The answer that lies within
Whilst we may be prone to being irrational at times, there are steps that can be taken to control our future investment decisions and to ensure we stick to the plans we create for managing our portfolios.
Residents of the United States, please read this important information before proceeding
Please read this important information before proceeding.
A Case Study from Ancient History
Self-control strategies are characterized by the use of techniques such as checks, barriers and rules that aim to moderate and guide behaviour. We have previously referred to a particularly compelling example of self-control strategies in action: Homer's story of Ulysses. During his journey back from the Trojan wars, Ulysses had been warned about the Sirens by the enchantress Circe. But, determined to experience their songs for himself, he ordered his crew to stuff their ears with wax and, ordered them beforehand to bind him to the mast of the ship. The crew was also ordered not, under any circumstances, to change course or to untie their captain. Ulysses was indeed beguiled by the Sirens' song; if he had not been bound to the mast, he would have jumped into the sea and drowned.
Strategies Available to Us
Individuals use these self-control strategies in many scenarios including decisions that relate to managing finances. Ulysses himself delegated decisions, used specific rules, deliberately limited his options and involved others to help him. There are seven broad strategies to help us control ourselves in both general and financial decision making, these are detailed in Chart 14.
One key reason why individual investors systematically underperform professional investors is not that they're inherently worse investors...but simply that professional investors are aided by a strong set of institutional rules that ensure greater control of their knee-jerk reactions.
Another great example of using a self-control strategy in both financial and general life comes from Professor Thorsten Hens, who advocates the use of diary keeping:
"A good idea is to monitor one's investment decisions by an investment diary. Write down why you have chosen which strategy and also keep track of the gains and the losses and the emotions they trigger, but do not act on these emotions! With some hindsight you will see that your diary swallows a lot of your emotions and helps you to stay to your strategy. This has parallels in more general situations. My wife writes in her diary only once a week. I guess if she didn't we would have split up some 30 years ago - soon after we first met!"
Barclays' Greg Davies also advocates the use of a more structured approach to investment decisions, taking time to sit down and draft your own investing rules and frameworks.
"One key reason why individual investors systematically underperform professional investors is not that they're inherently worse investors...but simply that professional investors are aided by a strong set of institutional rules that ensure greater control of their knee-jerk reactions: Nick Leeson and Jérôme Kerviel, two rogue European traders6, are exceptions that prove this rule by showing how destructive professional traders can be when they find ways around these checks and balances."
Strategies in Use Today
To understand the extent to which high net worth individuals currently employ self-control strategies, we asked our respondents whether they used these strategies in their lives generally and in their financial decision making, and then whether they considered them effective. The results are included in Chart 15.
The results show that the use of general decision-making strategies is widespread: even the least-used strategies are used by three-quarters of the sample (73%). The most popular strategies include setting deadlines to avoid procrastination and using cooling-off periods to reflect on decisions (both used by 93% of high net worth individuals).
When making financial decisions, the self-control strategies that are used the most by our respondents include:
- Cooling-off periods.
- Other people.
We also see that some strategies seem to be more suited for financial decision making than general decision making. Rules and people are more likely to be used in financial decision making compared to general decision making. Conversely, delegation, avoidance and limiting options are less likely to be used in financial decision making.
Greg Davies at Barclays highlights the relatively low use of the "limiting your options" strategy for financial decision making: "This is really interesting and bears out something we observed in client behaviour over the financial crisis. You might intuitively think that the approach of simply excluding some options from your future choices would be a great way of controlling your behaviour - but people are very reluctant to sign up for it. It seems we place a great deal of importance on flexibility, even if this flexibility could be harmful to us. So, rather than the extreme Ulysses option of tying yourself to the mast but exposing yourself fully to the temptation of the Sirens' song, most people seem to prefer the softer option of plugging their ears with wax and lessening the temptation itself to constraining their own options. After all, in the words of Oscar Wilde, 'the only way to get rid of a temptation is to yield to it' - so better not to expose yourself to it in the first place."
Dr. Barbara Fasolo notes that regret is one of the most dominant emotions influencing investment decisions and may explain some of these strategies. Individuals are driven to avoid a situation where, despite being satisfied with the process undertaken to make an investment decision, the outcome of that decision is unsatisfactory. This desire to avoid anticipated regret leads to using others.
One of the emotions that seems to be most dominant in investment decisions is regret. For some, one strategy for less regret is to leave the decision to somebody else because you really don't want to face having made the wrong decision.
Dr. Sheena Iyengar, Professor of Business in the Management Division at Columbia University and Research Director at the Jerome A. Chazen Institute of International Business, suggests a cooling-off strategy as pausing to understand and visualise the consequences. Money is often looked upon in an abstract context and assessing the concrete ramifications of financial decisions helps individuals to employ greater self-control.
