Behavioral Finance Insights: Personal Finance and Planning
Behavioral finance is one of the new paradigms in the financial theory that aims at anticipating and comprehending the psychological financial decision making, especially of individual investors in conjunction with the systematic implications of the decisions in question on the financial market. Very simply, the basic premise of behavioral finance follows that individual investors or entrepreneurs tend to deviate from acting rationally in a utility-maximizing manner something that usually leads to business failures in the long-run. Essentially, behavioral finance does not substitute the existing theories on investment and finance. In other words, it complements and attempts to improve on their areas of weakness. Here, the sole agenda analyzed by behavioral finance deals with personal financial planning and investment decisions, which are closely related to psychological investment.
Based on the above description, this paper identifies and examines the insight provided by behavioral finance for personal financial planning and personal finance. Firstly, the paper analyzes the insight provided by behavioral finance in relation to various elements and components of behavioral finance. In essence, some of these elements include; psychological bias, bounded rationality, information processing, cognitive disorganization, deceptions and illusions, perceived information, activation plus mistrust of financial advisers and service providers. In addition, the most prevalent irrational behaviors, which individuals often exhibit involves the tendency of separating money into more than one mental account. Such depends a great deal on the magnitudes, purposes and sources of such money. Secondly, individuals are prone to exhibiting loss aversion. The problem associated with loss aversion is that the majority makes decisions and plan with their money in the context of a particular problem, rather than taking into consideration the potential effect of the decision on their available wealth. Thirdly, the aforementioned cognitive bias, especially representativeness, which argues that an individual gives too much weight to the information that, is more recent and easily accessible. Lastly, the paper avails a comprehensive and detailed conclusion with regards the insight gained from behavioral finance.
The first component of behavioral finance is mental accounting; an idea that was developed and coined by Thaler Richard in the year 1985 (Charupat, 2003, p. 44). , this is a tendency of separating money into more than one mental account by individuals. Such depends a great deal on the magnitudes, purposes and sources of such money (Jennings, 2005, p.45). For this reason, money available in different individual accounts is often treated differently. In reference to that, the value an individual person assigns to $1000 in one mental account plus the willingness to undertake risks by investing the money differs significantly with the same amount in another mental account (Charupat, 2003, p. 46). In short, persons at times behave in a conservative manner while at the same time tend to be reckless with their money. For example, an individual will always remain careful, especially with the money they earn on daily, weekly or monthly basis than that they find through other activities such as casino or lottery winnings and tax refunds.
Similarly, the given magnitude or quantity of found money also influences an individual propensity to take a risk and spend. However, the propensity to take a risk and spend further depends a great deal on whether the money is found or earned and the timing of income. Based on this, Shefrin and Thaler (1988, 6) argue that one subconsciously divide and separate the money into three distinct and unique mental accounts: future income, current income, and current assets. In other words, an individual is more willing to spend money available in the current income account than money in the future income account. At the same time, people tend to plan for big purchases such as houses and cars while are lenient with small expenses. Such follows the fact that a person plans and saves for big purchases in his mental current assets account. Indeed, most people fail to recognize and account for small purchases, which can accumulate for a short period of time and, consequently hinder long-term financial plans and savings (Charupat, 2003, p. 45).
Mental accounting adversely affects personal finance through the inculcation of an excessive spending habit. One of the prevalent habits brought about by mental accounting revolves around the use of credit card. According to one of the reports released in 2003, there was approximately $13,000 household credit card debt (Charupat, 2003, p. 43). This amount is, indeed, dangerously high, in reference to the high credit card debt interest rates, which usually amounts to 20%. Mental accounting makes people spend a lot of money through the use of credit cards since an individual does not feel that he or she spends anything while using their credit cards (Charupat, 2003, p. 44). Nonetheless, the problem of mental accounting can be avoided by allowing one’s pay to be invested automatically since the idea of separating accounts in mind leads to false belief, which proves detrimental in the long-run. Such can also be supported by taking a holistic view of all liabilities and assets (Hershey & Neukam, 2003, p.70).
