The role of herd behavior, loss aversion and framing in marketing

investment products and increasing sales of banks.

Eliza Zisopulu, IBS M_31, West Pomeranian Business School

Introduction

Individuals make decisions every day choosing from available options without much
analysis of the level of rationality of their decision-making processes. However, from
the psychological point of view, decision-making is a very complex mental activity. Decisions
are not made in a vacuum but people make judgments based on their personal preferences,
knowledge, previous experience and many other factors which are being pursued by many
researchers around the globe. Mathews (2005) defines decision-making as the process
of choosing a particular alternative from a number of alternatives. According to him, it is
an activity that follows after proper evaluation of all the alternatives. At the same time,
the evaluation is prone to numerous judgment errors and cognitive biases that cause our
decisions to deviate from fully rational choices. Behavioral finance, the study of the influence
of psychology on the behavior of financial practitioners (Sewell, 2007), shows that choices
made by individual investors may be subject to manipulation. In this paper the focus will be
on the marketing strategies and techniques used by the banks and financial advisors to
increase sales of investment products. Furthermore, the introduction of some new types
of financial products will be discussed to show how bank managers use aspects of behavioral
finance to better suit customers’ preferences and manipulate their choices. Herd behavior, loss
aversion and framing will be the key concepts discussed in the paper.

Every investor differs from others due to various factors including socio-economic
background, level and area of education, age, race and gender. The last factor seems to be
a subject of a heated debate, with a number of scientists claiming that men tend to be more
confident than women given the same level of knowledge. However, according to Skała
(2008), “the link between gender differences and overconfidence has not been unequivocally
established”. Nonetheless, even though individual differences are present among people, it
turns out that we are all prone to similar judgment errors which makes us vulnerable to
manipulative activities of others.

If our choices are a determinant of the financial prosperity of such influential and
powerful institutions as banks, which have enough capital at their disposal to research the
psychological aspects of our choices, we can be sure that we will be secretly manipulated by
carefully prepared marketing strategies and sales techniques. It is not a secret that bank front
line staff is provided with intensive training to advise them on how to sell a product
effectively and how to communicate with clients to reach sales targets. Separate trainings are
given to product managers who are responsible for developing a product for sale, and to
marketing specialists to help them create effective marketing techniques.

Herd behavior phenomenon

Herd behavior in financial markets can be defined as mutual imitation leading to a

convergence of action (Hirshleifer and Teoh, 2003). In other words, herd behavior is the
tendency of individuals to mimic the actions of a larger group no matter if the actions are
rational or irrational. Herd behavior may happen due to the social pressure of conformity
(agreeing with others). People seem to have a natural desire to be accepted by a group and try
to achieve it by following the actions of others. They follow the advice coming from an old
proverb: “When in Rome, do as the Romans do”.

The second reason for explaining the phenomenon of herd behavior may be the
common rationale that it is very unlikely that such a large group of investors can be wrong.
What is more, when a large number of people make profit on an investment for a certain
period of time, others, not yet involved in this type of investment, will often decide to join as
they fear that they will end up being the only ones who did not take advantage of this unique
opportunity.

Banks seem to recognize the phenomenon of herd behavior and take advantage of it.
They use intensive advertising campaigns when a specific type of investment becomes more
and more popular and when they can quote positive returns on this investment. Consider
mutual funds which became very popular and advertised in the Polish media in 2007 and 2008
when the instruments shown very good historical results. Many professionals at that time
thought that after such a long period of bullish market, a turning point is inevitable to come.
Increasing popularity of mutual funds boosted the value of investments but when the market
turned bearish, the same herd behavior caused the prices to plummet. Terrified investors were
selling out their units of mutual funds, thus pushing the market further down.

Even though buying stocks when the market is down and selling them when the
market is high would be a rational choice, encouraging people to make decisions which are
against the current market trends is a very hard task to do. That is why banks and financial
advisors rarely bother to fight with the general tendency. Instead, they choose to follow the
herd behavior and provide customers with instruments they are currently searching for.

After the recent breakdown on stock markets, safe instruments came back to the first
plan. TV and radio commercials, leaflets, posters, etc. were full of catchy phrases advertising
high interest term deposits and bank employees were instructed to increase their depo sales.
Hardly anyone was advised to buy risky instruments such as stocks and mutual funds even
though their price was becoming more and more attractive. Banks needed to obtain capital as
interbank transactions hardly existed and even if they did, the interest rates were sky high.
Nonetheless, banks took advantage of the herd behavior phenomenon and a fight with interest
rates lasted for almost a year.

Loss aversion

Loss aversion was first convincingly presented by Amos Tversky and Daniel
Kahnema. It is commonly defined as the tendency of people to strongly prefer avoiding losses
to acquiring gains. Many studies suggest that losses are twice as psychologically powerful as
gains.

