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.
by:- Kort McCulley
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.
by:- Kort McCulley
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