For many individuals, financial decisions are driven largely by emotion, not by logic. And over the past year, American households experienced significant stress that impacted their emotional health and outlook.
Even if their finances weren’t directly hit, many households adjusted the way they saved, spent and invested. For financial institutions, understanding the pandemic’s emotional toll on customers and prospects is essential for meaningfully speaking with and serving them.
That is why in the Wealth Trends 2021 report, Equifax examined the Covid-19 pandemic’s financial and emotional effects on consumers. The report reveals that underlying cognitive biases, combined with recent experiences, could impact consumers’ future financial health and outlook.
How Cognitive Biases Impact Consumer Decisions
Life experiences shape attitudes. They form the beliefs people hold of the world around them and influence how they decide to live in it. This influence impacts everything from the food consumers eat to where they vacation, how they spend their money and how they invest and save.
For example, people who grew up during the Great Depression experienced significant scarcity. Their households adapted to the financial collapse by scrimping and scaling back on spending as much as they could. Their bank accounts may say otherwise today, yet these people still feel mentally and emotionally that they must continue these behaviors.
Although consumers are optimistic about their financial future, similar behaviors are appearing due to the pandemic. Memories of it will influence their emotional, physical and financial behaviors for decades.
The science of behavioral finance identifies five key cognitive biases that may affect consumers’ financial decision-making. Recognizing these biases can help your financial institution develop more relevant campaigns to address the questions, challenges and misconceptions your current and potential customers have.
The result is improved campaign performance, more productive (and proactive) conversations and improved financial outcomes for your customers.
Cognitive Bias 1: Recency Bias
Recency bias means when making decisions, a person favors recent events over historic ones. Rather than making objective calls based on a larger picture of events, many people tend to focus on a recent memory or happening to guide their outlook and actions. The Covid-19 pandemic has caused tumult for many individuals and families. Although there is light at the end of the tunnel, many are displaying recency bias by holding onto the uncertainty and fear that the pandemic accelerated.
Consider this. The pandemic was the first major economic upheaval affecting Generation Z and the second affecting Millennials. This bias may be especially strong for them as they try to build their careers, families and financial portfolios. At the height of lockdowns and social distancing orders, many households planned for economic volatility.
Deposits increased as a share of total assets during the pandemic, reflecting Americans’ flight to liquidity. Some 40% of parents with three or more children started savings accounts during this time. By overweighting toward cash, some individuals lost opportunities to invest.
There are other ways recency bias can impact financial decisions — positively and negatively. People who lost their health insurance during the pandemic may be investigating health savings accounts (HSAs) as an investment choice. Others may have bought life insurance after losing loved ones to Covid-19.
What You Can Do:
To overcome recency bias, acknowledge the challenges and lessons of the recent past while keeping your customers focused on the future. Help them focus on a brighter tomorrow. Suggest financial strategies that will help them better prepare and adapt for future events.
Cognitive Bias 2: Choice Bias
When someone has choice bias, they validate their decisions based on their established beliefs, even if better ideas and options are introduced. Although it’s human nature to dislike admitting a mistake or poor decision, choice bias can keep customers and prospects from doggedly throwing good money after bad.
When trying to tackle choice bias, it isn’t enough to simply propose other, better-fit options. Dig deeper into customers’ current financial situations. Identify gaps and losses suffered. Highlight why and how the factors that inspired their original decisions may have changed.
For example, Millennials made excessively conservative investments after the Great Recession. Show them stock market gains from the past decade to make the case for a more aggressive investment portfolio.
What You Can Do:
Effective financial decisions require assessing and responding to changing circumstances. To help customers with choice bias get “unstuck,” regularly review their investments and financial products for new opportunities. Quarterly or annual consultations with customers can help build trust and forge more long-term profitable relationships.
Cognitive Bias 3: Paradox of Choice
In his famous TED Talk, Malcolm Gladwell spoke in depth about how too many choices can hinder the decision-making process. This is the concept of “paradox of choice.” When people are forced to sift through too much information to make a decision, they don’t feel equipped to make a good choice. They tend to respond by feeling anxious and overwhelmed. When presented with fewer, more relevant options, the process feels more tolerable, and people feel more satisfied with their decisions.
