Behavioral Economics. Why We Make Irrational Economic Decisions

We like to think we’re rational creatures, especially when it comes to our money. Careful budgeting, smart investments, and logical spending — that’s the picture we paint for ourselves.

You’re out shopping and see a “Buy 1, Get 1 Free” sign for shirts you like. Even if you only need one shirt, the deal is too good to pass up. So you buy two.

Or let’s say you’re booking a vacation.

When given the option to “Pay Later” instead of paying now, you choose it even if it costs more overall with interest.

You just want to pay as little upfront as possible.

In both cases, you made financially irrational decisions. From an economic perspective, you’d maximize value by only buying what you need and opting for the lowest total cost.

Yet we constantly make decisions like these that defy pure logic around money.

Why does this happen?

The answer lies in the emerging field of behavioural economics. It combines psychology and economics to examine how emotions, cognitive biases, and social pressures influence financial decisions.

Understanding these irrational biases is the first step to overcoming them and making smarter money choices. Let’s break down key concepts in behavioural economics:

The Power of Heuristics

Our brains are incredibly complex, but they’re also programmed to conserve energy. Enter heuristics — mental shortcuts that help us make quick decisions without having to analyse mountains of data every time. Here’s the catch: these shortcuts can lead to some predictable biases:

• Availability Heuristic: We tend to overestimate the importance or likelihood of things we can easily recall. Just saw a news story about plane crashes. Suddenly, you might feel more anxious about your upcoming flight, even though statistically it’s an incredibly safe way to travel. This can warp our spending habits too, making us impulse buy based on recent ads or focus excessively on the risk of loss when investing.
• Anchoring Bias: The first piece of information we receive becomes disproportionately influential. In a negotiation, the initial offer sets the stage, even if it’s far from the true value. Retailers exploit this with “was/now” pricing that makes a sale seem far more enticing.
• Representativeness Heuristic If something looks like a duck and sounds like a duck, well, it must be a duck, right? We instinctively categorize things based on superficial similarities. This can lead us to believe a flashy presentation equals a sound investment, when in reality the two might not be related.

The Emotional Rollercoaster: How Feelings Sway Our Spending

Logic alone rarely determines how we use money. Emotions play a powerful role too:

• Loss Aversion: Studies show the pain of losing $100 feels far worse than the joy of gaining $100. We become hyper-cautious to avoid loss, even if it means missing potential upside. This can lead to keeping money in a low-interest savings account instead of investing, driven by fear.
• The Endowment Effect: We place a higher value on things simply because we own them. That mug your uncle gifted you? You’d probably demand more to sell it than you’d pay to buy one, even if they were identical. This can make it hard to let go of investments, even if they’re underperforming.
• Social Proof: “Everyone’s doing it” is a surprisingly powerful force. We’re likely to spend or invest in things we see our peers doing, whether it’s the latest gadget or a hot stock tip. This can lead to following the herd rather than making our own informed decisions.

Nudge Theory: Small Changes, Big Impact

Can our awareness of these biases help us make better choices? Yes, and that’s where “nudges” come in. Unlike heavy-handed regulations or mandates, nudges are small tweaks in how choices are presented that steer us towards better decisions without restricting our freedom. Here’s how they work:

• Defaults Matter: Turns out, we’re quite lazy. Opt-in enrollment in retirement plans dramatically increases savings, simply because we tend to stick with the default.
• Framing is Everything: Presenting costs as daily amounts ($1 per day vs. $365 per year) can make expenses seem smaller. Marketers use this to make subscriptions look more appealing.
• Make Good Things Easy: Putting healthy snacks at eye level encourages better choices. This same principle can apply to financial decisions — simplifying access to savings tools increases their use.

Nudges are subtle changes to how choices are presented that influence behaviour for the better while still preserving freedom of choice. For example:

• Make retirement plan enrollment opt-out instead of opt-in. Participation rates increase dramatically even though employees can still opt out.
• Display fruits and salads prominently at the front of a buffet line. People will be more likely to select them.
• Set default printer settings to double-sided. Paper usage decreases but people can still change to single-sided.

Choice architecture involves designing environments and processes that account for common mental shortcuts and biases. Examples include:

• Adding friction to impulse spending by requiring waiting periods or extra confirmation steps.
• Providing personalized projections of potential financial outcomes based on current habits.
• Reframing lifetime costs in relatable daily amounts e.g. “smoking costs you $200 a month”
• Using social proof of positive behaviors like showing employees how colleagues are saving.
• Simplifying complex decisions into limited straightforward options or starting points.
• Making better choices more convenient through digital tools while adding steps for poor ones.

Should We Fight Our Biases?

Recognizing our biases is the first step, but can we fully eliminate their influence? Perhaps not entirely. Here’s why it’s a nuanced issue:

• Efficiency: Heuristics allow for efficient day-to-day decision-making. Imagine the analysis paralysis if we carefully weighed every financial choice!
• Context is Key: Biases can serve us well in familiar environments, based on our past experiences. The problem arises when they’re misapplied in complex or unfamiliar financial situations.
• Education, Not Elimination: Understanding our biases is a powerful tool to protect ourselves from their worst effects.

How can we use this knowledge to manage our finances better?

• Slow Down: If it’s a high-stakes decision, resist the urge to act impulsively. Give yourself time to consider alternatives and consult objective resources.
• Pre-Commit: Before temptation strikes, set limits (e.g., automatic transfers to savings) that help you adhere to your long-term goals.
• Seek Diverse Perspectives: Counter groupthink with outside opinions, especially when investing.
• Beware of “Free”: True costs are often hidden, so factor those in before jumping at tempting offers.

The key lesson from behavioural economics is that our financial choices are often swayed by irrational psychological factors. But being aware of them is half the battle.

Here are some tips to counter biases and “nudge” yourself towards wiser money decisions:

• Recognize when you’re using heuristics or being influenced by biases. Stop and reassess.
• Analyze choices in terms of calculated costs and benefits over time, not just upfront.
• Slow down decisions. Don’t rely on gut instincts.
• Look for contrary information, not just confirming evidence.
• Use choice architecture on yourself like commitment tools that add friction to impulse spending.
• Automate positive financial behaviours like savings so they happen by default.
• Avoid environments with unhealthy signals like casinos priming you to gamble.

While we can’t be 100% rational, being aware of mental pitfalls means we can consciously counteract them. The brain can be trained through practice.

Over time, you’ll find yourself making fewer snap emotional decisions and more calculated choices optimal for your finances. You’ll think critically about how options are presented to you.

The end goal isn’t to take all emotion out of money. But by understanding influences like heuristics and biases, you can make financial choices that truly align with your long-term interests.