The laws of supply and demand and the ideal behavior of free markets are all based on logical, rational economic decisions.
However, factoring in human nature, people often do not make the most logical economic decisions.
The field of Behavioral Finance (as made famous by the book Freakonomics by Steven D.
Levitt and Stephen J.
Dubner) is the study of social, emotional and cognitive factors on economic decisions.
Behavioral Finance can explain why people make irrational economic decisions and provide guidance on how to help people prepare for a secure financial retirement.
Bad Decisions As human beings, we often rely on what psychologists call heuristics.
These simple, efficient rules often point us to the right conclusion.
Unfortunately, when used for economic decisions, these same heuristics can lead to seemingly irrational choices.
Here are a few well-documented examples.
- Availability Heuristic - Using personal experience or knowledge to make judgments about a larger group - Representativeness - Assuming a sample of events is representative of results, when actual results are either random or not based on prior results - Overconfidence - Attributing a high degree of accuracy to one's own prediction even when there is little information that would support an accurate prediction Importantly, heuristics can lead to choices that do not reflect the best policy for the health and stability of a 401(k) plan.
Although it might seem counter-intuitive, the best practice to maintain a steady rate of risk in an account is to sell off high performing assets and purchase lower performing assets from year to year.
This emphasizes the age old practice of "buy low, sell high.
" Yet, it is often hard to emotionally detach and sell well performing assets.
So What? By understanding how and why people make both rational and seemingly irrational economic decisions, retirement plans can be structured to make it easier for employees to make sound financial decisions.
For example, to avoid "paralysis of choice" 401(k) plan participants should not be given too many plan options.
In the study How Much Choice is Too Much?: Contributions to 401(k) Retirement Plans, Sheena S.
Iyengar, Wei Jiang, and Gur Huberman analyzed the investment habits of over 800,000 employees.
Research found that when faced with too many investment decisions, 401(k) participant investments fall and/or employees will procrastinate indefinitely.
Additionally, investment education and investment advice can be provided so that employees do not rely on deep-seated heuristics.
For example, believing that prior portfolio performance reflects one's ability to choose winning investments may have more basis in heuristics than in fact.
However, factoring in human nature, people often do not make the most logical economic decisions.
The field of Behavioral Finance (as made famous by the book Freakonomics by Steven D.
Levitt and Stephen J.
Dubner) is the study of social, emotional and cognitive factors on economic decisions.
Behavioral Finance can explain why people make irrational economic decisions and provide guidance on how to help people prepare for a secure financial retirement.
Bad Decisions As human beings, we often rely on what psychologists call heuristics.
These simple, efficient rules often point us to the right conclusion.
Unfortunately, when used for economic decisions, these same heuristics can lead to seemingly irrational choices.
Here are a few well-documented examples.
- Availability Heuristic - Using personal experience or knowledge to make judgments about a larger group - Representativeness - Assuming a sample of events is representative of results, when actual results are either random or not based on prior results - Overconfidence - Attributing a high degree of accuracy to one's own prediction even when there is little information that would support an accurate prediction Importantly, heuristics can lead to choices that do not reflect the best policy for the health and stability of a 401(k) plan.
Although it might seem counter-intuitive, the best practice to maintain a steady rate of risk in an account is to sell off high performing assets and purchase lower performing assets from year to year.
This emphasizes the age old practice of "buy low, sell high.
" Yet, it is often hard to emotionally detach and sell well performing assets.
So What? By understanding how and why people make both rational and seemingly irrational economic decisions, retirement plans can be structured to make it easier for employees to make sound financial decisions.
For example, to avoid "paralysis of choice" 401(k) plan participants should not be given too many plan options.
In the study How Much Choice is Too Much?: Contributions to 401(k) Retirement Plans, Sheena S.
Iyengar, Wei Jiang, and Gur Huberman analyzed the investment habits of over 800,000 employees.
Research found that when faced with too many investment decisions, 401(k) participant investments fall and/or employees will procrastinate indefinitely.
Additionally, investment education and investment advice can be provided so that employees do not rely on deep-seated heuristics.
For example, believing that prior portfolio performance reflects one's ability to choose winning investments may have more basis in heuristics than in fact.
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