Below are terms and theories often referenced when discussing behavioral decision making. In a nutshell, behavioral decision making marries psychology and economics. It studies how people will consistently make irrational decisions, causing them to take actions that do not benefit themselves.
The terms below have been adapted from The Science Behind the MORE Design, by Steve Vernon, FSA, and Elizabeth Borges at the Stanford Center on Longevity.
This is how your decisions are influenced by the initial emotional reaction you have to a term or idea. For example, people often have a strong association to terms like
retirement, annuity or
When presented with a number, people use that number as an anchor when making a decision and do not adjust their decisions appropriately. For example, when a person decides how much to contribute to his or her defined contribution (DC) plan, the default contribution serves as the anchor. What a friend chooses as a retirement age can also serve as an anchor.
When there are too many options, it can paralyze decisionmaking ability. When given too many options in an investment portfolio or a prescription drug plan, participants are more likely to choose the default option.
Individuals will seek out information that confirms, rather than challenges, their existing beliefs. If people have a preconceived notion that they are well prepared for retirement, they won’t notice warning signs.
CONSUMERISM AND CREDIT CARD EFFECT
We live in a culture that equates happiness and success with material goods. This makes the idea of saving difficult, and it perpetuates a reliance on credit-card spending.
Investors tend to sell what is performing well but hang on to what is performing badly to avoid realizing a loss. In essence they hang on to investments that are causing them a loss, even though this will result in a portfolio of only poorly performing investments.
Decisions of others, including the plan sponsor, a spouse or friend are followed. This is commonly seen when the DC plan default contribution rate is interpreted as investment advice.
How decisions are described, or framed, can influence the outcome. For example, if an annuity is framed as lifetime income that isn’t affected by stock market crashes, participants are more likely to choose an annuity. Conversely, if the purchase price of an annuity is framed as a loss of savings, participants might be less likely to choose an annuity.
Putting off greater long-term rewards for short-term gains. People may decide today to save more for retirement tomorrow. When tomorrow comes, they’ll put it off another day.
ILLUSION OF CONTROL
Overestimating the extent to which people’s own actions will produce a given outcome. If people buy a lottery ticket with numbers they choose, they will place more value on it than on a lottery ticket that was randomly generated, even though they have the same odds of winning. Those in retirement often assume they’ll do a better job controlling their investments on their own rather than buy an annuity.
INERTIA, STATUS QUO AND THE DEFAULT HEURISTIC
Numerous psychological factors fuel one trait: People are reluctant to change. Workers will stay in the default option regarding whether to participate in a DC plan, how much to contribute and how to allocate funds.
The potential for loss will have a much stronger pull on decisions than the potential for gain. People may view DC contributions reducing take-home pay rather than gaining much more with a company match.
People are not as accurate as they think they are. This trait is seen more strongly with men than women when it comes to tasks that are perceived as traditionally masculine, such as financial management. Overconfidence can also play out in estimating one’s ability to manage money in retirement.
Despite having done the same task in the past, people underestimate how long it will take them to complete it. They are inaccurate in judging themselves but accurate in judging others. People often don’t give themselves enough time to plan retirement decisions.
People are often inconsistent when it comes to taking risks. For example, when presented with the choice between a sure gain and a probable larger gain that involves risk, individuals prefer the sure gain, demonstrating risk aversion. But when presented with the choice between a sure loss and a probable larger loss, individuals prefer the larger possible loss, demonstrating risk-seeking behavior. Since the sure loss will be very painful, individuals are motivated to take a risk to avoid a loss. Also, individuals tend to overvalue the likelihood of low-probability events and undervalue the likelihood of high-probability events.
SERIAL POSITION EFFECT
The order of information presented impacts how accurately people recall it. The first and last items presented will be remembered the best. When presented with a DC plan, people may be more likely to choose the first or last investment choice.
These are like social cues—shaking hands when you meet someone, being quiet in a library. People notice the behavior of others around them and are influenced by it. If it’s known that peers are saving for retirement, workers are more likely to save for retirement.
People remember stories better than they remember statistics. Telling of someone relatable who fell upon financial hardship in retirement will have far more impact than presenting statistics of how many will struggle in retirement.
People believe good things will happen to them and bad things will happen to others, especially those things that are perceived as controllable. Many assume investment returns will perform better if they choose the investments themselves rather than rely on a statistically proven model.