Behavioral finance

Running Head: BEHAVIORAL FINANCE AND RETIREMENT PLANS

Behavioral Finance:
“How Participants Behave and Perceive Risk when Planning for Retirement”
Azalea Colon
Metropolitan University, Cupey Campus
Abstract
Today more people are living longer, fewer companies are offering defined benefit plans and retirement is more and more linked to the health offinancial markets. People are now changing their behavior to deal with troubling economic times and are shifting away from the rational models proposed by the classic economics theory. Behavioral economics and finance offer new insights about the investment behavior, paradigms and participants perception of the future. Research in this field has provided policymakers, plan sponsors and consultantsvaluable information about how plan designs must be modified in this century.

Participant directed defined contribution plans have become the cornerstone of the private-sector pension and retirement system around the world. This trend towards giving the individual more choice also underlies the problems that the Social Security Administration inevitably will confront in the future. This globalmovement toward participant-directed retirement plans suggest that the employee-citizen to whom the responsibility of choice has been given, is a well informed individual who acts rationally to maximize his self-interest. In other words, it is assumed that the individual can interpret and weight information in a useful and adequate way and make an informed decision about his financial future.However, recently different perspectives have arise regarding how people really make economic decisions. Fundamental economic proposes that people can and try to maximize their self-interest, but it also recognizes that these decisions more often than not have imperfect outcomes. Certain types of decisions and problems may be too complex for individuals to master on their own. (Simon, 1955)Sometimes individuals have the right intention but lack self-control and will power to carry out the appropriate changes in behavior. These new notions of how people behave have rapidly spread across the economic and behavioral finance field. The central topic of this research is focused on how individuals really make decisions to plan and save for retirement. The goal of this work it to gain insightin the light of what new literature offer us about how workers decide to save, how they manage their investment risk and ultimately, how workers and retirees may deviate from the rational investor.
Conceptual Framework
Behavioral finance is the application of psychology to financial behavior; the behavior of practitioners. Behavioral finance and behavioral economics are related studiesthat apply scientific research in cognitive tendencies and human and social emotions, for a better understanding about decision-making and how it affects market prices, benefits, and resource allocation. (Shefrin, 2000) It has two building blocks: cognitive psychology and the limits to arbitrage. Cognitive psychology studies the way people think. There is broad psychology literature documentingthat people make systematic errors in the way that they think: overconfidence, too much weight on recent experience, preferences, etc. Precisely, behavioral finance studies these patterns to help explain how people make financial decisions and, how these decisions affect the financial markets. Limits to arbitrage refers to predicting in what circumstances arbitrages forces will be effective andwhen it won’t be. (Ritter, 2003)
Development of the Behavioral Finance Field
During the classical period, economics had a close relationship with psychology. For example, Adam Smith wrote The Theory of Moral Sentiments, an important text describing the psychological principles of the individual behavior, and Jeremy Bentham wrote extensively about the fundamentals of utility. Later on,...