Another element of behavioral finance that affects personal financial planning and personal finance is activation. In the immediate aftermath of making a decision, most people do not necessarily act upon the same. In fact, an individual makes appropriate and result-oriented decision but due procrastination and inhibition factors he or she end ups abandoning the decision (Montier, 2007, p.17). This means that even after spending much time and taking considerable steps in financial decision-making, still an individual requires some kind of motivation to act accordingly with reference to the decision in question. As such, for effective and productive investment there must be sufficient if not desired motivation to overcome the prevailing feelings and inclinations, which may restrain personal action (Hershey & Neukam, 2003, p.68).
Loss aversion is an element of behavioral finance that is closely related to the above discussed “mental accounting.” In one of their seminal papers, Kahnemana and Tversky (1979, p.270) assert that the effect of a loss on one’s happiness is stronger than a gain with the same magnitude. The above means that people usually hate to lose more so when it comes to financial undertakings: individual persons are loss-averse. They further argue that people will tend to take chances so long as the choice can make them avoid possible losses.
Notably, loss aversion can play a pivotal role in causing an individual to make unsound and unproductive financial decisions. Odean (1998, p. 11) in his trading patterns study, for instance, realized that investors could gain up to 1.68 times than the total number of times they made losses. Odean conducted his study using approximately 160, 000 potential consumers of a United States discount broker. In his findings, Odean further reported that the investors were more likely to sell stocks that perform perfectly well than those that perform otherwise. Odean’s findings are directly proportional to the notion that individuals are comfortable with a sure gain, and they are ready to take risks with the sole purpose of avoiding any possible loss. This is what Odean (2003, p.42) referred to as “sunk cost fallacy.”
The aforementioned idea implies that an individual will base his or her future spending or investment on how much he or she has spent or invested (Hershey & Neukam, 2003, p.68). On the same note, loss aversion also causes people to be conservatives with regards to their saving, financial planning, and investment strategies. This means that the potential threats posed by short-term losses often cloud one’s judgment. The impact of short-term losses may make an individual fail to plan and invest on a promising project or program in the long-run. In other words, failure to realize the return-on-capital affects negatively one’s personal finance and financial planning. The available funds that would be invested, therefore, remains a dead stock that neither brings forth profit nor grow. To curb the challenges posed by loss aversion, an individual should take a holistic and long-term approach with regards to the investment. In essence, the person involved in this kind of decision must not view the financial planning idea only in the short-run but rather take calculated risks that will finally lead to productive results. Still, he or she must also forget about the past and instead decide effectively on future benefits and costs (Olsen, 2008, p.2190).
Apart from the above, mistrust of financial service providers and advisers is another characteristic of behavioral finance that has if used applied effectively can impact positively both personal financial planning and personal finance. Therefore, in personal financial planning and personal finance, an individual seeks help from financial agents and experts. The agents in question may be organizations that provide financial services and products to individual investors. However, some inhibitions usually arise, which questions whether the experts are trustworthy and experienced enough or not. In this case, trust is a crucial factor that dictates an individual’s decision (Olsen, 2008, p.2190). For example, one may decide to use his money to invest in real estates, but if they do not trust or feel at ease with the financial adviser, there are higher chances that they may neither act nor execute the investment decision (MacKillop, 2005, p.65).
Bounded rationality is a theory that views decision makers as rational beings whose main intention is to satisfy their emotional needs. The theory does not regard decision makers in terms of maximizing utility (Hershey & Neukam, 2003, p.69). In this case, an individual values the decision since it is a form of search guided solely by personal inspiration levels. The aspiration level, here, refers to the value of a given goal, which an individual want to achieve through undertaking a satisfactory choice. In relation to personal financial planning and personal finance, the goal mentioned above can be security, return maximization or better and beneficial retirement plan. According to the theory of behavioral finance, people fail to make rational decisions as a result of human behavior. As such, bounded rationality argues that individuals are intended to be goal-oriented or rational as well as being adaptive (Olsen, 2008, p.2189).
