Personal Financial Planning - Essay Example

What insights does behavioural finance provide for personal finance and personal financial planning? Introduction It is an open secret that the survival and successful living of humans are very much dependant on the amount of resources available to them. It is in this direction that there are theories and conceptual frameworks that try to define the basic needs of humans based on the number of resources they require to make a successful living (quote). But it has not always been that people have had as many resources as they require to survive and makes life easier for them. It is against this backdrop that the subject of finance arises as finance looks at the availability of resources to a person and how well these resources are managed make meaningful impact of their availability (quote). Finance would therefore normally be made up of key concepts including the acquisition of resources, management of resources and the investment of resources. As a matter of fact, whether or not a person will have successful finances depends on a lot of issues and factors. It also depends on several components of the person’s personality with psychology playing an important role in some case. Generally, when there is an influence of psychology on the finances of a person, we say behavioural finance is at play. In the present paper, the various ways in which behavioural finance affect personal finance and personal financial planning shall be studied into detail. What is behavioural finance? Generally, behavioral finance may be explained as the association of psychology with finance. Since psychology deals with the way a person makes mental and emotion reactions and decisions (quote); and finance refers to the means of acquisition of resources, management of resources and the investment of resources, behavioural finance can thus be defined as the management and investment of resources based on a person’s state of mind and current emotions. It is against this background that behavioural finance theorists argue that the specific behaviours of a person in relation to the mood in which a person finds him or herself at any point in time while making finance related decisions are determinant factors in directing the focus of the investment preferences that will be make by the person (Kiyilar and Acar, 2009). Imperatively, behavioural finance could be said not to be a permanent state of a person’s financial lifestyle but a series of temporal personal financial attitude (quote). With this said, it is important to acknowledge the fact that behavioural finance is not just a state of a person’s attitude towards finance but could be as broad a subject as how larger financial outfits such as international companies, governments, and international organisations make financial decisions. But whether behaviour influences finance at the personal level or on a large scale, it is important to note that the eventual recipient of any consequences is the market. This is why Sewell (2007) defines behavioural finance as “Behavioral finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets.” Overview of personal finance Personal finance, though may assume a technical meaning and definition could be said to be phenomenon that is part of the everyday life of almost every person. This is because personal finance entails every bit of financial decision that a person needs to make as part of ways of obtaining, budgeting, spending and saving money within a specific timeframe (quote). Personal finance could also be extended to similar financial decisions made by family units, considering among other things, possible financial risks and unpredictable future occurrences. Generally therefore, every person who ever plans of getting money or whoever gets money takes part in personal finance. This is because personal finance certainly arises as a person projects on ways of making money and ways of spending money made. It is important to note however that the fact that personal finance takes place among almost every other person does not mean that personal finance is something that can be taken for granted as a natural happening of life. It also does not mean that all people achieve the same rate of success in personal finance. Indeed, there are very critical issues in personal finance, accompanied with personal finance planning processes that determines how well a person will be with his or her entire finances (quote). As part of this paper, attention shall be given to behavioural finance and how it influences the rate of success in personal finance and personal financial planning. Behavioural characteristics There are key characteristics in the behaviour of people that affects their attitude towards finance. Having a deeper understanding of these behavioural characteristics will make it possible for a person to know key finance and monetary factors that could possibly cause them to behave in a certain manner. Three of these key characteristics are discussed below. Change in monitoring of investment Investments are a crucial component of behavioural finance. This is because the investment of acquired wealth is part of the options that people consider in personal finance. However, the mere fact that a person invests does not guarantee that there will be success with personal finance. The need to find the relationship between persna finance and investment has led to many researchers studying the personal behaviour of people towards investments. In such a study, it was revealed that a host of people have a positive attitude towards short term investment in the sense that they monitor their short term investments so well (quote). A common reason that could be attributed to this situation is that in most short term investment, investors are quick to get proceeds on their investments for onward use. This therefore leads to constant monitoring of investment to know how well their investments are faring. In contrast, there are a whole lot of people who have negative monitoring attitude towards long term investment with the view that the rate of guarantee of success on long term personal investment is high (quote). There are also people who would not be so mindful of monitoring long term investments because of the notion that not much money is often injected into long term investment. As far as change in monitoring investment as a form of behavioural characteristic is concerned, it can be concluded that the more people become concerned about monitoring of investment, the better their chances of making the best out of their personal finance through investment. Change in investment target categories It would be noted that investments come in many different forms and categories. In the event of personal finance and personal financial planning process therefore, people have a lot of options to choose from (quote). Stock market, mutual fund and bonds are some of the options or target categories in personal finance investment. Current studies have however showed that the choices that individuals make in light of investment target categories is very much dependent on the personal interpretations and feelings they have towards the economic climate existing around them at any point in time (quote). Indeed, the wave of national and global economic climate influences the behaviour of people towards the selection of