Taking a risk, whether it’s in your personal or professional life, is scary because it exposes you to the unknown.
It disturbs human nature’s strong preference for known outcomes over unknown outcomes; which in the field of behavioural finance is called ambiguity aversion or uncertainty aversion.
In the context of financial advice, it means that people will typically opt for the strategy or solution that will deliver the most certain outcome, based on probabilities.
Uncertainty aversion lends itself to what psychologist Daniel Kahneman describes as fast thinking or System 1, which relies on heuristics or rules of thumb for decision-making.
While system 1 does the job most of the time, particularly for basic choices like the quickest route home, system 2 or slow thinking, pushes people to consider other possibilities. It can lead to better outcomes.
Unfortunately, people don’t spend a lot of time thinking. In today’s fast-paced world, it’s all about speed.
The other problem with slow thinking is that it invites doubt.
Uncertainty aversion, on the other hand, suppresses doubt.
But the advice profession owes its existence to doubt. Life insurance, superannuation, retirement planning and estate planning are all about preparing for an uncertain future.
Doubt is an adviser’s best friend. Ironically, eradicating it is often their main objective. However, certainty is an illusion because no one can accurately predict the future. The idea of it is a tool used by politicians, religions and organisations to support their agenda.
An important part of an adviser’s role is to help clients understand the completely random nature of some events, such as a global pandemic, getting struck by lightning, contracting a disease and even being made redundant. Market booms and busts are largely random too.
Advisers also help manage uncertainty through careful planning so people feel confident and secure about achieving their goals. Perhaps most importantly, advisers know how to act in a crisis. Statistical evidence aids the later but arguably hinders the former.
This is because presenting something in statistical form creates a sense of predictability. Even using words like “average” and “median” imply statistics.
Consider the widely held belief that a comfortable retirement costs the average couple $1 million.
Unfortunately, for most people, statistics are hard to understand. What does an eight in ten chance of outperforming the market over the long term really mean?
Furthermore, statistics don’t provide the full picture. ASFA estimates the lump sum needed to support the average homeowner couple in retirement is $640,000, assuming a decent return on that capital, a partial Age Pension, modest inflation and a life expectancy of around age 85.1
Obviously, some people will need more while others will need less, depending on their circumstances, spending habits and other variables.
Then there’s the statistic: a pandemic is a once in 100 year event. This fails to acknowledge that one in 100 year events can happen in clusters, such as Sars, Ebola, Bird Flu, Swine Flu and Zika Virus.
To try and make life more predictable and therefore comfortable, actuaries and researchers seek out statistical correlations. However, some correlations are completely unrelated.
For example, there is a strong correlation between the per capita consumption of mozzarella cheese and civil engineering doctorates awarded globally, and between the number of people who tripped over their feet and died, and the number of lawyers in Nevada.
This highlights the divide between correlations and causations.
A causation is when one event can be used to reliably predict another.
The power of I don’t know
Despite our best efforts to eliminate uncertainty and make sense of random events, we need to accept that the world can be a scary place.
The advice process should leave room for questions, doubt and slow thinking.
Clients should be encouraged to think long and hard about their values, goals and priorities. They should deeply reflect on what’s truly important to them, what they can and can’t compromise on, and their ability to tolerate risk.
This rich information can’t be properly unpacked on the spot in a one hour meeting or extracted from static fact find questionnaire.
Clients should be able to complete fact finds with their adviser and independently over time. They should be able to regularly update information as their thinking evolves and flag areas for further discussion. Technology should enable this.
But slow thinking isn’t just for clients.
Right now, many advisers are concerned about macro-economic issues, such as inflation and interest rates. While there is plenty of compelling evidence to suggest that interest rates will stay lower for longer, no one really knows.
Remembering that it’s natural to avoid ambiguity and suppress doubt, sometimes advisers need the courage to tell their clients, “I don’t know”. Doubt is healthy and making significant decisions in the absence of doubt can lead to foolhardiness.
After all, maybe this is a random walk down Wall Street.