"People need to see consequences. It is very easy for money to look abstract, whether it is for a trade or numbers on a screen, or whether it is getting a mortgage loan or deciding to invest for retirement. People have to be given the consequences in ways that are not abstract, but in understandable and concrete terms."
Strategies in Combination
There are also patterns in the combinations of strategies used. Strategy use tends to occur in groups where high use of one strategy was often seen together with high use of others. Some strategies that are used together in groups are as follows:
1. Delegation and using other people.
2. Rules, deadlines and cooling-off periods.
3. Limiting options and avoidance.
This suggests that multiple strategies can be used to achieve a certain objective whether it is the involvement of others (group 1), being more structured (group 2) or removing temptation (group 3).Greg Davies comments how these strategies can be used by different individuals: "The evidence in the data suggests that individual investors may have natural preferences towards using strategies in one of these groups over others. For example, it may be easier for naturally gregarious individuals to control their behaviour through the involvement of others (group 1); those who are naturally organised and systematic might prefer group 2 strategies; whilst some might simply prefer not being tempted in the first place (group 3)."
Dr. Barbara Fasolo illustrates this use of multiple strategies through the example of investors who aim to avoid regret. They may seek to limit the amount of information and choice they expose themselves to as a rule of thumb for coping with an overwhelming amount of information and uncertainty: "The more you look (at investment returns) the more you feel regret. You could invest in that one, that one, or that one..."
Identifying the Use of Strategies
In Chapter 1 we saw that some parts of the high net worth population were more likely to want self-control than others. Those with the highest use of self-control strategies are those with a high desire for discipline. It appears that those who want self-control in both their financial and non-financial lives are achieving this through the use of self-control strategies.
When looking at the use of strategies, we revisited three groups to see if their use of self-control strategies also differed. Strategy use by age, wealth level and source of wealth are summarised in Charts 17 and 18.
An analysis of older investors' personality and desire for financial discipline showed a "Zen of Ageing" effect where older investors gained more composure, were less prevention focused and had a lower desire for self-control. We see this translate into a reduced use of self-control strategies in general as we get older. Older investors are less likely to use all self-control strategies with the exception of using other people to help them reach their investment goals.
Looking at the differences arising from an individual's wealth (Chart 18), other differences in strategy approach are noticeable. Those with only inherited wealth are more likely to delegate (both financial and general decision making) and use avoidance in financial decision making.
Strategy Use Summarised
Strategies tend to be used by those who seek greater discipline in their approach to financial management, as discussed above. However, other trends are clear from our study as well. In particular, the use of strategies tends to be:
- Decreasing with age.
- Higher amongst women7, who also believe that strategies are more effective.
- Lower with joint financial decision making.
- Higher for those who inherit wealth.
Strategies in Action
Strategies that can help us to moderate behaviour are not limited to those tested in our research. In fact, strategy use is widespread and can take many forms depending on the context. There are plenty of examples of strategies in action, which often reveal some unexpected results.
One recent study by Daniel Richards of the Open University Business School looked at whether the ability to place stop loss rules in advance of trading online has helped individuals to overcome a costly bias, the reluctance to realise losses. It turns out the answer was a clear "yes." In fact, 20% of investors in the study actively used such rules. Even more interesting was that when this 20% of investors did not use a stop loss rule to control their behavior, they showed this bias to a greater extent than the other 80%. In other words, those who used the rules were more prone to behavioural biases when the strategies were not adopted, suggesting that they were deliberately using them to control their own usual lack of control - a conclusion made in our study above.
Another example of complexities surrounding self-control strategies is provided by the website stickK.com, which helps everyday people commit to and achieve their financial and non-financial goals through the clever use of incentive-compatible contracts. Dr. Ian Ayres, Professor of Law and Economics at Yale University, co-founder of stickK describes stickK as the following:
"stickK.com is a commitment store, a commitment service, where we offer people layers of accountability. They get to choose what types of mechanisms that will keep them on the path toward their goals. If a user wants we’ll nag them, we’ll inform friends whether or not they succeed, or whatever they choose. A referee can decide whether or not they succeed, and most uniquely, the site allows them to put money at risk that is forfeited if they fail to meet their commitment."
To give an example of the contracts on stickK, you could put £100 on the line to achieve a goal of losing a specific amount of weight. You would need to designate a referee to monitor your progress and validate your weight loss, and you would also specify a charity for the £100 to be donated to in case you miss your goal. Users are also encouraged to increase the incentive to meet their goals by specifying an anti-charity, which is a charity they detest. In the U.K., this is often a rival football club and in the U.S. it is often a contribution to a politician with opposing views.
