When individuals make decisions, they rarely weigh all possible outcomes to make their choice. Instead, while we may like to think that this is how we make decisions, the reality is that our brains simply don’t have the capacity to consider all of the possible variables and outcomes involved in most decisions. Further, sometimes our decisions are based on fleeting recollections of how we felt while experiencing something, which often has little to do with how much we are actually enjoying what it was we were experiencing (e.g., remembering that a movie was good because of the fun experience we shared with friends, as opposed to the movie actually being good). While neoclassical economics has examined theoretical models of effective decision-making involving what we should do and how we should calculate whether to make one choice or another, behavioral economics suggests that what we actually do is quite different because we generally can’t really make calculated decisions in an unbiased manner, given the (strong) influence of our feelings and emotions.
Researchers have developed a decision-making framework based on three ways that individuals can make use of “Utility”, which describes the potential happiness that can be brought about by a particular choice. Expected Utility considers whether an individual thinks they will be satisfied by a potential future outcome, and decisions are essentially made based on pure conjecture and subjective opinion (e.g., I want the vanilla ice cream because I think it sounds good right now). Experienced Utility, on the other hand, is based on how an individual remembers the feelings when they experienced the decision being considered in the past, though it does not generally involve the actual experience itself (e.g., I want the vanilla ice cream because I remember how I had so much fun with my friends when we went out for vanilla ice cream last week). Thus, Experienced Utility is not often a useful tool to make important, objective decisions. On the other hand, with Remembered Utility, we remember the choice itself when we made it in the past, and its specific aspects that actually brought us pleasure or displeasure (e.g., I want vanilla ice cream because I remember how delicious it was and how much more I enjoyed it over the chocolate ice cream), which makes it particularly effective as a decision-making framework.
Researchers have also established that when we use Remembered Utility, we tend to remember experiences in three discrete phases (the starting event, the ‘peak’ positive or negative event, and the end event), and our decisions are generally only influenced by the peak and end events. This phenomenon, called the “Peak-End” Rule, has shown that the way an experience associated with an unpleasant ‘peak’ is recalled is more positive when the end event can be perceived more positively relative to the peak (i.e., “it was bad for a while, but it turned out better in the end”). This difference in how these two events are perceived (the end relative to the peak) can have a significant impact on how we later feel about the event and our willingness to do it again. For example, even though the peak event of giving birth can be excruciatingly painful, the end event of holding the baby after it is born is so positive for most new mothers that they would be willing to have a second child.
In financial planning, the Peak-End Rule can be used to help clients overcome challenging tasks that they imagine will have negative outcomes (potentially due to their irrational use of Expected Utility) by helping them identify similar challenges that were resolved positively and comparing the peak and end events to the current situation, which helps clients realize that positive outcomes are possible. Additionally, clients who aren’t sure whether they are choosing realistic goals for their future plans might consider testing out their options to have an appropriate basis for using Remembered Utility (e.g., suggesting that a client who wants to budget for an annual 3-month European vacation during retirement try it out now, to see if the location and length of time is something that they will actually enjoy before they create a long-term plan committing to such a large budget item).
Ultimately, by understanding how individuals tend to make decisions, financial advisors can help clients plan their futures by using the Peak-End Rule and Remembered Utility not just to help their clients to formulate suitable financial goals that will be most likely to bring them happiness, but also to find workable solutions to attain those goals!