Framework for Better Financial Decisions

Framework for Better Financial Decisions

The faculty at the Booth School of Business at the University of Chicago put out a fascinating paper regarding how the government might help in changing people’s financial decision-making framework.  Here is a link to the paper.

Let’s start with some alarming statistics from the report:

  1. Household non-mortgage debt is $3.5 trillion.
  2. Less than 50% of households report being able to cover an unexpected $400 expense without borrowing or selling possessions.
  3. Sometimes, people are receiving 30% of their annual income in the form of a tax refund.

There is a growing body of evidence that people are generally terrible decision makers particularly with regard to their personal finances.  Here are some examples of the behavioral factors involved:

  1. “The most important determinant of outcomes is the set of options consumers decide to evaluate, known as the consideration set.  Many mistakes stem from either considering bad financial options or failing to attend to better ones.  For example, many home buyers do not do any comparison shopping when they apply for a mortgage; they simply go with the first financial institution they contact, which may not necessarily be the best option.”
  2. “The combination of limited financial literacy and complicated choices can also result in inattention, internal conflict, the application (and potential misapplication) of simplifying heuristics, and avoidance.  Inaction in the face of complexity is itself another common financial mistake.”
  3. Biased Judgements and Preferences – “Numerous studies show that individuals give more weight to potential losses than to equivalently sized potential gains.  They also give disproportionate weight to present over future outcomes.”
  4. “Finally, social context may affect consumers’ financial decisions.  Individuals may look to the choices others make for guidance about what is best for them, and they may be motivated in part by how others perceive their decisions.”

The list goes on and on.  In short, there are lots of ways we can shoot ourselves in the foot.

So, what can be done about it?  Educating yourself and establishing a decision-making framework for your financial decisions should help.

The paper discusses different ways that the government could intervene to help overcome the behavioral mistakes. The two ideas that were most often cited in the paper were providing checklists to consumers that could guide the decision-making process and a recommendation-making software framework solution.

Both were based around the same concept of providing context and a template for decision making based on some level of tailored circumstances.

The argument against government intervention, in this case, is that this is what the financial services industry has to do now.  Examples that come to mind are the “Long Term Care Buyers Guide”, Annuity Disclosures, and Mutual Fund Prospectuses.  These documents were all designed to protect the public and provide a semblance of that framework.

Where it has gone all wrong is the insane amount of legalese required by corporate lawyers (and rightfully so to a large degree) that have made it totally useless to the public.

To this point, when the government has gotten involved to help the public, the requirements that need to be met or the CYA that firms inevitably practice, often overshadow any potential benefits.

An idea that is discussed that could be extremely useful is an automated email that helps people make smarter decisions at specific milestones or decision points.  These might include a promotion, raise, work anniversary, and so on.

Having specifically timed emails could, in fact, help people make incrementally better decisions that add up to a material increase in personal net worth over time.   People that would follow this protocol will not only end up better prepared financially but also have much greater peace of mind.

As an investor, establishing the framework that would allow you to make better on-going decisions could be hugely influential to your future success.  Some ideas of changes you could make this year to make better decisions might include:

  1. Allocating 50-100% of your raise towards your 401k (Roth option if you have one).
  2. If you are paying off any debts this year, immediately re-allocate the debt payment towards your savings account or towards an investment account.
  3. If you receive a large refund, consider changing your withholdings on your form W-4 to receive more money in your ongoing paychecks to invest or save.
  4. Start a 529 plan immediately upon the birth/adoption of a child.  Every little bit helps.
  5. If you’re retiring soon, run the numbers on the long term value of delaying your Social Security benefits.
  6. If you’re retiring, take a look at some Single Premium Immediate Annuities that may be able to provide lifetime income for you throughout your retirement to avoid potentially running out of money.

The list above could be endless.  But setting up the decision-making frameworks and educating yourself will be worth all the time and effort spent.

This paper is definitely worth the twenty-minute read.  Here’s a link again.

 

 

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