In a recent article, I introduced the fields of classical and behavioral economics and finance. Classical finance assumes people make financial decisions in computer-like fashion — rationally and unemotionally. Behavioral finance which combines the study of economics and psychology argues that these assumptions do not reflect real life.
In his work in the 1950s, Herbert Simon, a cognitive psychologist and Nobel Laureate in economics identified three forces that limit people’s ability to make purely rational decisions: (1) bounded rationality; (2) bounded self-control and (3) bounded self-interest. In this article we’ll see how they might apply to one of the most important personal finance challenges that households face, achieving a secure retirement.
Bounded rationality and computational complexity: Even the smartest among us lack the time and brainpower to consistently collect, analyze, and act on all the relevant information needed to make intelligent choices on complicated issues. The retirement savings and spending problem is an excellent example of Simon’s “bounded rationality.”
Making smart decisions about retirement is hard. It requires determining how much to save and how to invest while working and assessing how much you can spend once you retire. This requires reasonable estimates of variables like lifetime earnings, investment returns, tax rates, health status, and longevity — none of which can be known precisely. Furthermore, figuring out retirement savings and spending amounts involve calculations that are challenging even for those with financial expertise. For others with more limited knowledge, tackling these problems can be confusing and stressful, which can further impede sound decision-making. Unfortunately, rather than struggle through the details, most people resort to shortcuts which often result in hasty, ill-advised decisions.
Bounded self-control and making tough trade-offs: Financial practitioners recommend that people plan their spending so they can maintain their desired standard of living over their entire lifetime. For most of us, this means controlling spending during our working years so we can accumulate sufficient assets to fund a secure and comfortable retirement. We all recognize this as sensible advice, yet in general, Americans continue to under save. In other words, it’s not a lack of awareness or even a lack of desire but rather a lack of willpower to make sacrifices today to get a payoff sometime in the future. This seems to be true even when the change requires small short-term sacrifices in exchange for a substantial long-term benefit. In many respects, saving for retirement involves behavior modification similar to that needed for dieting and exercise. It’s tough to change, and even if we do, we often lose our resolve to stick with it.
Bounded self-interest and generosity: According to traditional economic theory, individuals are concerned only about themselves and expected to act in a way that improves their own financial interests and not necessarily the welfare of others. In other words, self-interest is presumed to be the primary motive when making financial decisions. Behaviorists argue, and fortunately, our own life experiences demonstrate that people regularly sacrifice their own interests, to help others. In his book The Altruistic Brain, Donald Pfaff, a neuroscientist at Rockefeller University, says this model of human behavior is not supported by science and instead “doing good” for others is a trait that is hard-wired into our brains.
America is among the most generous nations in the world. In 2018 charitable giving to institutions, neighbors and strangers in need in the U.S. reached a record high of over $400 billion in monetary donations and over 8 billion hours of volunteer work. Also, older Americans are increasingly providing financial support to adult children, grandchildren, parents, and even siblings. In at 2013 study conducted by Merrill Lynch titled Family & Retirement: The Elephant in the Room, the authors found that while generosity, especially toward family members, is a key source of satisfaction for older Americans, it can also be a cause of stress and worry. For many less affluent retirees, balancing the financial needs of others and their own retirement security can require living a more frugal lifestyle than they could otherwise enjoy.
Logic vs. emotions: Conventional economic theory assumes humans make logical, unemotional and sound financial decisions and then act accordingly. But as anyone who ever started a new diet, exercise regimen or savings program knows, there is a disconnect between theory and practice. Research in behavioral economics shows us that human emotions get in the way and cause individuals even with the best of intentions to often make poor decisions. In other words, in real life, emotions usually trump logic.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions. John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com