Patrick J. McGuigan and Alan B. Eisner
indicates that planners save more. This conclusion doesn’t
appear revolutionary, but when researchers broadly agree
that 60% of Americans will end their lives in financial
failure, its implications are profound. Effective financial
planning requires people to forgo immediate gratification
for the delayed reward of financial success. The discipline
to say no is among the most painful exertions of human will.
The latest technology and up-to-date information on planning
is a woefully inadequate base for an effective financial
advisor. Knowledge of planning must be combined with an
understanding of human decision-making.
what one wants is difficult. Determinants of taste are complex
and poorly understood. Little empirical agreement exists
about even the most fundamental preferences in daily life.
The most common finding is that preferences seem to change
during the process of elicitation. People learn about what
they want within the context of what’s available,
and learning about additional options causes preferences
mundane decisions require that people predict their future
preferences, and many of these predictions are wrong. Even
something as trivial as a grocery list requires a prediction
of future appetite. But how many of the items purchased
end up in the trash, replaced by other items that were not
on the list? This is a result of the person’s incorrectly
predicting future preferences. The consequences range from
inconsequential to severe.
a financial plan to succeed, it must be predicated on an
individual’s preferences. But developing a plan is
difficult if someone doesn’t know what she wants or
if what she wants is likely to change. Therefore, plans
should adapt to shifting preferences. Planners should adapt
as well, explicitly discussing with clients the contingencies
built into the plan to accommodate change, and confronting
shifting preferences head-on as a natural feature of the
that have problems with self-control have problems with
wealth accumulation. Self-control is a continuous set of
choices that often need to be made in light of considerable
distraction, temptations, and obstacles. Given that a majority
of Americans are now overweight and that being overweight
is now the leading cause of death in this country, one can
fairly say that many Americans have a problem controlling
maintain self-control, many individuals require moral support.
Meeting once a year with a client may not be enough when
memories of the benefits of planning for the future fade
fast. Another strategy that planners can use is to invest
in illiquid assets, or use investments with early withdrawal
life insurance is considered a form of forced savings. Some
financial advisors recommend that people buy term life insurance
and invest the rest in investments that pay a higher rate
of return than the cash-value life insurance. In reality,
most people buy term and spend the rest, because the control
factor is eliminated.
their book Why Smart People Make Big Money Mistakes—and
How to Correct Them: Lessons from the New Science of Behavioral
Economics (Simon & Schuster, 1999), Gary Belsky
and Thomas Gilovich offer interesting paradoxes. First,
why do so many Americans keep their money in savings accounts
when they are actually losing money? Second, why are people
willing to spend more on an item when they use a credit
card than when they pay in cash? Third, why are workers
happier with a 10% raise when inflation is 12% than they
are with a 3% raise when inflation is 4%? Finally, why do
so many people have low deductibles on their insurance policies?
These are among the difficult conundrums that planners have
to navigate. Human judgments are subjective and biased,
and these biases can have a catastrophic effect on a person’s
accounting describes how many people separate money into
different accounts and categories within their minds and
develop rules about the expenditures of money in these accounts.
Mental accounting usually helps people economize their time
and thinking. They also use it to help control behavior.
Some people, for example, decide not to spend more than
$X on a type of activity or product.
mental accounting does not always work perfectly. For example,
consider a person who buys 100 shares of stock for $10 each,
after which the price of the stock declines. He does not
want to sell the stock because he would have to declare
the loss and close the mental account for this stock. The
stock declines further, and he still does not sell the stock.
to eliminate someone’s mental accounting is useless.
A good planner will work to discover a client’s mental
accounting rules and how those rules might be modified to
the client’s advantage. The planner can learn how
a client tracks money by asking questions intended to elicit
mental accounting rules.
for the Future
is about process, not outcomes. There is no way of seeing
30 years into the future with any certainty; nonetheless,
the planner must strike a balance between today’s
resources and tomorrow’s needs. Getting to know the
client is critically more important than getting to know
what the client wants, because what the client wants will
J. McGuigan, CLU, ChFC, CPCU, FLMI, is a doctoral
candidate at Pace University and assistant professor of finance
at Central Connecticut State University, New Britain.
Alan B. Eisner, PhD, is the graduate program chair
and associate professor of management at Pace University,
New York, N.Y.