The way we treat our finances is often emotional. I think a lot of people would agree with that- we can spend a lot of money because we’re feeling happy (celebration) or miserable (retail therapy). Behavioural economics says basically that, except also frames worldwide economies in a similar way. So what could that mean for our finances?
Not That Rational
Behavioural economics isn’t the coolest kid in the economic-theory playground. Lots of the more grown-up theories are all about the rationalism- namely that people look at all the relevant factors and then make a sensible decision based on the information they have collated. I don’t know exactly which people the rationalists refer to, but I certainly am not one of that camp. My financial decisions are swayed by a million different, often emotional, factors. How much money I currently have. How I’m feeling about myself and my life that week. The mental state of having a ‘treat’ or a financial cleanse is a massive contribution to how I spend money. There are a lot of people who are, I am sure, far more rational about money than I am. But emotions are, whether to a greater or lesser extent, a factor in our financial dealings. So what does that mean?
The Value Of Money
A big cheers to the Ross Gittins at the Sydney Morning Herald for some informative tips on the key features of behavioural economics. One major tenet is that people do not regard a dollar as the same value across different situations. Rationalists would suggest that a dollar is a dollar and people will always regard it as such. Obviously, that’s not true. I’m happy to give a couple of dollars tip to a waitress but would never buy a coffee that costs more than $3, when in actual fact that is exactly the same. It’s suggested we give more weight to some costs in order to keep our balances in budget. I think the great value of behavioural economics is what it allows us to recognise within ourselves. If our behaviour with money is, to a large extent, emotional, we might be able to get our heads around our own financial patterns and plan for them more effectively. If you’ve ever found yourself thinking, ‘why on EARTH did I spend that?’, you’ve just made an emotional financial decision. Once you recognise that, every time you go to make a financial call, ask yourself what emotions are at play and take that into your decision-making.
According to behavioural economics, it’s not so much that we hate risk. We just hate loss. Of course we do, our whole lives we’re brought up to feel the pain of loss keenly. So some people are willing to take massive risks in order to temper a loss, whereas it would be a more sensible financial decision to wear the loss and not take the risk. Gittins’ example is this- say you were offered the choice between starting the day with $150 and losing $50 or just having $100 throughout the day. Rationally, we shouldn’t care, but I would be willing to bet most of us would keep the consistent $100. Financially, we don’t really enjoy change. Knowing that about ourselves can help us put together investment plans with the right kind of risk, know when to cut our losses and invest in something with better prospects, and know our limitations in making financial decisions across a wide sector of situations, without changing values attached to the money in question.