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- Chapter 19
Behavioral Financial
Planning
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- 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.
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- 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
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incorporated under the term Life Planning.
- 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.
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- 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.
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- 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.
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- 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
7 other variables.
- 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
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- 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.
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- 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.
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- 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.
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- 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.
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- 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
13 with well-tested quantitative criteria.
- 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:
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- Restricting Negative Behavioral
Responses, cont.
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- Apply Behavioral Characteristics to
PFP
Practical examples of behavioral characteristics:
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- Apply Behavioral Characteristics to
PFP, cont.
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- Apply Behavioral Characteristics to
PFP, cont.
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- Apply Behavioral Characteristics to
PFP, cont.
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- Apply Behavioral Characteristics to
PFP, cont.
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