Human Nature versus Rational Financial Decision Making

Behavioral economics or understanding how consumers make financial decisions has become a very popular topic recently. Companies, as varied as brokerages, auto manufacturers, and fast food restaurants are all trying to better understand how their customers make buying decisions. With this understanding, they hope to be more able to design products and set pricing policies.

This article addresses some issues raised in the book “Why Smart People Make Big Money Mistakes – And How to Correct Them” by Gary Belsky and Thomas Gilovich. Many of the conclusions of these authors may be applicable in managing your business and also in better understanding your financial decision-making process.

The two basic principles discussed in this book are:

• Mental Accounting – Even though “a dollar is a dollar”, we often put a higher value on some dollars and thus tend to waste the less valuable dollars.
• Prospect Theory – How we frame financial decisions (or label potential outcomes) affects our attitudes toward risk.

Mental Accounting

Our views of different “types” of money are often based on their source, relative size, and expected use. In one MIT experiment, students with credit cards would pay twice as much for basketball tickets than students using cash. Casino winnings are often bet more aggressively than gamblers’ “own” money. A $150 option on a $30,000 car seems cheaper than a $150 sweater, despite it being the same amount at the end of the day.

Making it easy for customers to pay with credit cards would seem to be a logical implication of this concept. Along with the convenience of a credit card purchase, the actual delay in payment (once the credit card statement is received) lessens a buyer’s resistance to make a purchase decision.

From your personal financial perspective, it makes sense to remember that every dollar is really worth the same 100 cents, regardless of whether it is spending an extra $75 for a nicer hotel room or saving 10 cents a gallon on your next gasoline fill-up.

Prospect Theory

We tend to put a greater emphasis on losses than gains. It seems that the pain of a $1000 loss is about twice as great as the joy of a $1000 gain. This can result in different decisions depending on how the decisions are framed. We tend to be more aggressive when facing losses than when facing gains. Investors tend to hold losing positions too long hoping for a rebound in the stock price and sell profitable positions too early.

We also tend to keep things the way they are and to like what we have. The resulting resistance to change often results in missed opportunities and the anguish of regret. Just think of how easy it is to delay taking the steps to having a better-organized financial situation. Reviewing your investment portfolio, setting up an estate planning meeting with your attorney, updating your business plan or agonizing over the prospect of creating a household budget are all things we know we should do, but find easy to put off.

Summary

Most business and personal financial decisions are conscious decisions for change. Overcoming the resistance to change is easier when barriers to change are lowered and the human and financial benefits of change (including making the decision) are great enough to overcome the natural tendency toward preserving the status quo.

You may want to consider this book by Belsky and Gilovich for some valuable insights that you can put to work in your business and your personal financial planning.