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Personal Finance

Is your money playing tricks on you? Economics and your mind

March 16th, 2013 by

Why our brains are hardwired to make bad financial decisions

 
 
 

We’ve all made our fair share of bad financial decisions. Whether it’s blowing your Christmas bonus on a new pair of shoes (instead of paying off that credit card), or holding onto a stock (even when all signs point to sell), we’ve all made financial choices that we regret.

The question is, why?

According to a new area of science called behavioural economics (BE) - which combines psychology, economics, finance, and sociology - it has to do with the way our brains are wired. 

Behavioural economics defined

Behavioural economics studies the effects of social, cognitive, and emotional factors and their influence on the economic decisions that individuals and organizations make. The aim is to better understand how psychological phenomena, including emotions and group dynamics, influence our ability to make sound financial choices.

Multiple studies have shown that individuals often make financial decisions that are not in their best interest – or at least, not what most economists would consider to be the most beneficial choice. Simply put, your brain is interfering with your ability to invest.

Learn how the following tendencies studied by behavioural economics can impact your ability to save, invest, plan, and earn.

Herding and groupthink

Herding occurs when a group makes a faulty decision because group pressures have led to a deterioration of moral judgment and mental efficiency. When a group is affected by herding or “groupthink”, it fails to recognize better alternatives and will often make irrational decisions.

Herding is most likely to happen when the members of a group have a similar background, when there are no clear rules for decision-making, and group members are insulated from outside opinions.

This can be especially detrimental in family discussions concerning money. In order to avoid this slippery slope, decision experts recommend that you adopt one or all of the following measures:

  1. Assign the role of leader to anyone other than the head of the family.
  2. The leader should avoid stating preferences and expectations at the outset of a discussion.
  3. Family members should routinely discuss financial deliberations with trusted outside advisors and report their findings back.
  4. A trusted family member should take on the role of devil’s advocate in order to question assumptions.

The optimism bias

One of the most basic findings of behavioural economics is optimism bias or the positivity illusion. Basically, this means that people judge their chances of experiencing a positive outcome – landing a good job, winning the lottery, finding Mr. Right – to be higher than average. However, when the same people assess the probability of something bad befalling them – sickness, layoffs, divorce – they estimate their odds to be lower than those of other people.

Interestingly enough, the optimism bias transcends gender, age, education, and nationality. And while it’s nice to see the brighter side of life, over-optimism can often come back to haunt you – especially when it comes to your finances. Optimism and a false sense of control can cause us to make the following poor financial decisions:

  • Misjudging propitious investment decisions for skillful choices (sometimes you just get lucky).
  • Having a low emergency fund (life won’t always treat you well).
  • Underestimating the need for insurance and estate planning (you won’t live forever).

Confirmation and hindsight bias

They say “seeing is believing”; however in certain situations, what you perceive isn’t necessarily a truthful representation. The tendency for our minds to introduce preconceptions and prejudices is strong. These predispositions are referred to as the confirmation and hindsight biases in behavioural economics.

In investing, the confirmation bias suggests that an investor would be more likely to look for information that supports their original preferences, rather than seek out additional information that could contradict them. Failure to look at both sides of the coin will often lead to faulty decision-making.

Hindsight bias, on the other hand, occurs when a person believes (after the fact) that the onset of some past event was obvious and predictable. This type of bias often causes overconfidence, as investors (falsely) believe themselves to possess superior stock-picking abilities.

The primacy and recency effects

These two characteristics of behavioural economics play heavily into product marketing in order to control and influence your desires.

First, marketing companies will bank on the primacy effect to catch your attention. This is because people tend to remember the first information presented to them about a product or service. Additional information presented after the fact is considered secondary, and thus not as influential.

However, the recency effect will often trump this original opinion, as people tend to remember the most recent information presented about a product above all else. Marketing companies use these two cognitive functions to not only control the first message consumers hear, but also to control the last message you hear before making a buying decision.

If you find that you’re easily swayed by marketing propaganda, you can avoid making poor purchasing decisions by:

  • Doing your research based on your needs. Don’t let advertisements tell you what you need. Instead, look for product reviews and information. This will help you to determine your true needs and avoid the primacy effect.
  • Use a shopping list. This will help you conquer the recency effect by keeping you on task. Trust what you’ve written down – you’ve already done the research on these products and know that you need them.

Don’t play the fool

Don’t let your mind fool you into making a bad financial decision. Avoid short-term payoffs in exchange for long-term goals by conquering common biases and ingrained behavioural traits known to interfere with your decision-making abilities.  

 

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