What is Financial Psychology?

Last updated on August 31st, 2022 at 06:46 am

Financial psychology

Financial psychology is the study and application of psychological theories, methods, and practices to the areas of personal finance and financial services. The field takes into account two areas. First, financial psychology includes how each of us relates to and makes decisions about money. In other words, financial psychology includes what psychologists refer to as “individual differences” in money-related behaviors and decisions. Second, financial psychology covers the client-advisor relationship, that is, the application of psychology in the context of an individual’s relationship with a financial professional.

To understand financial psychology, consider the basic definition of psychology from the American Psychological Association (APA):

Psychology is the study of the mind and behavior. The discipline embraces all aspects of the human experience — from the functions of the brain to the actions of nations, from child development to care for the aged. In every conceivable setting from scientific research centers to mental healthcare services, “the understanding of behavior” is the enterprise of psychologists.

If we use that definition as the basis for financial psychology, it is easy to see how the various fields within psychology each contribute to the study of the mind and behavior when it comes to money.

Financial Psychology: The Individual or Client Perspective

From an individual perspective, financial psychology encompasses practices related to managing one’s financial life (that is, personal finance) and draws heavily from developmental, social, cognitive, and consumer psychology. Put another way, financial psychology often refers to an individual’s mind and behavior when making spending, saving, and investing decisions. The individual (or client) side focuses on how we make decisions about saving, spending, and investing.

As an example, consider the way you made your last significant financial decision, perhaps the purchase of a car or home. From a purely economic perspective, there is a “right” answer in terms of the most advantageous financial response to your decision. This economic “right answer” is not always chosen. Why? We are influenced into decisions by others (social psychology), we have expectations or schemas for what we want our lives to look like today (developmental psychology), and we have biases in our decision-making (cognitive psychology). These psychological variables (and many more!) may lead us away from the most financially advantageous answer when considering how we spend our money.

Financial Psychology In The Client-Advisor Relationship

From a client-advisor standpoint, financial psychology includes aspects of the academic fields of financial planning, therapy, counseling, and coaching. The CFP Board defines client psychology as the biases, behaviors, and perceptions that impact client decision-making and well-being (CFP Board & Chaffin, 2018). We view client psychology through the lens of a client-advisor relationship. As a financial planner, for example, client psychology permeates each interaction with a client. Some examples of where an understanding of financial psychology can improve the client-advisor relationship include:

  • establishing rapport with a client who may be unwilling to take advice (client personality),
  • helping a client overcome biases in decision-making that lead to negative investing outcomes (cognitive psychology), and
  • addressing the needs of a client in the later stages of life (developmental psychology).

Each of these challenges requires considering how the advisor and the client think, feel, and behave in the context of the financial planning relationship.

What Makes Us Unique? Measuring Personality

Financial psychologists apply psychological theories, methods, and practices to the areas of personal finance and financial services. A key component of applying financial psychology measuring client personality, values, attitudes, and beliefs. The fields of personality and individual differences and psychometrics cover how we measure what makes us unique when it comes to characteristics such as investing composure or general personality.

Assessments, including observations, structured interviews, and tests, can identify or uncover specific characteristics or patterns of behaviors when it comes to spending, saving, and investing. By measuring characteristics that are relatively stable over time, we can anticipate how we (or, how our clients) might take action in the future. Armed with this information, individuals and advisors can enhance future financial decision-making based on a scientific understanding of financial psychology.

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