On the Emotional Brink

May 15, 2023

Executive Summary

The latest news has brought attention to the potential consequences of a failure to reach bipartisan agreement on raising the debt ceiling—using terms such as “economic chaos,” “market panic,” and “painful crash” in attention-grabbing headlines. This scenario resembles a high-stakes game of chicken, where neither party wants to yield, leading to a lose-lose outcome if resolution is not reached. This political standoff serves to increase uncertainty for Americans, who are already grappling with economic insecurity caused by various factors such as inflation, the remaining ramifications of COVID-19, and rising interest rates. Given these challenges, it is crucial FPs understand the emotional and cognitive responses of investors to predict how they may react to the current situation and help them make informed financial decisions.

Recent news has been focused on the potentially disastrous outcomes should there be no bipartisan agreement on raising the debt ceiling. Both sides are negotiating based on other desires related to their political party’s goals (reduced spending and budget cuts vs. maintaining the status quo). This situation is basically a game of chicken, where the outcome is lose-lose if neither party yields.

In game theory, this is called an “anti-coordination” game—each party wants the other to yield while they stay-the-course. Should one party concede while the other doesn’t, the relenting party receives a detrimental blow to their pride and reputation (the latter of which is important in politics due to reelection and ongoing negotiations). In the interim, the biggest loser is the American public. Individuals have been overwhelmed with unprecedented uncertainty and market volatility due to inflation, COVID-19, mass tech layoffs, increasing interest rates, and prognostications of an impending recession.

With this latest political strife, it’s possible many investors who were able to remain calm and steadfast previously, will be pushed over the edge into emotional reactivity regarding their financial plans. Before discussing the emotional biases and responses FPs may see, what causes them, and what to do with them, there are some important details about the game of chicken that should be addressed. First, each player wants the other to relent, and to get them to do so, they must make a credible threat. Second, there is always the introduction of uncontrollable risk—something could happen along the way that results in catastrophe regardless.

Now, let’s contextualize this in the game currently being played over the debt ceiling.

1. Is each party making a credible threat to the other?

For the House/House Leader: no. Biden isn’t making any additional demands beyond raising the debt ceiling, so this looks much more like the GOP being opportunistic than the counter of staying the course while raising the debt limit.

For the President: yes. There is the possibility the Administration could invoke the 14^th Amendment. This effectively forces Congress to yield and change the proposed bill ensuring the Administration wins either way. In terms of reputational outcomes, while the GOP may gain leverage in future negotiations with House and Senate democrats by refusing to relent, the cost of doing so (saying they are willing to let the U.S. default if they don’t get what they want) is far greater reputationally.

The reality may involve some concessions on either side, and not complete defeat, but ultimately, neither party wants the US to default.

2. Is there uncontrollable risk?

Yes. There always is. But the likelihood of economic and financial pandemonium is highly improbable. So, why even bring it up? Individuals overreact to small probabilities and underreact to large probabilities due to subjective probability distortions (e.g., research has found that people treat a 1% probability more like 6% and a 99% probability more like 91%). This is why emphasizing the small probability of catastrophe, or the large probability of no catastrophe, may not be as effective as you were expecting.

A discussion about the above can help FPs provide perspective to their clients and ease their emotional fears. Discussing the strategic underpinnings of such an interaction can cool hot emotions and explaining probability distortions can help clients question their own responses. But what else is at play for clients?

When cognitive and emotional inputs diverge, leading to different proposed behaviors, usually the emotional inputs dominate.

Risk-as-feelings

Prior research has established that risk is assessed using both cognitive inputs (e.g., objective features of the risk such as probabilities) and emotional inputs (e.g., anticipatory emotions such as dread and the vividness of outcomes). In the case of increased economic insecurity, important anticipatory emotions include fear, anxiety, and dread. Those are feelings that are being experienced now, versus in the future when the results of any decisions come to fruition. When cognitive and emotional inputs diverge, leading to different proposed behaviors, usually the emotional inputs dominate. Paradoxically, this means that a person’s emotions can lead them to behave in a way that contradicts what they cognitively believe is the best (or preferred) course of action. The importance of emotions in determining risk-taking behavior has been applied specifically to financial and investment risks—research has shown that predicting investor behavior improves when you include measurements for feelings of dread.

How can Financial Professionals Help?

While emotions can be informative, they can also be unrelated to true correlates of risk, which means they should be ignored when this is the case. As an FP, you surely know that telling a client to ignore their feelings is not an effective or appreciated proposition. So how do you use these emotions to your (and your client’s) advantage?

Create commitment devices.

During onboarding or client meetings, have clients create a commitment with you to avoid emotional decision-making. Something such as, “unless the market deviates from long-term historical averages by more than X%, I will not deviate from my plans unless specifically advised to do so by my FP.” While this isn’t a binding contract, it is effective at preventing self-control lapses in the face of overwhelming emotional drives.

Label the feelings.

Labeling feelings helps people understand where those feelings are coming from and whether they are worth acting on. Naming feelings directly has been shown to significantly reduce physiological distress and provide clarity on the source of the feelings. Both things can help investors focus on a more cognitive, and thus reliable, strategy.

Ask for predictions.

Asking your clients to predict how you, as an FP, would respond can help anchor them on a more adaptive and optimal approach. While they may still incorporate some of their own emotions, imagining what an FP would do for their own allocations can act as a “cold shower.”

Conclusion

Emotions are unavoidable, motivating, and often overwhelming. The same could be said of political and economic uncertainty. As an FP, you can’t take feelings out of the equation, but you can acknowledge them and devise ways to help your client stay-the-course in times of high emotionality.