What Behavioural Economics can teach us about Financial Wellbeing
- Jim Coke
Behavioural Economics is a relatively new subset of economics that combines psychological, cognitive, emotional, cultural and social factors when examining decision-making. Unlike traditional economics that assumes that individuals are rational agents, behavioural economists don’t assume that. Instead, they believe that individuals use a plethora of concepts, mechanisms and devices in their decision-making.
For a behavioural economist, it’s these concepts, mechanisms and devices that impact financial wellbeing. Given the brevity of this article, only three will be discussed here. The first is that we think we make rational decisions, but these decisions are ‘bounded’ and limited by many other factors we pay little attention to. Second, we make ‘counter-intuitive’ choices when faced with gains or losses, often working against ourselves. Third, we make choices about money based on its origin and intended use rather than its absolute value.
Satisficing
Herbet Simon (1957) is arguably the father of Behavioural Economics, and he began the descent of the economic agent away from rationality. His Bounded Rationality theory stated that people make decisions that are not entirely rational and based on optimised strategies. These decisions are ‘bounded’ because of the limitations of the mind and constraints in time. What happens is that we arrive at choices that are just sufficient and satisfy the need at hand. Simon stated that people don’t use rationality but ‘Satisfycing’ to make decisions - we choose what is sufficient and satisfies. How does this teach us about financial wellbeing? Well, if we accept, as Simon argues, that our decisions are indeed ‘bounded’, we should want to remove those boundaries and make better choices.
We can start by removing time as a boundary and not make any decisions that place a time limit. Of course, this might be hard in today’s economy. Still, the next time you see a clock or timer counting down to the end of a sale or something pressuring you to make an order before the ‘window closes’, be mindful of the fact that any decision you make is likely to be bounded by time. Similarly, heuristics (rules of thumb) are also boundaries that Simon discusses. Heuristics will often appear in financial decision-making that relies on memory and recall. Any psychologist will tell you that memory and recall are very unreliable; we don’t give it much weight in our legal system or in other matters of evidence. Why do you think all your eCommerce platforms try and shape your memory and recall by repetition, suggestions and what you have ‘searched for’?
It’s always best to check on recorded facts and figures and not memory and recall. ‘Thinking’ about something before you decide to do it is a sure way of relying on heuristics. Don’t. Go away, do your research, check your receipts, look at your statements, examine your outgoings and then decide. It seems like common sense, but how many times have we been faced with a decision that needed to be made quickly, and we ‘thought’ about it and then handed over our debit/credit card? If you are like most people, you have done that on so many occasions and there is a substantial chance that what you thought were rational decisions were Satisficing decisions.
Prospect Theory
Daniel Kahneman and Amos Tversky in 1979 taught us that we often work against ourselves by making ‘counter-intuitive’ choices when we are faced with gains or losses. Kahneman was later awarded the Nobel Prize in Economics in 2002, making him the first recipient for Behavioural Economics. Their Prospect Theory showed that people behaved in ways that were counter-intuitive to their position. In a series of experiments where subjects were given choices in various scenarios, they showed that their behaviour towards risk was at odds with what they stood to gain or lose.
Prospect Theory explains that when people are faced with gains or the chance to acquire gains, rather than attempt to take advantage of them, they are, in fact, risk-averse and often shy away from them. However, when people are faced with losses or the possibility of a loss, they behave counter-intuitively. Rather than make choices to limit the loss, they tend to be more risk-seeking and make choices accordingly. Put in simpler terms, when people are presented with the chance to make gains, they hesitate and find ways to avoid the additional gains. But when they are faced with losses, they seem to throw caution to the wind and “go for broke.” Okay, this may be an oversimplification of a well thought out theory, but it drives the point home - we should be doing the opposite to what we usually do when faced with gains and losses. So how does this help an individual attain financial wellbeing?
If we recognise that we tend to exhibit different behaviours depending on how gains or losses are presented, we can start to examine our choices when it comes to spending. And don’t think this idea is too abstract or theoretical to decide how you spend your money. Merchants use it against us all the time. When advertising, brands avoid accentuating the gains but focus on your perceived losses if you don’t take their product or service. It’s a classic routine you see everywhere. How many times have you been told not to miss or lose an opportunity before it is gone? Or have you been presented with something being scarce or ‘just two left’ emblazoned somewhere for you to see? If we make financial choices based on the possibility of a loss, we may be choosing counter-intuitively and spending out of fear. What is the remedy to help your financial wellbeing? Buying decisions should not be made impulsively but be made well in advance so that perceived gains or losses do not drive them.
Mental Accounting
Finally, the last behavioural economic concept which can teach us about financial wellbeing is Mental Accounting. Many readers have probably heard of the author of Mental Accounting or at least his most famous idea; Nudges. In 2017, Richard Thaler was awarded the Nobel Prize in Economics for his contribution to Behavioural Economics. Chief among his contributions is the concept of Mental Accounting, which argues that people place more emphasis on the origin and intended use of money rather than its absolute value. In other words, we put different values on money depending on where it came from, how we got it or the effort we took to accumulate it and forget its actual amount when making decisions. How does this impact our financial wellbeing?
The value we place on money because of its origin and intended use affects how we spend it, ultimately affecting our financial wellbeing. How does mental accounting work in practical terms? Well, money is entirely fungible in that it is made up of units that are all interchangeable and indistinguishable from one another. A pound is the same no matter where it comes from or how it is spent. However, that is not how we think. We give money labels and put them into ‘mental accounts’, assigning values to them. Let us take a simple example of mental accounting at work.
Money earned through a job by way of a salary or commission is treated as the ‘main’ income source; we are more likely to use it to pay our main bills and reserve some for savings. But if we found money in an envelope on the street or received a gift or an unexpected inheritance from a deceased relative, we give it the label of spending money. You might think of a lavish dinner, impromptu holiday, a luxury piece of jewellery or anything you consider a treat. Because you have different labels on the money, you are likely to spend them differently. Even though money is interchangeable and indistinguishable from one another, we still create mental accounts for them. If this becomes a pattern and you get too emotionally attached to where and how you got the money, well, you can imagine where this will lead to and how it will affect your financial wellbeing.
So, what can behavioural economics teach us about financial wellbeing? Behavioural Economics is still a young field, and new theories are continually being developed and tested. What is certain is that financial wellbeing depends on thechoices we make about spending, and Behavioural Economics arms us with the tools to understand those choices. Many more tools exist that have not been discussed here, but the three above can guide us in making better choices about spending and saving. Ultimately, those choices will lead us to a state of being where we can meet our current and ongoing financial obligations. Achieving this allows us to feel secure about our financial future.
Author
Dr. Jim Coke is a member of the Chartered Banker Institute and the Chief Behavioural Officer at Level Financial Technology Limited (www.getlevel.co.uk). The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of any other agency, organisation, employer or company. Assumptions made in the analysis are not reflective of the position of any entity other than the author