Q&A: Behavioral Finance

Behavioral Finance (1)

Question: I just read a Wall Street Journal article that attempts to claim that Roth 401(k)s and IRAs are better than the traditional types. Although such a column is not unusual in and of itself, this is the first one I have read that actually has some logical basis.

However, careful reading reveals that this claim is based more on human behavior than on sound economics.

Although (as you have previously indicated) there are rare scenarios in which a Roth is financially advantageous (e.g., if one anticipates a higher tax rate in retirement than while gainfully employed), I think you could easily dispute this article’s claim, and I would agree with you. After all, if a person can afford to contribute 10 percent to a Roth, he/she can easily afford to contribute more (e.g., 12 percent or 13 percent) to a traditional account.

This kind of reminds me of the scenario in which a person may have multiple nonmortgage debts. Many financial experts will recommend paying off the lowest balance first. I say forget the balances and pay off the debt with the highest interest rate first. Simple mathematics will support my recommendation. However, in recent years I have come to realize that when human behavior is considered, the former may be a better plan for some people because they get a psychological boost from paying off a particular debt and then focusing on the next one. I personally would never have this problem, but I get it that some people do.

So, my question to you is, as a financial advisor, how do you determine which type of client you have — one who behaves irrationally regardless of sound financial advice or a normal person? (Then again, who’s to say who is normal?) Anyway, do you stick to your basics and let the chips fall where they may, so to speak, or do you try to determine whether a client is in the irrational category? After all, paying extra interest to become debt-free is better than becoming frustrated and remaining in debt.

Being an engineer and focusing only on the numbers, I have had these types of arguments with people for more than 40 years and have only recently recognized that human behavior may play a role in what may be the better approach for some people. What’s your opinion?

Ric: It is common for some people to be unable to see the world as others see it — and to be unaware that they lack this ability. It’s the difference between intelligence quotient (IQ) and emotional quotient (EQ) — and why it’s so important that you never ask friends, family or colleagues for financial advice. The reason: They will give you advice that reflects what they would do, which is not necessarily the same as what you should do.

Skilled financial planners avoid this problem. We understand our biases and are careful not to impute them to our clients. Instead, we view finance through the lens of our client. This affects many aspects of personal finance. How should I split my assets among my children in my will? How much risk should I take in my investments? Should I pay off my mortgage? Dozens of decisions must be made, and emotion colors all of them. (Unfortunately, not all planners have such skills, meaning you need to watch out for planners who let their biases color their advice!)

As a result, we spend a lot of time getting to know each client. Good advice they won’t follow is bad advice. So we need to make sure they will accept, follow and sustain the strategies we provide. Otherwise, bad results will follow. This is why we fret over automated investing services and risk tolerance questionnaires — let alone advice offered in magazines and on TV shows. They don’t know the client and thus can’t be expected to offer advice that matches the client’s personality.

We’ve studied behavioral finance for decades (Richard Thaler just won the Nobel prize for his work in this area). I’ve written extensively about it in my books, and we produced a two-hour seminar on the topic, helping people understand that their emotions dictate how they view money decisions — and cause them to make bad ones.

Once we understand our clients’ motivation, we know if telling them, say, to pay off low-balance/high-interest debt is smarter (for them) than paying off high-balance/low-interest debt. Good advice for one client might be bad advice for another.

So when someone asks you for advice, you should reply, “What I would do is not necessarily what you should do. Therefore, you should ask a professional financial planner.”

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