Applying Behavioural Economics to Your Personal Finances
An intro to behavioural economics and its application to daily life
This is my official first attempt to write about science for the everyday reader, I hope you enjoy it! (Feedback is always welcome).
Behavioural economics is a relatively new field of study, that has developed over recent years. It investigates why humans make the decisions that they do, and how to change the choices people make for the better.
This article will introduce the application of behavioural economics to your daily financial decision making.
An introduction to behavioural economics
Behavioural economics is a field of study incorporating cognitive neuroscience, psychology, and economics.
Researchers carry out experiments on emotions, the environment and social factors influencing our decisions. This includes understanding how cognitive biases, heuristics, and framing impact our irrational decision making.
Simple definitions
A heuristic is a mental shortcut that allows people to solve problems and make judgments quickly and efficiently and a bias is an inclination toward a way of thinking.
“A bias may be thinking that all creative people are left-handed”.
An example of a heuristic is thinking irrationally that there is a shortage of jobs in your town due to increased news reports about unemployment. An example of a bias may be thinking that all creative people are left-handed.
Framing refers to the way in which a choice is presented to you, for example, the strategic way in which sweets are presented at the counter when you visit a supermarket.
Historic theories of economic behaviour assumed that people apply rational thought processes to every decision to maximise personal benefit. Irrational behaviour, on the other hand, is described as decision making that does not make complete logical sense. For example, this could be you buying an additional item at the supermarket because it was on offer at buy one get one free, but, you are unable to consume all the contents before the sell-by date.
Trader behaviour
Historically, behavioural economic theories have been applied to investor finance and the decisions a trader makes.
These reference biases and heuristics such as overconfidence (see the Dunning Kreger effect), where traders believe they are better than they really are, as found by James Montier — 74 per cent of traders were guilty of over-ranking — believing that they were above average at investing. Or gamblers fallacy, where a gambler believes that if an event occurs frequently in the past, it is less likely to happen again in the future.
“With the increasing range of products and service choices on the market and the increased responsibility of the individual, focusing on household-related decision making is imperative”.
Your day-to-day finances
Righty so, behavioural science is becoming increasingly popular and being applied to an increasing number of areas, including individual finance and decision making. Here we are talking about the decisions we make day-to-day, such as whether to pay the minimum on your credit card, save as opposed to spending or what car to buy.
With the increasing range of products and service choices on the market and the increased responsibility of the individual, focusing on household-related decision making is imperative.
The mistakes we make
When we make decisions, we are likely unaware of the many internal and external factors at play, and how they influence the choices we make. Sometimes we are simply confused and do not understand the terminology or what something really means. Or we may understand but are deliberately ignorant and choose not to act.
“The ‘pain of paying’ causes us to prefer using credit cards instead of cash, that way we cannot see the money we are spending”.
Consider our empathy gap, this is a phenomenon where our inability to correctly estimate how our changing mental states, impact our behaviour. This causes us to incorrectly predict our future behaviour. You may think you’ll only buy a small dish when you go to dinner, but hunger may take over leaving you with a much larger dinner bill than anticipated.
Or think about the fact that we are loss averse. Many people sign up for free trials thinking they’ll cancel it at the end of the term but end up committing for not wanting to lose out on the service or product — we don’t want to miss out. The ‘pain of paying’ causes us to prefer using credit cards instead of cash, that way we cannot see the money we are spending.
As with the traders mentioned earlier, overconfidence also impacts an individual’s household finance. In a study carried out in Poland, overconfidence in debt literacy was linked to more borrowing.
How behavioural economics can help
There are many other cognitive biases that impact the economic decisions you make, I encourage you to read up on the availability bias, the endowment effect and representativeness.
If we return to the basics of psychology, a component of behavioural economics, understanding, and becoming aware of why you do the things you do is the first step to having a greater understanding of yourself. For example, knowing more about some of the things that motivate your behaviour can be useful if you are trying to stick to a weight loss plan or save more money.
If we consider overconfidence, being aware of the influence it has on your decision making, and taking active steps to create systems to reduce its impact have proven effective. Findings suggest that a psychological sense of shared ownership of money management in the home is associated with lower levels of overconfidence.
The field of behavioural economics is ever-evolving, as scientists continue to research and refine theories to support and understand how humans operate.
A fun place to start is by signing up to Brainy Tab. They’re a company that has created a Chrome Add-on that shows you a new bias every time you open a new tab. Their aim is to help expose more people to these concepts and take active steps to improve, as they believe that being aware of your biases, greatly helps you overcome them.
About the author
Krystle McGilvery is a qualified Chartered Accountant who nudges founders and individuals, through her consultancy KM Consulting to build financial confidence and make better economic decisions. She is also the founder of the educational company Mind Over Money. Krystle is based in London, UK, and is a mature student at Warwick University. She loves yoga, dancing, and creating fine art.
Connect with her on Twitter , LinkedIn, Instagram, or email krystle@krystlemcgilvery.com.
