What Really Drives Our Financial Decisions?

It’s timely that Richard H. Thaler just won the Nobel Memorial Prize in Economic Sciences. His key teachings describe how “irrational” we really are about our economic decisions—even predictably irrational.

Professor Thaler is one of the key thinkers in the field now known as behavioral economics. He is the author of a best-selling book, Nudge, on how people can make better decisions. He also had a cameo appearance in the 2015 film The Big Short, teaching us about the role of synthetic collateralized debt obligations (CDOs) in the 2008 financial crisis. Now, that was a time when it seemed that almost everyone was acting irrationally!

Thaler teaches that we are not rational economic animals who “maximize utility” as we make decisions based on supply and demand. No, we are human beings that bring our emotions, unconscious motivations, and irrational behavior even to money matters. I might even say, especially to money matters!

This is not really news to most economists and even us laypeople. We have instinctively known for a long time that the “rational” model does not match reality. However, Thaler is credited with showing that people depart from rationality in predictable ways. And understanding predictable patterns at least allows us to plan. Chaos does not give that option.

Thaler worked with Professor Daniel Kahneman (who received the 2002 Nobel Memorial Prize in Economic Sciences) and Amos Tversky in defining the field of behavioral economics. Kahneman’s best-selling book Thinking, Fast and Slow posits two modes of thought: System 1 is fast, instinctive, and emotional, i.e. irrational; and “System 2” is slower, more deliberate, and more logical, i.e. rational. He also explained the cognitive biases we all have in both systems that color our decisions. It’s a fascinating book—I highly recommend it.

Learning to drive a car is a great example of how trying to use System 2 does not work—you can’t think fast enough to make all the decisions necessary to even pull your car out of its parking space. It’s really System 1 that must kick in with practice to make the thousands of decisions necessary to go that quarter of a mile to the grocery store.

So how can Thaler’s and Kahneman’s work help you better understand yourself? How can it help you make better decisions?

  1. Think about how to nudge results via the “defaults” in your environment. One great example is to make savings to your 401(k) plan automatic rather than decide how much to contribute after you get your paycheck or bonus. Thaler even showed that overall employee participation in a company 401(k) plan was higher if the company made participation the default, forcing people to “opt out” rather than “opt in.” In other words, we can set up defaults that promote good decisions and behavior rather than force the decision. This way, we can use our tendency toward inertia to help ourselves! How many of us would have voluntarily paid our Social Security taxes when we were in our 20s and 30s?
  2. Be mindful about your mental biases. We’re all human, so we can’t get rid of our biases. However, we can try to notice them better. One interesting bias is “mental accounting,” where we mentally divide money into different pockets. An example I often see is people who treat their investments and their debt as belonging to different types of money—even though money is money. So they will keep paying interest on their credit card debt rather than take money out of investments to pay off the debt.
  3. Don’t make things too complex. Why? Because we tend to follow the path of least resistance. I see this all the time in helping clients make investment choices. If I lay out the entire theory of strategic asset allocation and periodic rebalancing, it comes across as complex and difficult, and this just freezes people into inaction. But if I can offer them three basic investment models and make the rebalancing automatic, I am focusing their attention on a much simpler decision.

Another way to think about what really drives our financial decisions is represented in the graphic below. Susan Bradley from the Financial Transitionist Institute used it in her presentation to a conference of financial planners that I attended in August at UC Santa Cruz. The graphic drove home the importance of knowing more than just the “technical” stuff. And it speaks simply and eloquently about the way we try to get to know our clients at Aspire.