What is Financial Psychology?

Financial psychology is the study and application of psychological theories, methods, and practices in personal finance and financial services. The field considers two areas. First, financial psychology includes how we relate to and make 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 to 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.

• American Psychological Association, 2020

If we use that definition as the basis for financial psychology, it is easy to see how the various fields within psychology 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 finances (personal finance) and draws heavily on 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 making decisions about saving, spending, and investing.

For example, consider how you made your last significant financial decision, perhaps purchasing 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 in our decisions by others (social psychology), we have expectations or schemas about 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 every interaction. 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 a client’s needs in the later stages of life (developmental psychology).

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

What Makes Us Unique? Measuring Personality

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

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