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Updated on Thursday, January 30, 2020
We walk through the world feeling as though we’re in control of our actions. We make decisions for well-rationalized reasons, and sow the consequences, good or bad.
But human brains are pretty wild creatures. And unfortunately, they’re prone to some patterns that can lead to unwise choices, even if those choices seem like smart moves.
We can get some insight into these patterns — and, even more importantly, tactics to fight them — from the field of behavioral economics.
What is behavioral economics?
Behavioral economics is a hybrid discipline. It brings concepts of human psychology to the study of economic decision-making, which can help us learn why we tend to make the financial choices we do.
One of the most important and foundational findings of behavioral economics is the concept of “dual-process” thinking, which separates our behavioral motivations into two categories: System 1 and System 2.
System 1 thinking is the kind that doesn’t feel like thinking at all. It’s fast, instinctual and based on gut reactions. It’s implicit, whereas System 2 thinking is the slow, deliberate kind that actually undergirds rational decision-making.
The trouble comes because it can feel like we’re using our slow, rational second system when we’re really relying on the lizard-brain first. The human brain can essentially trick itself thanks to some built-in psychological tendencies that may have been protective from an evolutionary standpoint, but today can lead to costly decision-making errors.
Fortunately, by identifying these tendencies in your own psychology, it’s easier to counteract them with sounder, System 2 decision-making.
4 ways behavioral economics can impact your personal finances
Below are some of the most prevalent ways in which concepts from behavioral economics can have a real-life effect on your budget.
Would you rather have $100 today, or $150 a month from today?
Although the latter is obviously a more rational financial choice in the long run, most of us feel tempted by the instant gratification aspect of the former. Over a lifetime, constantly focusing on the present tense can make it difficult to build a robust financial future.
For instance, classic studies suggest that people are more likely to overspend because they’re less concerned about their future finances than about their current desires. That’s one reason it’s so easy to fall into credit card debt, for instance; you can buy what you want now and worry about the ramifications later.
Even more tellingly, this little psychological loophole isn’t across-the-board consistent: It’s mediated by mood. Research has found that people may be less prone to temporal discounting — and more willing to wait for the better reward down the line — when they’re happier.
Money is money, of course — but thanks to the human penchant for categorization, it’s not always that simple in our minds. According to the concept of mental accounting, we assign value in relative terms, even when that value should be fixed.
How might that play out in your finances? Well, think of how you respond to news of a windfall, like a Christmas bonus or a hefty tax refund check. Many of us see these funds as “fun money,” and spend it more superfluously than we do with our regular paycheck. Just because it’s a bonus doesn’t mean it won’t grow if you stick it in your investment account.
Mental accounting may also be the reason it feels less painful to spend money on a credit card than in cash, and thus cause you to spend more of it. It’s also probably one of the factors that lead many lottery winners to financial ruin. Although the money was unexpected, it isn’t actually endless, and spending it without a plan can quickly spell bankruptcy.
When it comes to making choices, the way those choices are presented to us can make a serious difference. For instance, it sounds a whole lot better to say something’s discounted to 10% off than to say it still requires 90% of the purchase price.
How a price is framed can impact whether you process a purchase as a loss or a gain — many times in ways that aren’t intuitive. For instance, in some cases, an item may actually sell better when it’s set at a higher price, since that high price lends the product a sheen of luxury compared with its competitors.
Along with the framing of a product itself, the cognitive bias of anchoring can change how you view its final purchase price. Anchoring refers to the human tendency to overrely on the first piece of information we receive — and to prioritize comparison over calculation.
A prime example of anchoring: the car dealership, where just about everyone knows the sticker price is a markup. We expect to negotiate the costs down, but seeing that higher figure makes us feel better about our “discounted” final price, even though we’re likely still paying more than the car is worth, particularly if we’re financing the purchase.
How to battle against your nature
So now that you know your brain has some not-so-great tricks up its sleeve, what tools can you bring to the table to combat them?
According to both financial planners and psychologists focused on behavioral finances, the most important thing is to slow down and think seriously about why you’re about to make the financial decision or purchase you’re considering. That way, you’ll be able to utilize your actual rational decision-making mind and engage in System 2 thinking.
Once you’re intentionally deliberating, rather than just responding emotionally, you can take the time to think your choices through to their ultimate outcomes — which is particularly important when considering large and emotionally loaded decisions.
Take, for instance, the purchase of a home. Although it’s easy to get caught up in imagining which bedrooms your children will sleep in and where they’ll do their homework, it’s good financial practice to come back down to earth and calculate the entire purchase price of the house including mortgage interest over time. Although the bank is required to disclose that information to you, you might not see it until closing, at which point the decision-making part of the process has already come and gone.
By learning to take a step back from the cues — or “nudges” — being used to impact your choice-making process, you can take control of that process back. Then, you can rest assured that your financial decisions are just that: your decisions.