This year the Nobel Prize in economics went to Richard Thaler on his work in behavioral economics. He is the pioneer of the Nudge Theory, which helps explain why people make irrational decisions while also helping others exercise better self-control. His work influenced behavioral finance as well. For years now, we’ve been a huge proponent of behavioral finance. Heck, I’ve even written a white paper on its dangers and affects concerning financial planning. On the coattails of behavioral economics being legitimized, I thought it would be a great opportunity to educate on how it transcends to our core value. It’s simply why working with a professional is essential for most of us to achieve financial success.
What is Behavioral Economics/Finance? The definition of behavioral economics/finance is a mouthful! Basically, it takes behavioral and cognitive psychological theory and combines those with conventional economics and finance. The result provides an explanation for why people make irrational financial decisions. We are hardwired to make decisions on instinct. It’s part of the fight-or-flight mentality, our natural survival tactic.
Why is it so dangerous? The issue arises when we take this fight-or-flight mentality and apply it to our personal finances. For instance, we have a few dismal days in the stock market and it causes you to suddenly change your entire investment philosophy. Your strategy was built on logic and academics during a calm, cool, and collected time. If you used logic, research, and analysis (instead of your instinct of flight) you’d uncover some startling facts. For instance, going back as far as to 1997, 6 of the 10 best days in the stock market have been within 2 weeks of the 10 worst days. When it comes to personal finances, the stakes are enormous (especially as retirement approaches for the bulk of our clients). Our finances determine many things. Can I retire at 58 or 68? Will I afford paying for college? They also determine what happens to our family in the face of a tragedy. Most of us, if left to our own devices, are just too close to the situation to make purely logic based decisions. In my white paper, I even referenced the 11 most common behavioral finance biases. These biases are often what prevents us from making sound financial decisions that are in our best interest.
What’s the solution? Richard Thaler’s solution is brilliant, yet simple. Reframe the narrative; “trick” your emotions into making the rational decision. For instance, have you ever worked for a company that starts you at a 6% 401(k) contribution and increases your contributions 1% a year unless you opt out? Well not surprisingly, this “nudging” has changed the way people save for retirement. This has led to a substantial increase in the amount of money currently saved in employee’s retirement plans, to the tune of $7.4 billion dollars per year. The solution when it comes to personal finances is also quite simple. Align yourself with a professional who will help you make intelligent, academic-based decisions. It is the single largest benefit of working with a financial planner. To quote Nick Murray (an industry icon): “the great advisors deal not in prediction and performance, but in planning, perspective, and behavioral coaching.”
Nobel thoughts Certainly here at Diversified we aren’t looking for any Nobel prizes (although I’d gladly take the 9 million Swedish Krona for winning). However, we do feel strongly about the craft we work so hard to perfect. We feel immense value in our partnership with clients. At the top of our value-added list is getting our clients “out of their own way.” We educate, coach, and (dare I say it) rewire them, so that we can collectively make the most informed and appropriate decisions.