When it comes to financial affairs, there are two schools of thought: Traditional financial theory and behavioral finance. Traditional financial theory assumes that people make decisions by gathering all relevant data and possess the skills to process this information in a rational, unemotional way to arrive at an optimal choice. Behavioral finance, which studies the psychological factors affecting financial behavior challenges traditional assumptions.
Students of this field believe that people make decisions based on incomplete information, and for the most part, lack the ability to use that information to make the smartest choice. Furthermore, they argue that emotions and biases distort reasoning leading humans to act unpredictably and irrationally, leading to poor decisions. Real life experience seems to support the behaviorists. People in otherwise similar personal and financial circumstances can behave very differently when it comes to spending, saving and investing their money.
In addition to being logical and calculating, traditional finance assumes that people possess and exercise the self-control to make financial decisions that are in their long-term best interests. Psychologists have instead shown that self-control varies widely from person to person and that many are influenced by social and psychological factors that lead them to behavior that is destructive to their most important goals.
Knowledge versus actions
Decades of behavioral research also demonstrates a disconnect between knowledge and behavior. Even when we are smart enough to know what we should do we usually end up doing what we want to do. For example, studies on retirement readiness and savings levels show that while most respondents believe they should be spending less and saving more for their future, follow up surveys with those same groups indicate little or no change in savings patterns.
In matters involving investing, we see the same divide. Successful investing principles are available to nearly everyone. Still, individuals can be their own worst enemy by allowing emotions of overconfidence, euphoria, and panic to dictate when they buy and sell financial assets. They also continue to fall prey to abusive sales pitches for the holy grail of investing—low-risk high return products.
Today, Americans are increasingly responsible for managing their own finances, and the challenges have never been more significant. Longer lifespans that require a larger pool of savings to fund and continued increases in medical and long-term care costs are just a few of the issues they face. Given the implications for our well-being, especially later in life when we have fewer options available to shore up our finances, anything we can do to improve the quality of our decisions now will serve us well. In future articles, I’ll discuss some of the behavioral issues that cloud our decision making and make some suggestions for mitigating their impact.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit sentryfinancial planning.com. This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.