It’s not your fault, you’re only human. But because you are a mere mortal, you’re bound to be making some, let’s say, suboptimal decisions. Humans have systematic biases—as psychologists have proven again and again—that can get in the way of the best intentions. This is particularly the case with money.
In many countries, governments have been inspired by behavioral economics and academics such as Nobel prize winner Richard Thaler to help citizens make better financial decisions with actions that counteract inherent biases, or so-called “nudges.” A common example is automatic-enrollment retirement savings plans, or opt-out plans, which demonstrably increase the number of people saving for retirement compared with opt-in plans.
These nudges, of course, don’t cover the full breadth of financial decisions most people have to make. Even if you consider yourself an expert in personal finance, most people could learn something from psychology and behavioral economics about how to manage their money better. First of all, most people “actually don’t know what is in their best interest,” according to Stephan Meier, a professor at Columbia Business School. Or, they simply don’t act in their best interest.
So, where might you be going wrong?
Present bias
People tend to value the present too much when planning for the future. This leads to what economists call dynamic inconsistency.
Think of the now famous marshmallow test originally run in the 1970s by Walter Mischel of Stanford University. An illustrative version goes like this: Children are given a marshmallow and told if they wait to eat it, the adult will come back and give them another marshmallow. Even though it’s in their best interest to wait and get two delicious marshmallows, many children, when left alone, struggle and end up eating the one before the researcher returns with another. (There are plenty of cute videos of kids battling temptation.)
Adults struggle just as much with this, in what is called present bias. If you were acting rationally and optimizing your maximum lifetime utility (as most economic models expect you to) then the decision you make shouldn’t change based on the time frame. Although you may want to plan for the future, such as by saving more, you may get antsy in the present and borrow or spend your money instead. You’ll save more tomorrow, you tell yourself.
Research by Columbia’s Meier shows that present bias can lead to higher credit card debt, higher rates of default, and lower credit scores. In a 2010 paper with Charles Sprenger, Meier found that present-biased people had an outstanding balance of $1,565 on their credit cards, versus $776 for non-present-biased people.
Planner versus doer
Present bias raises the problem of self-control, a pesky issue prevalent in financial decision-making. The internal struggle between making a sensible decision for the future or picking something that provides instant gratification is what Thaler and others describe as your planning self and doing self. While it sounds obvious, this is not to be taken lightly. “Most of us realize that we have self-control problems, but we underestimate their severity,” Thaler writes in Misbehaving: The Making of Behavioral Economics. “We are naive about our level of sophistication.”
Even though this is a flaw, it can be mitigated by using another human bias to your advantage. If your doing self is in charge most of the time, then your panning self needs to remove choices that encourage short-term decisions (going against the economic theory that says more choices are always better). The planner can do this by separating money into different spending pots that have different purposes: essentially, budgeting. This is what Thaler calls mental accounting. In economic terms, it makes no sense because money is fungible. If you run out of money in the pot marked for entertainment, you should just take it from the one marked for groceries. But thanks to human flaws, mental accounting works, so your grocery money will be saved and next Friday night will be spent at home.
Erm, confusion
To put it simply, people are confused. Many don’t understand the details of financial products. How could they? These products are increasingly complicated, with arcane documentation that requires a law degree to understand them. Think of the huge variety or rates, terms, and fees that make the mortgage market a minefield to navigate.
Financial illiteracy can lead to firms making a profit at your expense. Credit markets are an area where consumers are particularly prone to mistakes, in part due to the complexity of costs but also because of the impact of intertemporal decisions (an individual’s current decisions affect the options that become available in the future), and the lack of incentive for firms to educate their consumers.
In short, don’t be overly confident. It usually pays to seek advice.
Status quo bias
Seeking advice also requires overcoming inertia. Given the option, most people are likely to stick with the status quo even if there are large gains to be made from a change that incurs little or no cost. Automatic-enrollment plans for retirement savings are designed to overcome status quo bias, by making the default, or do-nothing option, a beneficial one. But after this initial government nudge, inertia can still stop you from managing your savings in the most efficient way.
The default options tend to be invested in safe funds of assets, where additional investment gains accumulate slowly, and could have high management fees. But most people don’t make changes to their retirement savings portfolios unless they change jobs and are confronted with a new set of forms to fill in.
Recognizing your own status quo bias and acting against it would encourage maximizing the contribution matched by an employer and reconsidering the funds in your portfolio to take on more risk, if you can stomach it, with an eye to minimizing management fees.
Loss aversion and anchoring
One of the key observations in behavioral economics is loss aversion. People experience the negative feeling of loss about twice as strongly as they feel a positive sense of gain for the same amount of money. In other words, you’ll put in much more effort not to lose $100 than to gain $100. This can get you into trouble when investing.
A related concept, called anchoring, exacerbates the problem. When selling something, your reference point is probably the price you paid for it, and your mind is anchored to that price. Even if the value of that item is worth a lot less, you might not sell it because you are anchored to that purchase price and want to avoid the sense of loss. With a stock, for example, watching the price fall won’t necessarily make you sell, if you’ve missed the chance to sell at your purchase price. Worse still, loss aversion has been shown to make people take on big risks to recuperate losses, even though this can generate even more significant losses. It’s why so many traders end up buying high and selling low.
Once you close this page, you’re bound to keep making some of these mistakes. Systematic biases are hard to overcome because they are human nature. When it comes to managing money, we are often our own worst enemies.