Financial services as an industry is moving at warp speed to embrace psychology. The trick is that we have a definition problem when describing the field that encompasses the mind, behavior, and money. If you look at the media coverage of finance and psychology, most content focuses on cognitive errors in decision-making related to investments. In other words, most of the media and most financial services concentrate on behavioral finance. However, this focus is slowly broadening: there is much more to financial psychology. But, this still begs the question: what’s the difference between financial psychology and behavioral finance? Let’s take a look at each area and some examples to help differentiate the two.
The American Psychological Association (APA) provides succinct definitions of both behavioral economics and behavioral finance:
Behavioral economics: an interdisciplinary field concerned with understanding how heuristics, biases, and other psychological variables influence economic behavior.
Behavioral finance is a field closely related to behavioral economics, that studies the impact of emotion, cognitive biases, and other psychological factors on financial decision making and hence on financial markets. In particular, behavioral finance emphasizes the role such factors play in irrational investment behavior (e.g., under-or overreaction to financial information) and its consequences in market fluctuations (e.g., financial bubbles, panics).
There is a clear focus on the economic outcomes related to individual financial decision-making in these definitions. Likewise, there is also a focus on cognition, the mental processes that impact how we decide on a course of action. This is why, for the most part, those who write about or discuss behavioral economics and behavioral finance seem to focus exclusively on biases in decision-making. For example, herd mentality, mental accounting, and loss aversion are all biases (or errors) in the way we make any decision. Behavioral finance applies this specifically to money-related decision-making.
If we only focus on the cognitive biases portion of our financial lives or how we work with clients, we ignore the rest of the field of psychology! Unfortunately, even though there are 54 (or so) divisions of the APA, there isn’t a specific division devoted to financial psychology, nor is there a clear definition. Therefore, we define financial psychology this way:
Financial psychology is the study and application of psychological theories, methods, and practices to the areas of personal finance and financial services. It is the study of the mind and behavior as it relates to spending, saving, and investing decisions. Financial psychologists apply psychological theories, methods, and practices to the areas of personal finance and financial services.
According to this definition, the mind and behavior of how individuals manage their financial lives is financial psychology. Financial psychology, compared to behavioral finance, includes everything from patterns of spending behaviors established during adolescence to how clients discuss money-related issues with their spouses or family members. Likewise, the definition also encompasses the interaction between the individual and anyone providing financial advice.
Financial Psychology Encompasses Behavioral Finance
Because cognitive psychology is a component of the more comprehensive field of psychology, naturally, biases in decision-making (that is, behavioral finance) in some sense is subsumed within financial psychology. Understanding how clients make investing-related decisions is necessary, but not sufficient, in providing holistic advice designed to help clients achieve financial goals and enhance their financial well-being.
Financial professionals need to adopt a broader approach to thinking about the psychology of finance. Limiting the way you help clients to simply discussing or pinpointing cognitive biases ignores the power and benefit of the research and techniques from areas such as:
- Clinical Psychology: Financial psychology is based in the world of clinical and counseling psychology, where clinicians working with clients who exhibited money-related disorders began a process of uncovering money-related beliefs and utilizing therapeutic techniques to work with clients. Organizations such as the Financial Therapy Association and AFCPE are working on using many counseling and clinical techniques.
- Learning & Developmental Psychology: This is the land of habit formation and habit change. It’s also the field that covers how we develop our money beliefs (or “money scripts”) and the influence of caregivers/parents on our perceptions related to careers (read: income) and work.
- Personality & Individual Differences: Research has demonstrated a link between robust personality factors (e.g., factors from the Big Five model) and various financial outcomes, including net worth, income, and savings rate. This is also where financial services can recognize the value of measuring characteristics via psychometric assessments.
- Social Psychology: We are influenced more than we like to admit. We are influenced into spending and investing decisions more than we realize. By appreciating the influence that others have on your client’s financial decision-making, you can better prepare them for ensuring they adhere to their unique plan.
While focusing on the crazy stuff investors do makes for exciting financial journalism, improving financial well-being requires a broader approach than behavioral finance. Financial psychology is a broad and growing field. It includes research, methods, and techniques that can benefit the well-being and success of clients well beyond investing-related decision-making.