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Behavioral Financial Planning

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Presentation on theme: "Behavioral Financial Planning"— Presentation transcript:

1 Behavioral Financial Planning
Chapter 19 Behavioral Financial Planning

2 Chapter Goals Improve upon PFP performance.
Apply behavioral finance to PFP. Target human characteristics that can undermine your objectives. Learn how to overcome human weaknesses. Identify goals that differ from traditional money ones. Evaluate the strengths and weaknesses of behavioral finance.

3 Overview Knowledge of actual human behavior is arguably more important for PFP than for any other area of finance, given its closeness to human actions and its emphasis on practicality. Many people come to financial planners as much to “get structured” as for the specific recommendations. Behavioral financial planning operations can be separated into two components. Traditional money planning and making more efficient financial decisions. Help clients reach their nonmonetary goals which are incorporated under the term Life Planning.

4 The Goal and Role of Behavioral Finance
Our goal is to understand and evaluate the contribution of behavioral analysis to PFP. To understand the role of behavioral finance, we recall what finance is and contrast finance theory with actual behavior. By traditional finance, You are assumed to act logically all the time. You have perfect knowledge of all the information you need. You have full capability for recalling past experiences. You have the intellectual capacity to make the right decisions at all times. Markets are highly competitive with no opportunity for expecting and achieving greater than average profits. All other human beings have the same tastes, preferences, beliefs, and abilities.

5 The Goal and Role of Behavioral Finance, cont.
Behavioral economics and behavioral finance examine people as they actually are. Behavioral finance: The study of human makeup and actions that result in deviations from logical economic and financial behavior. Behavioral finance is controversial. Criticisms: It has no scientific underpinning. It can’t represent all people with one analysis, much less measure them numerically. Its generalizations come from laboratory experiments and questionnaires, not from how people act in real life.

6 Understand what Behavioral Financial Planning Is
Behavioral financial planning The analysis of individual conduct and the development of practical techniques to improve decision making. From a financial standpoint it looks at human weaknesses and ways of overcoming them to bring you closer to your goals. Behavioral financial planning continues the broad definition of behavioral finance. Its mandate is to focus on any behavior that provides a shortfall from ideal results and can be improved upon.

7 Separate Human Shortcomings into Categories
Human shortcomings as they relate to finance, can be thought of as differences between ideal financial outcomes and actual ones. Two categories: Cognitive errors. Lack of knowledge. Weakness in perception and memory. Limited processing scope and speed. Visceral feelings or emotions. When emotions are thought out and stable, they reflect our preferences and lead to pleasure. But visceral feelings can imply urges to take action that are often short term in nature and can cloud mental processing. Can be caused by biological, cultural, psychological, or other variables.

8 Separate Human Shortcomings into Categories, cont.
Examples of visceral feelings are rage, hunger, fear, pressure, and so on. Finance people might say that those feelings can be irrational because they can result in a very short-term level of satisfaction and long-term dissatisfaction. Full knowledge of the outcomes beforehand might not change the situation because reasoning ability may be cut off. In sum, all the behavioral characteristics we have

9 Heuristics and Biases Heuristics: Simplified human approaches to complex tasks. Biases: Actions based on a flawed view of reality that are inevitably harmful in the long run. Heuristics and biases were popularized by psychologists Daniel Kahneman and Amos Tversky in their experiments in the 1970s. Many researchers would probably say they had a great deal to do with the revival of interest in behavioral issues in economics and finance.

10 Heuristics and Biases, cont.
Common heuristics: Anchoring: Using an outmoded or inappropriate standard can result in making incorrect decisions when the standard is no longer appropriate. Framing: How you communicate a thought can affect the response. Representativeness: Judgments made on the basis of only one or two characteristics instead of embarking on a detailed analysis. Availability: Believing the likelihood that something will occur in the future is determined by how often we recall it. Hindsight Bias: Believing, after the fact, that an outcome could have been known beforehand. Salience: Placing too much weight on recent vivid experiences.

11 Behavioral Life Cycle Theory
The behavioral life cycle theory was formulated by Richard Thaler and H.M. Shefrin. According to their model, people have two sides to their thinking; personality and actions, called multiple selves. Your planner side acts rationally, always in control, thinking of what is in its longer term interests. Your doer side is more emotional, reacting impulsively to short-term pleasures without regard to their long-term consequences. Actual behavior comes from a current resolution of the conflict between the two sides only to be repeated again in future decisions.

12 Satisficing and Mental Accounting
Satisficing: A method by which individuals seek a satisfactory solution, not an optimal one. Once they find that satisfactory solution they stop the process. Satisficing is a term made popular by Herbert Simon, who also introduced the term bounded rationality. Mental accounting, as popularized by Richard Thaler, is an attempt to explain the way the brain works in decision making. The brain compartmentalizes our actions, placing them into certain categories. The categories make sense to us and help motivate us so that we maintain control over our actions. The process may not be rational in the economic sense of the word.

13 Restricting Negative Behavioral Responses
Weaknesses in human behavior bring about results that are less than optimal. Ways of overcoming or at least minimizing these weaknesses are: Formal Financial Learning: To the extent that we can become more knowledgeable about finance in general and useful financial techniques in particular, our actions can improve. Experience: Experience with real life financial elements can improve the way we operate. Self-Understanding: Once we understand our shortcomings, we can focus on them to obtain better results. Develop Effective Rules of Thumb: When you find investments that have attractive operations, compare them with well-tested quantitative criteria.