Another example of a commitment device is Save More Tomorrow, a savings plan designed by behavioural finance experts Richard Thaler and Shlomo Benartzi. This plan enables people to allocate a portion of their future salary increases toward their retirement savings. Rory Sutherland, Executive Creative Director at Ogilvy UK an expert in behavioural marketing, noted on Save More Tomorrow:
"It's extraordinary that billions have been spent in pension marketing over the last twenty years and no one actually thought about what - when it comes to putting your name on the dotted line - is keeping you from signing up for that pension."
There are a number of hindrances to signing up for pension savings. Loss aversion means that we dislike experiencing a loss, in this case our spending money, to build up our pension savings. We also find it easy to commit to self-sacrifice in the future but when the moment arrives we strongly prefer consumption now. Finally, we prefer the status quo and people are generally reluctant to expend effort to change this.
Save More Tomorrow is designed to deal with each of these three issues. Firstly, it plays on our tendency to procrastinate - to put off things until tomorrow - by asking us to save more in the future, not now. Secondly, at no point do you experience a loss: instead you commit to building up your savings rate out of future pay increases. Thirdly, the contribution rate increases are automatic once you sign-up for them and the increase becomes the status quo option that you would have to actively opt out of.
The Visible Benefits Strategies Bring
There are two ways to understand what benefits these strategies bring. The first is to ask the direct question of high net worth individuals about how effective they think strategies are. The second is to see how the use of strategies is associated with other factors such as financial satisfaction.
As Charts 19-21 show, investors do believe that strategies are effective and that their effectiveness appears to be linked to how often they are used, it is the strategies that are used most that are considered the most effective. This is the case for both general and financial decision making.
Closer inspection of these data findings show that high net worth individuals believe that setting deadlines is the most effective strategy in both a financial and broader context. However, they believe that rules are more effective in their financial lives rather than more generally. They also believe that limiting and avoiding options are much more effective in their general life rather than when dealing with their finances.
There are also some interesting variations across demographic groups. Older high net worth individuals (Chart 20), for example, are less likely to judge many strategies as being effective.
When we look at averages across the many different types of strategies, men and women show some differences in usage and how effective they think the strategies are for helping people exercise self-control. Women do not use financial self-control strategies more than men on average. However, they show a greater interest in them, as they rate them as being more effective compared to men. When it comes to strategies outside of the financial domain, women think they are both more effective and are more likely to use them compared to men. On the whole, women show a greater interest in these strategies, which is consistent with their higher desire for financial discipline and lower composure.
The Hidden Benefits of Strategies
Whilst many high net worth individuals in this study are able to identify that financial strategies are effective, another of our key findings is that for particular personality types, these strategies are associated with increased financial satisfaction. Not only do strategies bring this hidden benefit emotionally, but our study also found strategies were associated with higher wealth levels.
These positive relationships associated with financial strategies hold true only for those who have a high desire for financial discipline - they tend to fit the personality profile of risk takers who become stressed easily and have a prevention-focused mindset. These strategies may add benefits for those that are prone to risky or impulsive behaviour, particularly if they tend to make emotional decisions when feeling stressed. Moreover, research shows that those with a prevention mindset thrive when they approach their goals in a way that fits their mindset.8 Prevention-focused individuals are vigilant about what could go wrong in the pursuit of their goals, so it makes sense that strategies that help them guard against themselves are both appealing and effective.
Chart 22 shows the positive relationship between use of strategies and higher levels of satisfaction, for those who want greater discipline in their lives. Comparing the group with the lowest strategy usage to the highest strategy usage, we see a 13% boost in financial satisfaction.9
Not only does strategy use make people feel more satisfied with their financial situation, but it also has a link to one's total net worth. For those looking for control, use of these strategies is associated with higher net worth - see Chart 23. The group with the highest strategy usage has a net worth 12% higher than the group with the lowest strategy usage.
Those who say they wish they had a more disciplined approach to their finances may actually need it or may simply value an ordered and structured existence. Either way, for these people, self-control strategies can be helpful both in terms of increasing contentment and the size of one's wallet. If anything, there is a negative relationship between use of strategies and positive outcomes for those who do not desire financial discipline - who may not need self-control or simply prefer a less structured approach to finances that emphasises choice and freedom. This is a lesson for financial advisors on the importance of understanding the financial personalities and objectives of their clients in order to best advise them both on how to tackle market challenges, and the challenges that lie within.
6 Nick Leeson's unchecked risk-taking caused the collapse of Barings Bank (UK) and Jérôme Kerviel's fraud and unauthorised trading cost Société Générale (France) €4.9 billion.
7 Women show higher use of general and financial strategies, however their use of financial strategies is not significantly higher than that of men.
8 Higgins (2004) Value from regulatory fit. Current Directions in Psychological Science for a review of this literature.
9 The lowest strategy usage group is the bottom 10% compared to the top 10% most frequent strategy users.