Shachar Kariv was recently interviewed by John Manganaro at Plan Sponsor regarding his research in Behavioral Finance, Q&A with Shachar Kariv – Part 2
Q: Is it right to assume that participants who struggle with defining their risk preferences will always do worse in the savings effort?
Not necessarily, and I’ll explain. One of the attacks most commonly leveled against economists and certain economic theories is that we make our judgements based on the assumption that the financial choices people make are driven by their rationality. I think this is unfair criticism, because any good economist knows people often rely on emotions or they simply make an uninformed choice when it comes to their finances. Solid economic theory takes this into account.
Another important thing to keep in mind is that, as economists, we’re not talking about rationality in the common usage—most people do not really know what economists mean when they talk about “rationality.” They equate the rational choice with the objectively best choice—but that is not what we are talking about in economics. The definition of rationality for economists goes like this: “You are a rational financial market participant if you have preferences that guide your behavior.”
You can see from this that an individual might have a preference that works against his ultimate best interest—for example he may take on less investment risk than he needs to have a good chance of funding an adequate income replacement ratio in retirement—but by our definition this does not mean he is irrational.
I think it is good in general for people to have reasons underlying their economic decisions, but having this element of rationality does not always or even generally mean that an individual will make the right or the best decision based on their objective circumstances. In fact, it can be more challenging to get a rational person on track in the retirement savings effort than it is to get an irrational person on track. If the former has strong psychological biases underlying his reason-driven decisionmaking, it will be hard for a plan sponsor or adviser to push him towards the more appropriate choice.