The University of Chicago’s Professor Richard Thaler walked off with the Nobel Prize in Economics for his work researching Behavioral Finance. His work, including his 2008 book “Nudge” demonstrates that humans are predictably irrational and can make bad decisions that fly in the face of good solid information. For example, people will refuse to spend more for an umbrella during a rainstorm or would shift from regular to premium gas when fuel prices fall. Yes, it makes no sense, but in our minds, we rationalize that our decisions are sound and appropriate.
Making rational or irrational money decisions
Bravo to the Nobel Prize Committee and congratulations, Professor Thaler. The light began shining on human behavior when the Nobel Prize in Economics in 2002 was awarded to psychologists Daniel Kahneman and Amos Tversky. They were awarded the prize for their research that countered assumptions of traditional economic theory. The team found that people make rational choices based on their self-interest, rather than by fully analyzing the situation.
If we observe human intelligence from the standpoint of innovation, we look pretty darn smart; from the invention of the lightbulb to the Smartphone—we’ve come a long way in a short period of time. But when it comes to human behavior, progress hasn’t been quite so dramatic. The factors that lead us are emotional rather than objective.
Consider some of the influencers on our financial decision-making:
Our money history—Our attitudes about spending, saving and money are learned in childhood and carried with us through life, residing in our subconscious, informing how we make lots of decisions.
Our friends, family and colleagues—we constantly judge and sift information. We decide, based on our ‘wiring’—how we act or react. For example, if you see that your colleague at work is going on exotic vacations and buying expensive cars when you simply are unable to afford those lifestyle choices, you might feel “less than” and therefore feel the need to overextend to level out the playing field.
The media plays a significant role in our decisions. You cannot turn on the TV or read a paper or magazine without seeing examples of opulence and those who live expensive lifestyles. Humans want to be “in”, admired by others, and looked at as someone important and powerful. The constant barrage can impact our decisions.
We deal with these internal and external forces in making decisions that when looked at objectively, make little or no sense, but at the time, is just part of our ‘normal’ operating system. Consider those who decided to sell off their equity holdings during the Recession. Their fear of losing everything provoked a decision that caused real harm to their wealth, instead of recognizing the role emotional distress they were experiencing due to the current economic situation.
Professor Thaler’s award refocuses our attention on the notion that, like the old Pogo cartoon line says, “We have met the enemy and he is us” is something to be taken seriously. We need to realize and accept that our money history, our relationships and the media all play a role in how we think and the decisions we make. But, there can be a light at the end of the tunnel; it’s not hopeless and we are not doomed to lifelong mistakes.
We can make strides in making choices that serve our goals and values more positively. Here are some tips:
- Further your understanding (read “Nudge” Thaler, “Thinking Fast and Slow” Kahneman, “Finance for Normal People: How Investors and Markets Behave” Meir Statman).
- Create a written statement of your values and goals. Be specific and crystal clear. Determine what “MUST” happen for you to feel satisfied.
- Work with a CFP professional, who acts as a fiduciary (your interest first), to create a written and specific financial plan.
- Make small steps that will enable you to experience measurable successes.
- Acknowledge your “humanness” and that mistakes happen.
- Review your progress, question your actions and reflect on the results. Be willing to make changes and alterations where appropriate.
Begin at the beginning, with the understanding that we are perfectly imperfect and that our journey is fraught with challenge. But it’s the only journey we have! Let’s celebrate Professor Thaler’s success and the important work he’s provided so that we can live a better, happier and more rational life.
