Paradoxes for Planners

By Patrick J. McGuigan and Alan B. Eisner

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Research 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.


Knowing 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 to change.

Many 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.

For 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 planning process.


Individuals 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 their appetite.

To 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 penalties.

Cash-value 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.

In their book Why Smart People Make Big Money Mistakesand 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 financial future.

Mental Accounting

Mental 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.

But 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.

Trying 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.

Planning for the Future

Planning 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 change.

Patrick 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.




















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