Being an adult and/or head of household requires someone to make decisions — some easy, some difficult. But over the past year, your customers and prospects have been bombarded with new information and choices. In many cases, these choices influenced the physical, mental and emotional well-being of themselves and their families.
Gen X and older Millennials caring for both children and parents have had especially difficult decisions. Should a teen get a food-service job and possibly bring Covid-19 home exposing at-risk family members? Should the family’s stimulus checks go toward bills, rent or savings?
Too many decisions, options and factors spark “analysis paralysis,” and customers and prospects will fall into one of two groups. They’ll make no decision at all. Or, they’ll make a decision and immediately suffer from “buyer’s remorse.”
What You Can Do:
Instead of offering customers dozens of possibilities, tap into your data to carefully curate two or three options that work best for customers’ unique needs and financial circumstances. A combination of economic and psychographic data can empower the successful curation of this list. Develop tailored talking points that outline benefits and expected outcomes.
Cognitive Bias 4: Loss Aversion
Millennial customers and prospects may have loss aversion bias. This can prompt them to choose a lower-level exposure to downside risk — even if it’s not recommended or contextually appropriate. There’s an obvious reason why. During the Great Recession, this generation saw parents lose homes and jobs.
As tuition increased, so did their student debt, only to graduate to a bleak job market. Reacting to this experience, Millennials have taken on less risk than their Gen X counterparts. Over the past decade, they’ve missed out on potential wealth increases derived from a strong market.
Stanford Pathways research also shows that Millennial labor force participation is lower than Gen X. This suggests that older Millennials may have stopped working, and younger Millennials have not started yet. Suggesting non-employer-based retirement investment and savings options, such as Roth IRAs, could be helpful for these customers and prospects.
What You Can Do:
Dividing investments into specific categories with their own goals – an approach called “mental accounting”– can reduce loss aversion. Advisers can suggest riskier investments for categories with long-term horizons, such as retirement and lower-risk investments for short-term categories.
Cognitive Bias 5: Framing Bias
When people absorb information, their overall response is often inspired by the surrounding context. Rather than focusing on specific facts, they may let adjacent details, anecdotes and even tone impact their decisions. This is framing bias.
Many investors and homeowners use good and bad past experiences to guide their financial decisions and philosophies. Customers and prospects who suffered major investment losses during the Great Recession may hesitate to make bold, aggressive investments.
They also may be more eager to have easy access to cash. The economic volatility sparked by Covid-19 may have forced these innate feelings to emerge and inspired similar behaviors moving forward. Advisors should have open conversations with customers and prospects about these experiences. Reframing financial opportunities in a positive light helps demonstrate that they can offer a path forward.
For example, the Great Recession was extremely difficult. Remind customers that they endured and now have tools, services and guidance to deal with disruption and achieve financial success.
What You Can Do:
Focusing on current portfolio performance can reinforce an existing bias. Instead, put recent market ups and downs in context as unavoidable bumps that may feel uncomfortable but are consistent with a long-term investing journey. Quantifying missed opportunities, such as pulling out of the market or never investing, can also help overcome framing bias.
Envisioning Future Selves
Focusing on the future in a concrete way can help your customers overcome cognitive biases. Research conducted at UCLA encouraged people to envision their “future self” making financial decisions. A control group that received a windfall of $1,000, invested just $80 for retirement. Another test group, presented with an avatar of their 70-year-old future self, set aside $172 — more than double the amount.
What might this look like in practice? Financial advisors could paint a picture of their customers’ lives and families in 20, 30 or 40 years. Will their children be in college or married? Are the customers preparing for retirement? Will they be pursuing dreams like entrepreneurship or travel? Helping customers envision their future selves can inspire unbiased financial decisions.
A Clear Vision of the Future
Solutions like WealthComplete can give financial institutions insight into customers’ and prospects’ financial situations. Once those with the greatest growth potential have been identified, successfully engaging them requires addressing any cognitive biases clouding their financial vision.
Empathetically acknowledging customers’ and prospects’ past experiences can help earn and maintain trust. Help them move beyond the limitations cognitive biases impose. Develop talking points to help reframe situations and guide conversations in a productive way. By offering carefully chosen solutions, financial institutions can guide customers toward a better financial future.