Contrarily, due to the emotional and cognitive architecture or make-up of human behavior, they fail in making crucial and equally important decisions with regards to their finance (Charupat, 2003, p. 47). In short, this rationality limit in reference to decision-making called bounded rationality. Briefly speaking, personal financial planning and personal finance are affected with such an attitude. Moreover, rationality limits can be divided into two; substantive and procedural limits. Procedural limits hinder the potential approach to deciding while substantive limit has a direct impact on personal financial choices. For example, in personal finance the concept of procedural bound determines how one will make a given choice to invest. Substantive bound, on the other hand, will play a crucial role in determining an investment decision (Olsen, 2008, p.2190).
Notably, individual financial decision-makers often face information plethora (Odean, 1998, p. 1889). In many occasions, therefore, it is difficult to discern the between the wrong and right information from unlimited sources. As such, making the best possible decision also becomes a challenge based on the above situation. In order to find some data or information that can be relied on in decision-making, individuals tend to narrow down and set rules, which are based on personal experience. Such general rules are referred to as heuristics. Heuristics help individuals in incorporating the available or common information into financial decision-making processes. Unfortunately, heuristics such as representativeness may lead to biases.
Nevertheless, representativeness is a perception that prompts people to make decisions based on the available information in their surroundings. Nonetheless, the person involved in the decision-making falls a victim of delusion with regards to consistent information, which may not be a potential investment opportunity (Odean, 1998, p. 1889). They believe that what is rampant and is happening now will reoccur in the near future. Take an investor with a positive gain in the month of April. It is most likely that the investor will spend a lot of money with the sole purpose of meeting similar goals in May. However, this is not always the case. Customers’ preferences and tastes change periodically. Similarly, due to high competition in the corporate world, the potential competitors will exploit other productive avenues so that they can outdo redundant and conservative business organizations. This means that the investor may make a huge loss in the end. Alternatively, each and every person who intends to spend money should take note of the fact that past returns or consistent information about investment do not guarantee positive future performance. Very simply, none should rely on fads as the determinant of investment strategy (Charupat, 2003, p. 47).
In summary, this paper has so far attempted to identify and discuss the insight brought about by the theory of behavioral finance to personal financial planning and personal finance. Again, the paper has described behavioral finance as the financial theory that aims at anticipating and comprehending the psychological, financial decision-making. In relation to that, it has also been clear from the paper that the behavioral finance is a tool in the financial theory works to explain why persons tend to make irrational financial decisions. In relation that, various elements or components of behavioral finance has been discussed a great deal throughout the paper. In this case, mistrust of financial providers, representativeness, cognitive biases, bounded rationality, loss aversion, and mental accountings are all playing a significant role in determining individual decisions in relation to personal finance and personal financial planning. Apart from the above, the paper has finally provided a number of recommendations aimed at helping individual financial decision-makers. In short, an individual should consider many factors while undertaking financial plan and before spending their money at hand.
References
Charupat, N. (2003). How Behavioral Finance can assist Financial Professionals. McMaster University Working Paper, pp. 41-52.
Jennings, M.M., 2005. Ethics and Investment Management: True Reform. Financial Analysts Journal. 61(3). pp. 45-58.
MacKillop, S. (2003). Confidence Builder. Investment Advisor. pp. 62-4.
Montier, J. (2007). Behavioural Investing: A Practitioner's Guide to Applying Behavioral Finance. London: Wiley.
Neukam, K. A. and Hershey, D. A. (2003). Financial Inhibition, Financial Activation, and Saving for Retirement. Financial Services Review. 12(1). pp. 19-37.
Odean, T. (1998). Volume, volatility, price, and profit when all traders are above average. Journal of Finance, Vol. 53, pp. 1887-1934.
Olsen, R. A. (2008). Trust as Risk and the Foundation of Investment Value. Journal of Socio- Economics. 37. pp. 2189-2200.
