Question

The purpose is to step back from the specific personal finance products and services and consider the question of how to develop a winning personal financial plan.

1. Assuming the average American consumer does not actively develop a personal financial plan, who is most likely to influence personal financial decision. Provide three examples of so called "financial advisors" one would meet along as consumers become adults and consume financial products. From mortgages, to the credit card offers in student unions, to the cashier offering an extended warranty - use these and other examples and explain if these individuals are likely to have your best interest in mind at the point of purchase.

2. Explore the resources American consumers have to develop a financial plan and educate themselves regarding the purchase of financial products. Using examples of both small and large financial product decisions, provide a description of what an informed consumer would look like. What resources would they consult prior to purchase and how do those resource help that consumer make informed and wise choices consistent with their financial goals?

3. Consider why some people are not deliberate in making a personal financial plan. What forces work against making informed financial decisions?

Answer 1

1. A financial advisor is someone who a customer or an individual meet as he progresses the path of his life. These advisors are experienced, well-educated, credentialed, financial professionals who work for the interests of their clients. A financial advisor is similar to an investment advisor, financial planner, investment manager, or investment consultant.

These individuals analyse client's financial status and helps the client set reasonable, achievable financial goals to be achieved during the course of their life. They make investment recommendations to their clients and provide financial advice. Advisors have expertise in tax planning, asset allocation, risk management, retirement planning and estate planning in order to help clients at all stages of their life. To quote a few examples of the financial advisors - Life Insurance agent, wealth manager, stock broker, relationship manager or a banker, a customer would meet them during various stages in their life and who are supposed to act on their customers interests.

There are two types of relationship that exist between a client and his advisor - Arms length relationship and fiduciary relationship. In the former, a broker-dealer scenario is set, where in the advisor recommends an investment to the client after understanding the client's suitability. The latter requires advisors to be registered with the Securities and Exchange Commission (SEC) and act solely on behalf of their clients displaying trust, loyalty and transparency in his interactions. The fiduciary relationship implicitly acts on ethics and requires that that a financial advisor must act on behalf of a client in a way the client would act for himself if he had the requisite knowledge and skills to do so.

2. The first thing that is required to make a financial plan is understanding of one's financial goals. All consumers regularly make financial decisions, some of which are consequential and some are projected. People make choices about their savings, debt borrowings and debt repayments, and how to manage existing financial resources on their platter. There are two very important factors that contribute to an individual's financial well being:

(i) The promotion of savings - Setting concrete, attainable goals can increase the motivation to save. Colby and Chapman demonstrated that people are more willing to forego small discretionary purchases in favour of large savings goals when they have smaller, weekly savings subgoals. When consumers are able to reframe their larger goals in terms of subgoals, they allow themselves to be able to attain their goals, and can collate higher levels of savings in the long run. Another resource that can help achieve this goal is to set aside a separate “account” for savings.

(ii) Debt borrowing and repayment - Generally a consumer experiences debt aversion, that may be due to the fact that a consumer wants to keep his accounts out of the red and also because he may experience stress from knowing that his account is in red. Yet, there is still an example where a consumer is likely to be in debt, despite his aversion. A consumer might keep on accruing debt in the form of credit card balances and may not even view it as a debt. Consumers view credit cards as a view of spending on their lifestyles and not a way of borrowing. An informed customer should view using a credit card as a way of being indebted. When consumers have a higher limit on their credit card spending, they infer that their future incomes will be higher, and thus, that they will have enough money at a later date to pay off their credit cards. This should be viewed differently; and informed customer should understand that higher credit limits often compound their unnecassary purchases and lead to higher levels of credit card borrowing.

While repaying credit card bills, customers pyscology tend to pay higher interest rates smaller debt first rather than paying the debt due from the distant past. They may not realize the accumulation of debt from distant past is the reason of their piling up debt balance and go on paying off the higher interest rate debt first. Also, customers get misleaded by the "miminum payment" on their credit card statements and feel that it may be okay till the time they keep on making these minimum payments and not repaying the full balance. An informed customer should understand that while information about repaying the minimum amount may not affect repayment, information about choosing larger repayment amounts does and it substantially reduces the debt balance and the interest to be paid. Importantly, information about the future interest costs associated with delaying repayment appears to be more effective than that which explains the time consumers have to repay their debts.

Budgeting: Consumers have a number of financial resources with which they make purchases; as such, they must constantly make tradeoffs and consider how well they can allocate their budgets. Budgeting is a very good strategy to avoid overspending. However, budgets that are too rigid do not go well with consumers financial goals. Research suggests that people fail to account for or underestimate the effect of expenses on their overall financial well being. Consumers do not properly weigh the extent to which expenses affect their disposable income and tend to underestimate exceptional expenses. Predictions about future spending will be improved when prediction targets are construed with a higher level of abstraction, cover a longer time period, or are associated with important events in one's life rather than specific time frames.

3. There may be some individuals who will be reluctant in choosing a financial plan for themselves. Behavioral tendencies on risk and uncertainty, self‐control, heuristics and biases, and framing relate to a wide array of decisions, both financial and non‐financial. There are some reasons below that map directly why some people show reluctance or bias towards financial planning:

(i) Lack of financial literacy: For consumers to make decisions and behave in ways that are consistent with their financial well‐being, they must have sufficient skill and knowledge in the financial domain. Financial literacy can be summed up as basic knowledge of financial concepts, awareness about financial products and basic mathematical literacy. Informed consumer should be able to differentiate between benefits of savings and risks of debt accumulation. There are also not much programs available to address this subject and increase the knowledge of the consumer. Financial education has shown some promise. For example, when goal‐setting and/or financial counseling is complemented with financial education, people have more favorable financial outcomes.

(ii) Future vs present tradeoff: Financial planning is all about what consumers want in present viz-a-viz what they want to keep for the future. Consumers most often discount the benefits of time value of money. Consumers feel that a small sum of money available today is worth more than what may be available tomorrow. This behaviour becomes a deterrant in savings for their future. Discounting behavior also seems to affect the tendency to get into debt. An example can be, consumers showing preference for mortgages that have minimal up‐front costs, but a decreased preference to abandon such mortgages that are no longer financially viable to them.

Because the availability of money has a significant impact on financial well‐being, it is important to understand how consumers think about their money and how to part with it. Two important aspects of financial behaviours involve the extent to which people plan to spend their money and the ease with which they are willing to part with their money. First, the extent to which consumers are able to control spending—rather than make impulsive spending; Second, the propensity to plan in the long run.

(iii) Situational factors: This section describes the role of wealth perceptions and the economy and relative status in one's financial well‐being.

a. Perceptions of wealth have some determinants. Positive determinant can be control of spending and negative can be anxiety over future availability of money. Perceptions of wealth have real behavioral consequences, especially when people feel impoverished or believe their resources to be scarce. When resources are scarce, people tend to meet their immediate needs first. wealth perceptions may arise from early‐life socioeconomic status: People who grew up with higher socioeconomic status tend to be less impulsive and more risk‐averse than those who grew up with lower socioeconomic status.

b. Economy. Changes in the economy have a direct consequence on the financial resources available to consumers. Macroeconomic changes / cycles affect consumers’ underlying tastes and preferences. For example, economic contractions and expansions have differential effects on risky decisions. Specifically, economic contractions promote risk‐averse decisions for negative outcomes, and economic expansions promote risk‐seeking decisions for positive outcomes. Consumers also consider their weath with respect to their overall status. When low socioeconomic status is made salient, people are more likely to engage in behaviors with high risk and low returns.

To conclude, consumers should differentiate between similar financial categories and products, and systematically investigate some of the most important and crucial financial decisions.