#328 - Oh, Behave! Behavioral Finance and Retirement: Are You Rational?

This month on the Retirement Answer Man show we are diving deep into behavioral finance. Do you consider yourself a rational person? Most of us think we are rational people, but according to Frederick Nitzsche rationality is impossible. However, without rationality, we are bound to make poor financial decisions. That’s why today we’re going to explore our humanness and focus on how we can make better decisions. Listen in to learn how to make better financial decisions so that you can rock retirement.

“Today we’re going to explore our humanness and focus on how we can make better decisions.”

What is behavioral finance?

Behavioral finance is an area of finance that attempts to understand and explain observed investor and market behaviors. One question behavioral finance seeks to answer is why do investors sell during bear markets and buy during market peaks? Behavioral finance tries to explain how our humanness affects the markets. When we study behavioral finance we have a better understanding of those things about investing that don’t make sense.

How do traditional finance and behavioral finance differ?

On the flip side, traditional finance assumes that investors are rational, optimizing market players. Modern portfolio theory is based on the premise that every investor is going to try to maximize returns and minimize losses in their portfolio. The sweet spot that every investor seeks is called the efficient frontier. So, according to traditional finance thinking, an investor would never deviate from the efficient frontier. Traditional finance assumes that an investor can filter information and assess the tradeoffs in order to maximize utility. But the reality is, self-deception and social influence have a huge impact on our decision making.

“Behavioral finance tries to explain how our humanness affects the markets. ”

What does Maslow’s Hierarchy of Needs have to do with finance?

Maslow’s Hierarchy of Needs plays a role in our decision making as well. Many of us have learned how quickly we can move down the pyramid from self-actualization to base needs during the recent turn of events in the world. Our own pessimism and optimism have so much to do with where we lie on this psychological chart. We use self-deception, irrationality, and bias to block our ability to make rational decisions. This month my goal is to help you learn to make reasoned decisions even with all of your cognitive biases.

Should market volatility affect plans to rebalance?

A listener asks if she should continue her plans to rebalance her portfolio amid the recent market volatility. There are two different ways to approach rebalancing. Some choose to rebalance according to a date on the calendar. Others choose the threshold approach which means they rebalance when their portfolios begin to tip too far in one direction or the other. David Stein recommends choosing one approach and sticking with it. Listen to this episode to see what he has to say about rebalancing, taxes, and other listener questions.

“This month my goal is to help you learn to make reasoned decisions even with all of your cognitive biases.”

OUTLINE OF THIS EPISODE OF THE RETIREMENT ANSWER MAN

WHAT DOES THAT MEAN?

[1:11] What is behavioral finance?

PRACTICAL PLANNING SEGMENT

[2:05] Why is behavioral finance important to understand?
[8:12] Maslow’s Hierarchy of Needs

Q&A SEGMENT WITH DAVID STEIN

[16:25] David Stein thinks that loss aversion is the most prevalent bias that people have
[18:54] Should Wendy take a lump sum or payments?
[23:40] A rebalancing question
[27:22] What could John do to lower his capital gains tax?