There’s a reason why so many people are anxious about their retirement -- it’s called human nature. Let’s see how we might be helped by changes in the way researchers and retirement analysts are looking at how we make decisions. Instead of making assumptions about how people behave that don’t hold up in the real world, this field, which goes by the name of behavioral finance or behavioral economics, examines the way real people make economic and financial planning decisions.
Until recently, "rational choice" theory has served
as the dominant model of decision-making in economics. This theory assumes that people make decisions by generating a
complete list of possible options, methodically evaluating the costs and
benefits of each option, then choosing the option that maximizes their
self-interest. Additionally, this theory assumes that people have access to all
the information needed to make this calculation.
Behavioral finance research has shown that most people aren't truly rational decision-makers. Instead, their rationality is limited by a number of psychological factors. Here are some examples of these limits as they apply to retirement planning:
- Most people have trouble generating a complete set of planning options to consider because they simply don’t have the time and money to do so. As a result, they generally decide among a limited set of alternatives.
- Even if someone can generate a complete list of retirement solutions, they likely can't predict how these plans might fare under different economic scenarios. Even economists and other experts have trouble correctly predicting economic markets, so regular folks are sure to have trouble as well.
- People tend to focus on just a few factors when
making retirement planning decisions, ignoring other factors that might be more
important. A good example is that many individuals and financial planners spend most of
their time actively managing their investments, when other decisions may be
more important, such as those having to do with asset allocation, reducing investment costs, deciding
how much to save, Social Security claiming strategies, and generating retirement income from savings.
- Many people fare poorly when it comes to anticipating their emotional reactions to various events. Some people may overestimate how happy they’ll be if they experience positive investment returns and assume too much stock market risk, overlooking the damage that might occur if the stock market crashes. On the other hand, others may underestimate their ability to bounce back from a stock market downturn and be too conservative with their investments.
- Even if you were able to overcome all the above factors to develop effective retirement planning strategies, you might not have the necessary willpower to carry out your plans. Research suggests that willpower is actually a finite resource: In one study, participants who were asked to resist eating chocolate gave up more quickly on a subsequent puzzle task compared with participants who didn't have to resist the chocolate. This indicates that people don't always possess the willpower to carry out decisions as rational choice theory would expect.
- Finally, rational choice theory assumes that people act primarily in their own interest. But in laboratory settings and in the real world, people are consistently altruistic and collaborative. For example, many people will give money to help close family members even if doing so jeopardizes their financial security.