Just the other day I was asked to expound on the difference between financial planning and finance. Since the context of the conversation was about bachelor’s degree, I got caught up in the differences between the courses of study. I thought about it later, and I think I’ve come up with a pretty decent explanation of the difference between the two. But before I tell you, you’re going to have to lean a new word: utility.
In economics, utility is about quantifying satisfaction. Let’s think of this in terms of breakfast. I wake up in the morning and I’m hungry. For the sake of this exercise, I have two choices in my cupboard. On one side, bacon and eggs. On the other side, oatmeal. Now, which would I prefer (which has the most utility?) Since I think of oatmeal as warmed over grain loogies, I’ll go for the bacon and eggs. But let’s say I’m vegetarian! Then, clearly, oatmeal would have greater utility. Utility also changes over time in a variety of interesting ways, but that goes beyond what you need to know here. If you want, there’s another explanation via investopedia and even more detail at wikipedia.
So: why did we bother with that?
Here’s what I believe is that major difference between finance and financial planning: financial planning is about maximizing utility, and finance is about maximizing profit.
I believe that making the maximization of utility the central focus of financial planning makes what I do more useful to my clients than mere profit maximization.* It also helps answer a lot a difficult life questions, and clarify priorities.
It’s easy, in financial planning, to fall into the profit maximizing trap. After all, we look like heroes when we get good returns or make a plan come together! But there’s a risk, with overmuch focus on profit, that utility – the client’s satisfaction – will fall by the wayside. And, when you get right down to it, that’s what it’s all about.
* I think I might be misunderstood here. It’s easy to misinterpret utility maximization as a call to short-sighted hedonism. My concept is that one should maximize utility throughout one’s lifetime – thus retirement saving, life and disability insurance, and other long-term consumption plans are called for.