Personal Finance
Personal financial planning involves analyzing an individual’s or a family’s current financial position, predicting short-term and long-term needs, and executing a plan to fulfill those needs within financial constraints. It depends on earnings, living requirements, goals, and desires.
Personal finance includes securing financial products like credit cards, insurance, mortgages, and retirement products. Personal banking, such as checking and savings accounts, IRAs, and 401(k) plans, is also part of personal finance.
Key aspects of personal finance are assessing financial status, buying insurance, filing taxes, saving and investing, and planning for retirement. It is a specialized field that has been taught in universities and schools as “home economics” or “consumer economics” since the early 20th century. Economists now emphasize the importance of widespread education in personal finance for the overall national economy’s performance.
It became increasingly evident that traditional theories were only able to explain certain “idealized” scenarios, while the real world was much more chaotic and disorganized. Market participants often acted irrationally, making their behavior difficult to predict using existing models.
In response, scholars turned to cognitive psychology to understand these irrational behaviors that defied modern financial theory. This led to the emergence of behavioral science, which aims to elucidate human actions, in contrast to modern finance’s focus on the “economic man” concept.
Behavioral finance, a subset of behavioral economics, puts forth psychology-based explanations for financial irregularities like extreme stock price fluctuations. Its goal is to uncover the reasons behind individuals’ financial decisions. The field posits that factors like information structure and market participants’ characteristics play a significant role in shaping investment choices and market outcomes.
Daniel Kahneman and Amos Tversky, pioneers in the field, laid the groundwork for behavioral finance in the late 1960s. Richard Thaler later joined them, integrating economics, finance, and psychology to introduce concepts such as mental accounting, the endowment effect, and various biases that influence human behavior.
Key tenets of behavioral finance include mental accounting, herd behavior, anchoring, and high self-rating and overconfidence. Mental accounting, for instance, describes how individuals allocate money based on subjective criteria, such as the money’s source and intended use for each account. This theory suggests that people tend to assign different functions to various asset groups or accounts.
