In 1987, two professors at UC Berkeley, Daniel Kahneman, a psychologist, and George Akerlof, an economist, offered a joint class called Psychology and Economics for the first time. They each went on to win the Nobel Prize for Economics in consecutive years in 2001 and 2002. Their groundbreaking work applying psychological insights into economic theory help us to understand why people make irrational choices. I was invited to the Haas School of Business campus at UC Berkeley to celebrate the 30-year anniversary of that first class. The alumni now leading these endeavors at prestigious institutions like Harvard, Princeton, Cornell and Berkeley shared research and recollections with each other, and I was one of the few non-academic guests.
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Some of the content was a little too academic for me (hello, econometrics formulas). However, there were some concepts that are unquestionably helpful to all of us in the business of helping people make good choices, and who isn't? So here are three ideas I found particularly interesting, with credit to brilliant minds who would no doubt find my summary to be a little oversimplified.
THE ROLE OF BEHAVIORAL ECONOMICS IN OPTIMIZING DECISIONS
1. The conflict between what we want and what is good for us is the core dilemma for every individual. We want to be healthy, but we don't really want to eat healthy or exercise. How people choose and trade between what they should do and what they want to do is the ultimate measure of where people's lives end up. In this context, the most important role of an adviser is to help people find the right mix of sacrifice and reward that will lead to the best outcome for any individual.
2. If you have an unrecognized weakness, it will be exploited for economic gain. It's not a coincidence that freshly baked cinnamon buns are sold right at the gate in the airport. The truth is that capitalism works by identifying a need and filling it. If you are not conscious of your weaknesses then you are likely going to be exploited. Advisers serve the important role of identifying blind spots for clients and helping them protect themselves from unconscious choices with unintended consequences.
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3. People typically place too much attention on what is in their line of sight and not enough on outlier events. Few of us realize optimal outcomes in an economic sense because we confront unanticipated events that we aren't prepared for and take too long to adjust to. This happens because:
a. We concentrate on what is immediately in front of us. It's easy to imagine taking a vacation in the next year; it's tougher to think of retirement decades from now. The future reward of a comfortable retirement is distant, and the immediate sacrifice of saving is disproportionately painful. When it comes to investing or financial decisions, we rely too much on what has happened recently.
b. We don't want to think about the unpleasant things. Getting ill, dying or having an accident are uncomfortable events for us to think about, much less spend time preparing for. This means in general people have a predisposition to overly optimistic outcomes (few of us think we are average, and yet at least half of us must be less than average).
c. We don't imagine anomalies and outlier events. Our brain thinks in patterns and we systematically average our experience to anticipate the future. However, life is filled with many unique outlier events. No one lives an average life.
THE INDISPENSABLE ADVISER
Over dinner, I asked several of these folks how we might apply their knowledge to help people make fewer mistakes in the real world. The general consensus was that even educated people make suboptimal choices and that ultimately science and research only go so far. Most humans need help confronting what they don't want to, and ongoing guidance to make the right choices. An objective, knowledgeable and caring perspective is invaluable in any economic context. We wealth managers are uniquely positioned to use science and human judgment to help people optimize one of the most important areas shaping their entire life: their financial decisions. In that context, we are invaluable.
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Joe Duran is chief executive of United Capital. Follow him @DuranMoney.
