose the more expensive trip – obviously not because it  promised to be more fun, but because the loss seemed greater.

The sunk cost fallacy prevented the subjects from recognizing that the best choice is to do whatever promises the better experience in the future, not the choice that negates the feeling of loss in the past.

The Lost Ticket Test: Kahneman and Tversky also conducted an experiment that also demonstrates the power of the sunk cost fallacy. They asked subjects how they would respond to 2 hypothetical scenarios:

Scenario 1: Imagine you go see a movie with a $10 ticket price. When you open your wallet, you realize that you’ve lost a $10 bill. Would you still buy a ticket?

  • The result: only 12% of subjects said they would not buy another ticket. An 84% majority would buy another ticket and see the show.

Scenario 2: Now, imagine you go to see the movie, pay $10 for the ticket, but just as you are entering the theater, you realize you’ve lost the ticket. Would you go back and buy another ticket?

  • The result: 54% said they would not buy another ticket. Only 46% would buy another ticket and see the show.

The 2 hypothetical scenarios yielded different responses, and yet, the loss was identical in each case – ie. you lose $10 and then consider paying another $10 to see the movie. Yet, somehow, the second scenario feels different. Because it seems more as if the money was allocated to a specific purpose, the loss is felt so much more.

Regardless of the differing outcomes of the two tests shown above, the results in each case illustrate that logic doesn’t always prevail over emotion in decisions in which people feel they have a vested interest. Because people do not always make rational decisions, it is that much more important to frame their choices in ways that can help guide them to make decisions that are in their best interests.

How Widespread Are Poor Decisions?

A variation of the scenarios given above will serve to illustrate just how pervasive these kinds of irrational decision making are today:

The Great American Gun Control Bugaboo: Statistics conclusively show that the more readily available guns are, the less safe people are. Yet, people cling to the notion that they need these guns to protect them from armed perpetrators, and even from the overreach of the government.  In fact, the opposite is true: guns make us less safe. It can clearly be seen that those states and nations where guns are less plentiful have significantly lower rates of gun violence.

This, too, is partly a form of the sunk cost scenario – people have invested so much emotional commitment to an idea that no amount of proof to the contrary can easily sway them. The loss here is not economic so much as the giving up of a cherished notion.

Beyond Persuasion: Choice Architecture

Financial planners know that no amount of logic can persuade a prospect to make the more logical financial decision when that prospect’s mind is set on something else.

And insurance agents know all too well that some prospects simply won’t purchase a much needed life insurance policy because the fear of the loss of the cash (even if they can afford the premium) is too great.  The hard reality that these people will eventually face is the fact that death is a 100% certainty, and it creates financial hardship for one’s beneficiaries. Ironically, clinging to the percentage of income that would have purchased a life insurance policy results in a much greater loss when that income is lost.

For marketers and sales professionals, it is imperative that the presentation be framed in such a way that it is easier for the client to make a more rational decision.  The challenge marketers face is to reframe the decision process to influence the consumer to make the choices that are in their best interests.  Market testing can verify that an approach can be more effective in guiding consumer decisions. Marketers need to combine a strong sense of fiduciary responsibility for the customer with the principles of behavioral economics to overcome cognitive biases that lead people to make the wrong financial decisions.