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Behavioral Finance: Good or Bad

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A couple of weeks ago I asked Are Roth 401(k)s and Roth TSPs Better? in response to an article in Money Magazine. I attempted to give an answer in part 2 the following day.

The argument was complex and worth reviewing those posts for more detail, here's the shortest version I give. Because many people simply put a percentage of their salary (say 6%) in a retirement account, it is better to got with a Roth 401(k) over a traditional one... you'll end up with more money in most scenarios.

Mathematically, I still don't fully grasp it. However, at the time it was explained to me, it made sense.

The reason it turns out better is "behavioral finance." Investopedia explains behavioral finance as:

"According to conventional financial theory, the world and its participants are, for the most part, rational 'wealth maximizers'. However, there are many instances where emotion and psychology influence our decisions, causing us to behave in unpredictable or irrational ways.

Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions."

Maybe that definition isn't exactly fitting of the situation, but it seemed like the idea was to tell people to go with Roth 401(k) because in general circumstances it will turn out better.

I've never been a fan of such financial generalizations. At the time, I cited people who give the advice, "Cut up all credit cards." It makes me cringe because I use credit cards to save thousands of dollars a year and never pay a finance charge. I also don't spend more money, because it is "less painful" then spending cash. To me it is exactly the same.

On one hand, I want to say this behavioral finance stuff is terrible. Instead let's just educate people so that they can be ideal "wealth maximizers" (love that term). If we show people how to make great financial decisions, they'll be better served in the long run.

On the other hand, I want to say, behavioral finance could be useful. It's easy for me as someone who blogs about personal finance on a daily basis to say, "let's teach people." However, I think there are a lot of people who are ummm, well too Lazy (in the bad sense), to learn. Maybe they are preoccupied with some of life's other problems. So for those people, maybe just telling them what to do is the right thing?

You may be able to tell that I'm leaning towards behavioral finance being bad. I think people should learn all they can about how their money works from a mathematical view. It's okay to point out the psychological pitfalls, but I don't think that should be the horse that pulls the wagon.

What do you say? Let me know in the comments.

Last updated on September 14, 2014.

This post deals with: ... and focuses on:

Finances, Psychology

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7 Responses to “Behavioral Finance: Good or Bad”

  1. Kosmo says:

    I don’t understand why there doesn’t seem to be more focus on trying to change the behavior, so that people could do what made sense AND be making the optimal choice at the same time.

    Are people really that resistant to changing their thinking? Maybe.

  2. Kosmo says:

    /Rant continues

    I guess this is how I view behavior finance.

    There’s a leak in my roof. I’m using a five gallon bucket to catch the water and empty it when it gets full.

    So the expert comes along and says “hey, you should put a 50 gallon drum under the leak. You wouldn’t have to empty it nearly as often.”

    No. You should fix the hole in the roof.

  3. Big-D says:

    I think it is bigger than that. I see this in the entire personal finance industry that you have to make big changes to see little results. This way you feel like you are going to get something. The whole “cut up the credit cards” or “envelope system” things are there to put smoke and mirrors in front of the fundamental problem people have. Their bad behaviors.

    At the end of the process of learning about personal finance, you should be doing things, which work for you, which help you, get into better financial shape. What people focus on in the “trick” or the “hack” which gets you there. It is almost a martyrdom statement “look at me, I am not using credit cards because I am trying to save cash.” Almost everyone else is like “OOOhhhhhh” and I am like “Do what works for you, but I would never cut up my cards.”

    Human behavior is simple to understand. We hoarde, we consume, and we covet thy neighbors flat screen TV. Seeing that, we do what ever the very least amount of effort is to get those things (Steal, sign paperwork, use credit cards, etc.) to get what we want. That is the issue, and changing how people have evolved over millions of years is not going to change overnight.

  4. Kosmo says:

    OK, fair point.

    However, the “experts” could at least present all the options, instead of pretending that the options that don’t conform to the standard behavior don’t exist. Pretending the problem doesn’t exist is conceding the war. Better to win a few battles here and there in an effort to make progress in the war.

    In the specific case of the Roth vs. conventional, a person might have the behavior to set asides the appropriate amounts to make the investments equal, but they are going to be taken down the path of investing in the Roth even in cases where the Traditional is better.

    • Lazy Man says:

      I’m reading a book called The Willpower Instinct, which is starting to change my opinion on this a bit.

      There’s a theory that willpower is like a muscle and we only have so much mental power to expend. Perhaps asking people to expend willpower on things that they tend not to care about (they should, but they don’t), is not a practical solution.

      However, rather than teach behavioral finance, I think I might teach them about willpower (I’m still trying to soak in the book), and explain why that is a valuable skill. It feels like if you have that, you can almost develop everything else.

  5. […] Perhaps if it isn't so overwhelming people will be more apt to do it? Is that too much like behavioral finance? […]

  6. Kosmo says:

    Even if the Willpower Instinct is correct, why not at least put all the options on the table and let people decide which ones they are able to utilize?

    Some of the people in the audience – particularly readers of Money Magazine – very well might have the necessary willpower. Why give them incomplete and arguably misleading information?

    Also, you wouldn’t necessarily need to force anyone to use more willpower. You could provide as simple chart that shows the amount to need to invest in a Traditional to equal the amount of a Roth.

    for example

    ***

    For each dollar invested in a Roth IRA, invest this amount in a traditional IRA for an equivalent investment:

    10% – $1.11
    15% – $1.18
    25% – $1.33
    etc …

    Then use this three step process:

    1) Determine if you expect your tax rate to be higher or lower in the future. If higher, invest in a Roth. If lower, invest in a traditional.

    2) Determine how much money you want to be taken out of your check (the decrease in take home pay)

    3) If Roth, simply invest this amount. If traditional, multiply this amount by the multiplier in the table (this does require a person to know their marginal tax rate)

    It seems to me that this is actually easier to use than the large table in the article.

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