The burgeoning field of behavioural economics analyses how people make decisions and why people don’t make the decisions that are best for them. It combines the fields of psychology, sociology, business and economics and is seen as fundamental to improving social outcomes.
In late 2017, the founding father of behavioural economics, Richard Thaler was awarded the Nobel Prize for Economics for “Integrating economics with psychology”.
He is one of the leading scholars in a field which says our choices are not rational, that they are moulded, influenced and “nudged” by factors we are not even aware of, as Thaler explains in his 2014 book, Nudge.
“Nudge Theory” is constantly at work, when we choose what to eat, what to wear, and what to invest in.
How can we make better decisions?
Being busy and thinking in the short term are the two main reasons we make bad decisions, according to Daniel Read, professor of behavioural science at Warwick Business School.
“The path of least resistance is a very powerful driver for us to make decisions,” Read says when discussing Nudge Theory with the Financial Times (FT) and outlining the insights behavioural economics has given us into our decision making processes (see video below).
“We don’t have time to spend on all the decisions that we need to make [and] we think about things in the short term,” he says.
Read says it is quite challenging to improve our decisions, which are largely driven by our individual situation or the context of that decision, as opposed to us as an individual.
However, the good news is that in a financial context, Read believes you can learn to make better decisions.
“You can learn about what are the right financial choices to make and you can implement them,” he says.
However others believe it might not be as simple as learning what the right choices are. You still need to choose them. For example, almost everyone says they would like to save more for retirement, but behavioural economics shows it’s hard to accept the looming financial sacrifice now for the promise of money later (see loss aversion and hyperbolic discount descriptions below).
Further to that, social psychologist, Hal Hershfield has found that the empathy we experience for our future selves is about equivalent to the empathy we have for total strangers.
He says this gap could be closed by starting a conversation with your future self. Hershfield suggests writing a letter to your future self or downloading an age-progressed image and placing it somewhere in the house where you make important decisions.
See more in his Ted Talk below.
A word of warning:
While companies and especially governments are increasingly using behavioural economics to craft services which are more frictionless and lead to a positive outcome, some companies – investment and otherwise – may also use behavioural economics to guide your decision in a direction that will be more financially favourable to them and may not actually be in your best interest.
For more information on behavioural economics and making better decisions, read Nudge: Improving Decisions About Health, Wealth, and Happiness, a book co-authored by the Nobel Prize-winning Thaler.
Other behavioural economics concepts (many of them – but not all – coined by Thaler):
Prospect theory is a behavioural model that shows people make decisions using a current reference point (e.g. current wealth) rather than a final outcome.
It says that because losing is a greater motivator than winning (Loss Aversion), people are more willing to take risks to avoid losses than they are to realise gains.
For example, most people will view a single gain of $50 more favourably than a gain of $100 followed by a loss of $50.
The pain of losing is psychologically about twice as powerful as the pleasure of winning. Therefore fear of loss is a greater motivator to people than the prospect of winning.
This is when we place more value on something that we own than we do on the same thing when we don’t own it, regardless of its market value.
Generally, once you have established ownership of something, you will tend to place a greater value on it. This is especially true of things with symbolic, experiential, or emotional significance.
Sunk cost fallacy:
Sunk cost fallacy is the concept that people will continue doing something – regardless of its worth – simply because they have previously invested time, money or effort into it.
Status Quo Bias
When people prefer things to stay the same by doing nothing or by sticking with a previous decision it is referred to in behavioural economics as the Status Quo Bias.
This can occur even when small costs are involved in making a change and the importance or benefits of that change is significant.
People feel greater regret for bad outcomes resulting from new actions taken than for bad outcomes that are the consequence of inaction.
This is evidenced in real estate specifically in a 2008 study where a large minority of respondents perceived losses as a result of a purchase as more severe than unrealised gains because they did make a purchase.
According to Thaler, people think of value in relative rather than absolute terms. They treat money differently, depending on factors such as the money’s origin and intended use, as opposed to assessing its bottom line.
For example people are:
- willing to spend more when they pay with a credit card
- more likely to spend a small inheritance and invest a large one
Self-control and Hyperbolic Discounting:
People usually prefer immediate reward over long term rewards, even if the benefits of the latter are far greater.
For example people would rather receive $100 today than $120 in one month, but would rather receive $120 in 13 months than $100 in 12 months. They are happier to wait an extra month for a larger reward when it is in the distant future.
Do any of these scenarios ring true to you? Perhaps you can recognise a behaviour in yourself that has held you back from moving forward with your journey to financial success?
To help you implement Read’s advice to “learn about what are the right financial choices to make” we’re offering a free 60-minute property investment consultation. We also offer tailored one-on-one education workshops. For more information, please contact us.
Important Note and Warning: This information is general in nature and should not be considered personal tax advice. We highly recommend you discuss these concepts with your accountant, property investment adviser and investment finance mortgage broker jointly to ensure any considered concepts are suitable for your personal financial situation, as one effect of the concept may negatively impact another part of your plan.