14 Restricting Negative Behavioral Responses, cont.
Limit Reviews of Performance: People tend to overemphasize recent results, extrapolating them into the future. Obtaining Assistance: Sometimes others are in a better position to identify our weaknesses and offer suggestions to help overcome them. Savings Mechanisms and Control: Saving is a problem for many, and some believe a particular problem for our country. There can be a great disparity between planned and actual savings. Control methods include are specified in the next slide:

15 Restricting Negative Behavioral Responses, cont.

16 Apply Behavioral Characteristics to PFP
Practical examples of behavioral characteristics:

17 Apply Behavioral Characteristics to PFP, cont.

18 Apply Behavioral Characteristics to PFP, cont.

19 Apply Behavioral Characteristics to PFP, cont.

20 Apply Behavioral Characteristics to PFP, cont.

21 Summarize “Money Planning”
To sum, the goal of behavioral financial planning is to bring actual performance as close as possible to ideal performance.

22 Broaden Behavioral Financial Planning to Include Life Planning
Life Planning goes beyond money planning to take into account the analysis and scheduling of steps for the realization of personal goals. Individual motivations cannot be measured in purely financial terms. Actions that deviate from money maximization may not be human weaknesses but long term human preferences. Life Planning is related to what the CFP Board calls values-driven planning or holistic planning. It deals with the personal side of the household enterprise, particularly with goals of its members.

23 Broaden Behavioral Financial Planning to Include Life Planning, cont.
Financial planners and/or other client advisors can aid in goal development and frequent reassessment. The planners emphasize clarity of goals thereby starting the client on the path to accomplishing them. They may ask questions such as “If you had five years to live, what would you hope to achieve in that time frame?” “If you had one day left, what would you regret not having done?” “If you had three very good years, what would you have accomplished toward your goals during that time frame and how would you have done so? How would your life have been different at the end of the period?” “What additional steps do you have to take to reach your goals?”

24 Broaden Behavioral Financial Planning to Include Life Planning, cont.
The goals and the process for meeting them influence the planning engagement. Meetings may be held periodically to evaluate progress and whether clients are on track toward goal achievement. It is acknowledged that goals may change over time and once goals are achieved new ones are often established. Planners who perform these broader services intensively are sometimes called “coaches”.

25 Broaden Behavioral Financial Planning to Include Life Planning, cont.
Life Planning is a relatively new area of financial planning. Currently planners vary greatly in their types of professional practice. Some planners restrict themselves to financial matters alone while others provide the kind of services described here. Life Planning belongs under our definition of behavioral finance since it deals with human actions that deviate from the solitary, machine-like financial goal of making as much money as possible. Both financial and nonfinancial goals are considered which accentuates the search for client goals and their implementation.

26 Broaden Behavioral Financial Planning to Include Life Planning, cont.
The essence of Life Planning is Goal Planning. When people are poor, they concentrate on such basics as food, shelter, and clothing. In middle-class society in the U.S. today some people seek to go beyond making as much money as possible. Goal Planning can be separated into two parts, emotions and non-monetary goal achievement. Emotions are basic motivational factors. Higher level goals can be identified through asking questions such as “What do we want to do with our lives?” and “What are our values?” These items under Goal Planning are difficult or impossible to measure in financial terms.

27 Broaden Behavioral Financial Planning to Include Life Planning, cont.
Research on happiness by behavioral economists suggests that pleasure from earning more money is temporary.

28 Broaden Behavioral Financial Planning to Include Life Planning, cont.
Behavioral financial planning is involved in both areas of Goal Planning. Both basic and higher level feelings typically have a selected minimum money amount to allow them to be considered. Basic needs should be anticipated and planned for. They require an established balance between work and leisure, ideally incorporating job satisfaction as well as pleasure and caring relationships in your personal life. Knowledge and discipline may be required to establish good health and ethical behavior. Consultations with others and establishing role models can help.

29 Broaden Behavioral Financial Planning to Include Life Planning, cont.

30 Become Familiar with the Financial Planners’ Function in Behavioral Analysis
Financial planners have a multifaceted role in behavioral analysis in both money and life planning. In money planning and life planning they can provide the benchmark of financial performance required by clients to achieve their goals as well as the overall planning methods for meeting them. Their role, often as the client’s closest advisor in financial affairs, can provide access to both personality and motivations. They are aware of client weaknesses and can point out specific ways to overcome them. People select an advisor not only for competence in financial matters, but also for assistance with human planning needs.

31 Become Familiar with the Financial Planners’ Function in Behavioral Analysis, cont.
Common nonfinancial needs include: To Trust. To Find an Interested Person. To Understand. To Help Establish Goals. To Feel Secure. To Be Serviced. To Be Understood and Appreciated. To Improve Competency. To Enjoy Interacting.

32 Evaluate the Benefits of Behavioral Financial Planning
Strengths and weaknesses of behavioral financial planning include:

33 Chapter Summary Actual finance differs markedly from ideal finance.
Human shortcomings come from cognitive errors and visceral feelings. Cognitive errors arise from lack of knowledge, weakness in perception and memory and less than ideal processing scope and speed. Heuristics and biases are inherent human actions. Heuristics can be either good or bad while biases can result in incorrect choice. There are a host of ways of overcoming behavioral weaknesses that are presented in the chapter. Life cycle planning goes beyond traditional financial planning to non financial personal goals. PFP is involved because cash flow often, directly or indirectly, helps fund these goals. Financial planners can have a strong role in behavioral finance both for money planning and life planning.

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