There’s nothing like a good buzzword—especially when you really know what it means. Here’s one that’s more valuable than you think: behavioral economics. It holds a surprising answer to why, despite all good intentions, careful planning and firm resolve, you can depart from reason and deviate from your financial goals until you’ve lost sight of financial freedom completely.
Much of traditional economic theory assumes we’re always perfectly rational beings who make money management decisions based on our own financial best interest. We all know that isn’t true. Behavioral economics is that blend of economics and psychology that examines how we really behave and make decisions around money versus how we’re supposed to—if we were robots, that is. An automaton would always have textbook financial behaviors based on pure logic and reason. We humans, on the other hand, are influenced by emotion, people around us, unreasonable thought processes, personal biases, changes in risk tolerance and so on. We’re somewhat irrational.
Irrational, but Predictably So
The best way to describe how people behave when it comes to money is a term coined by Dan Ariely and used for the title of a bestseller he authored: Predictably Irrational. We tend to be emotional, not rational, with money. Fortunately, our irrationality is predictable.
Behavioral economists have observed how we make certain decision errors in the same types of circumstances over and over. We’re pretty predictable and consistent. The value of discovering the patterns in our irrationality is that we can begin addressing it. Think about flipping a coin example. In a well-balanced coin, we know heads should come up about half the time. But if we know that the coin is weighted slightly so that heads comes up more frequently, we can use that info to guess heads and be right more than half the time. The same with human behavior – if we know about our tendencies, we can predict behavior and arrange the situation to take advantage of those tendencies.
Financial irrationality extends across society. However, according to the book Nudge by Richard Thaler and Cass Sunstein, it’s possible to structure our policies and financial services industry to nudge people to do what’s in their best interest. Here’s an example: By making automatic enrollment in an employee-sponsored retirement plan the default option instead of making non-enrollment the default, more people would participate in retirement plans. Why? It’s human nature to take the default choice because it requires no effort.
You can address the irrationality in your own habits by taking a look at some of the decision errors people often make.
Common Decision Errors
Many common financial decision errors involve predictable irrationality that’s tied into the difficulty our brains have with understanding probability.
One decision error we can fall into is described in my blog Mind Your Money: Optimism and Illusion of Control. By making the mistake of maintaining an all-pervasive optimism that includes the idea that we’re in control of things, we might think we’ll succeed when others can’t or win when the odds are against us. This can take the form of things like attributing lucky investment choices to skill, having early financial successes and expecting to repeat them, keeping a low emergency fund or none at all, and disregarding the need for insurance or estate planning.
We’re also prone to decision errors in our price perceptions. These errors relate to a common cognitive practice called anchoring. Anchoring is locking onto a certain price or value as a norm that influences our decisions about what we’re willing to pay.
For example, a loaf of bread is $5 where the cost of living is high, we’ll be willing to pay the same where the cost of living is much lower and we should be getting a better deal. This isn’t a big issue, right? Try it with a brand new car or a home! Anchoring can affect us when making large, infrequent purchases, negotiating prices, buying something unusual or assigning value to an investment.
There are all sorts of cognitive twists that can affect financial freedom. Some of these are loss aversion, representativeness, adjustment bias, cognitive dissonance, overconfidence, mental accounting, recency bias, availability and confirmation bias.
Money Management and Wealth Gathering
My blog Kirk vs. Spock: Human Nature Meets Personal Finance talks about what’s needed to tailor a financial program for humans with complex decision-making processes, this approach works with human nature—not just when it comes to decision errors, but through overall coaching and behavior changes around money.