Many individuals are unwilling to invest in more risky instruments such as stocks or
mutual funds. There is a vast number of people who use banks only for depositing and
withdrawing money from the current accounts, making money transfers, putting money into
term deposits or keeping them on saving accounts. However, these operations bring a very
low profit to the banks and so bank managers and product specialists constantly work to
develop new products. They seem to pay more and more attention to the developments and
findings of behavioral finance and take into consideration loss aversion of potential customers
but, at the same time, they need to increase profits of financial institutions. To reach this
objective banks have introduced so called structured products.
 Structured product offers customers flexibility and an individual made-to-measure
approach to investing. Simple structured products offer investors full or partial capital
protection but at the same time they enable higher returns through an equity-linked
performance. Thus, structured products are an attractive alternative to government bonds and
bank deposits.

Figure 1. Structured products positioning (source: BNP Paribas. Guide to structured products)

According to Hens and Rieger (2008), “structured products are immensely popular in
Europe: in 2007 in Germany alone the market capitalization with structured products was
above 200 billion Euro and 6.8% of invested assets are held in structured products. In
Switzerland market capitalization is 340 billion CHF which corresponds to 7-8% of all
invested assets.”

Also in Poland structured products are more and more popular and are actively offered
to individual customers. When advertising a structured product or advising clients, financial
advisors often use the argument that the money invested in structures is well protected
(usually in 100%) and so the customer does not bear any risk of losing money. At the same
time, the possible return on the investment is higher than on regular term deposits. However,
there are a few things that are rarely explained to a potential customer. First of all, if the
product does not succeed, the customer is given back the full amount which was invested
minus the initial fee which is usually about 5%. Secondly, the amount invested is protected
but not when the investment is terminated before the date of maturity (customers suffer a loss,
if they withdraw money before the investment ends). Finally, the term of a structured
investment is usually 1-5 years. Even in case of full protection, the money loses its value due
to inflation and if the investment does not succeed, the real value of money decreases and
investors make a loss.

Individual, inexperienced investors (so called “noise traders”) are not aware of the
above disadvantages of structured products. Many of them focus on the element of capital
protection. In this way banks benefit from loss aversion and attract customers to invest in
products which are more profitable to the bank.

In addition, structured products are often sold in a package with regular term deposits
with a much higher interest rates than if they are sold on their own. Customers are also
encouraged to invest in structures being given free gadgets such as mp3 players, cameras, etc.

The framing effect

The framing effect advocates that presenting the same option in different ways can
alter people's decisions. According to Plous (1993), individuals tend to make inconsistent
choices, depending on whether the choice concentrates on losses or on gains. As was
mentioned before in the paper, people value gains and losses differently and a loss of a certain
amount of money is more painful for them than an equal gain.

Being aware of this phenomenon, bank advisors are taught to frame their questions
and information about investment products in a way which is attractive to customers. If they
inform a client about a negative result of a structured product which was based on an index,
they do not simply say that the product failed. Instead, they say that even though the index
made a loss of, let us say, 15%, thanks to the built-in protection of the investment, the
customer receives back all the money that he had invested. This further ensures customers that
the structured products are safe and they feel a relief that they had not lost any money and at
the same time had an opportunity to invest in an index.

Financial advisors are also taught how to control a conversation with a client, how to
ask questions and use the methods proposed by Neuro-Linguistic Programming. Besides
structured products, so called unit-linked investments are another relatively new type of
investment offered by the banks in cooperation with insurance companies.

Unit-linked investments offer an easy and tax-efficient way to invest money in a wide
choice of funds associated with different assets and geographic areas. These products allow
individuals to develop a well-diversified portfolio which may be managed by the customers
themselves or by experienced investment professionals. The general idea is that a certain
amount of money has to be paid to the insurance company every month (year) which is
further invested in chosen assets. Even though the products have vast advantages, customers
tend to be very skeptic since the decision involves a long term commitment to monthly
payments (usually 10-15 years).

To be able to convince customers that unit-linked investments are a good choice and
the long term commitment will be profitable, bank employees are advised to frame the
questions directed to the customers in a proper way. The clients need to visualize their future
life and set objectives to which they would be willing to save regularly for a period of 10-15
years. Usually these objectives are: additional income on retirement, financing education of
their children, paying off a mortgage early, buying a house, etc. When using visualization
techniques, bank employees try to focus on visualizing positive potential effects of long-term
investments along with possible negative outcomes connected with the rejection of regular
savings. Again loss aversion plays an important role in increasing sales of banking products.

Conclusion

Brian Gaffney, CEO of Allianz Global Investors Distributors, once said that every
financial advisor should have a behavioral finance toolbox. He believes that how an advisor
frames the discussion with a client, will determine client’s decision-making. In his opinion,
the more vividly an individual sees their future, the more they save. Gaffney described an
experiment in which people in one group were shown what they would look like in 30 years’
time. The second group was not shown any simulation. The experiment revealed that people
who saw a simulation of what they would look like in the future, and saw that they would be
happier, saved more.

Another critical point advisors should take into consideration is herd behavior and loss
aversion. It is said that individuals tend to follow general trends and are twice as sensitive to
losses than they are to gains. Understanding these phenomena is crucial to comprehend
clients’ goals and be able to influence their investment decisions.
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