types or categories of investments to undertake. In this regard, individuals in economic climate conditions where there are higher interest rates on financial products like fixed investments, bonds and treasury bills will go for these kinds of investments. In a market where the interest rates are low and there is high inflation also, there is the possibility that there will be a change of investment target category towards the physical creation of markets. For instance such people will go into either manufacturing or direct sales to ensure that they take advantage of the rising inflation rates. All said and done, it is important that any forms of changes that take place with regards to personal investment target categories will be based on careful and prudent economic considerations rather than personal feelings of optimism or scepticism towards the prevailing economy. This is because once the latter happens, behavioural finance could be said to have affected personal finance negatively. Change in factors important for investment As it has been outlined earlier, there are several forms or categories of investments available to persons who wants to undertake personal investment as part of their personal finance. At the concluding part, it was admonished that a lot of critical economic considerations should go into the choice of investment target. Leading up to that, the kind of changes that can be seen in terms of factors that are important for investment is reviewed. In this, there are four major factors that have been identified as most important for investment and thus affecting the choices that people make regarding the line of investments they want to tred. First of these have to do with the kind of information that people get from the companies in which they are investing in. Commonly, it is a behavioural practice to look into and around the company and also listen to information from the company to decide whether or not to invest with them. The reason for this is that companies with reputable financial standings have often been perceived to be financially responsible in the management of investments (quote). The next factor is on recommendations and forecast received from financial analysts. With this particular factor, the authority that investors look at are third party and independent financial analysts rather than insiders from a given company. Thirdly, there is the factor of intuition, whereby people base on their personal feelings and assessment of a company. Finally, the general development of the market is also instrumental as people often look at the current prospects that an investment market has for them. With all of these, evidence based researches show that information from companies continues to be the most influential factors whiles intuition has declined sharply as a factor affecting choice of investment. Ways in which behavioural finance may affect personal finance Overspending There exists a couple of ways in which behavioural finance affects personal finance, including overspending. Overspending is simply a practice whereby people use more than they budgeted to use (quote). In relation to personal finance, any means by which people use a part of their money for purposes beyond what they planed constitutes personal overspending. In worse case, people spend so much that not just an allocated budget like budget on meals is overspent but their entire earning within a specified timeframe is overspent. There are a number of ways and means by which a person’s emotional decisions, and by extension, behavioural finance brings about overspending. First, when people get overconfident in their trend of earning, it can lead to overspending because such people are always hopeful of getting more revenue from their works. Overconfidence in the economic performance may also lead to a similar situation. What is more, poor planning is a behavioural attitude that leads to overspending as poor planning normally arises with specific behavioural considerations including lack of focus, poor forecasting, immaterial budgeting and the like (quote). It is also important to point out that spending attitudes like impulse buying could also bring about overspending. Under spending Under spending is also a way by which behavioural finance affects personal finance. This is because acts of wrong prediction of the economy and lack of trust in the existing economy can easily cause people to be highly precautious in their spending. Once such behaviour sets in, people withdraw on the quantum of spending that they had originally budgeted to do (quote). It is however worth noting that under spending, though it may save people some money in the very short term may not necessarily guarantee or constitute wise spending. This point would be better understood if saving and investments are seen as part of spending, whereby the less a person saves or invests, the less the person will be expecting in the medium to long term basis. As people take personal financial decisions therefore, they are admonished not to be led by acts and attitudes of personal emotional feeling but to characterise their predictions and spending lifestyle according to a well rehearsed pattern of economic practice. Once this is done, the fear of losing out on productive spending will be eliminated. All of these notwithstanding, it is said that under spending could also be a positive indicator of mature personal finance if the short term saving that are made as a result of refusal to spend beyond certain range is translated into subsequent future savings and investment. Protection against uncertainty Certainty and uncertainty are part of the human behaviour, which constitutes behavioural finance as most of the personal finance actions and decisions that people take depend on their thoughts of what the consequence of certainty or uncertainty would be to them (quote). Certainty simply refers to a situation of financial action or decision that brings out a known result. An example of this a personal savings account, which is known for sure to produce a minimum of how much was saved. Uncertainty on the other hand refers to a situation whereby the outcome of the financial decision is not known at all (quote). In such situations, people are not able to predict what the consequences of their action are going to be. An example of this could be given as betting and insurance. In the case of betting, one cannot be sure whether or not there will be a win. In the case of insurance also, a person may take car or health insurance and never get an accident or sick. Now even though the outcomes of most uncertainties are promising with large returns, behavioural finance often protect people against the other side, which is loss because through the financial behaviour of people, they may choose whether or not to take risk of an uncertainty. Inhibitions of behavioural finance to personal financial planning Personal financial planning is very necessary and important for successful personal finance to take place. However, there has often been cases whereby people are not able to plan so well for their personal finances due to inhibitions from behavioural finance. Three of the commonest factors that may inhibit personal financial planning as a result of behavioural finance are discussed below. Self deception Avoidance of regret Monetary illusion Conclusion Read More