Six Ways Our Brains Make Bad Financial Decisions
Dan Ariely and Nina Mazar, Special to The Globe and Mail
We all do it: hold on to a stock when every indicator screams sell, or spend our entire bonus on a new car instead of paying off debt. A whole new area of science called behavioural economics, or BE – a blend of psychology, economics, finance and sociology – has sprung up to explain why. According to BE pioneer and Duke University professor Dan Ariely (author of the bestseller Predictably Irrational) and Rotman School of Management researcher Nina Mazar, our brains are hard-wired to choose short-term payoff over long-term gain. Here are six common mistakes investors make – and how to avoid them.
SAVING: What’s more important: buying a new iPad now or saving that money for the future?
It’s not as stupid a question as you might think. We often make terrible choices when it comes to trade-offs between important distant goals and our immediate desires. This is one of the reasons our diets fail and we don’t exercise as much as we should.
Saving money as a habit is especially important, with big consequences later. The trouble is that we tend to discount future benefits (a phenomenon referred to as “hyperbolic discounting”), so much so that an iPad now really is more important to us, at least in its influence on our current decision-making.
One way to overcome these natural irrational tendencies is to use commitment devices. Several financial institutions allow consumers to pre-commit to saving a certain percentage of their future wage increases. Also, synchronizing savings with future salary increases is a much easier current commitment for most people to make than relying on sheer willpower to make regular contributions.
RETIREMENT PLANNING: How much money do you think you need for your retirement, assuming you plan on maintaining your current lifestyle?
The actual figure might shock you. Most people assume that in retirement they can comfortably live off about 60 per cent to 70 per cent of their current yearly income. Studies on spending habits have shown that a realistic figure is closer to 135 per cent. Why do we suddenly need more money? Because we often grossly underestimate our own spending habits, and then we fail to take into account that with our new-found retirement freedom, we are likely to engage more frequently in expensive activities. Unless you plan on spending retirement in your basement eating leftovers, your spending is likely to go up – and by more than you expect.
The solution? Start saving now. But this is much easier said than done, not just because of procrastination. The human brain is notoriously bad at nonlinear reasoning, and we consistently discount the benefits of long-term compound interest.
Saving early should be hugely important, but too often we succumb to retail temptation or procrastinate. Here is a useful trick that you can use to achieve your savings goals: Attach an immediate reward, like a movie, dessert or small retail purchase, to every retirement contribution. This is called “reward substitution” – the reward of financial security in retirement is too distant, so we can substitute immediate rewards and tie them to desired behaviours. Behavioural reinforcements like this are often surprisingly powerful in shaping our decisions.
INSURANCE: Why do we make such bad decisions when it comes to insurance?
The fact is, we are ill-equipped on a cognitive and emotional level to handle these random-based outcome decisions. Delayed benefits and complex probability calculations make insurance an uphill battle for our brains. We often let highly flawed intuitive statistical inferences and emotional appeasement guide decision-making as a result.
One example is the strange decisions people make regarding deductibles in homeowners’, health and car insurance. People hate deductibles. We go out of our way to avoid insurance policies with high deductibles, and we consistently end up choosing a more expensive policy in the long run. Behavioural economists believe that the explanation is irrational and arbitrary mental compartmentalization of insurance costs–the first dollar of every cost hurts the most and each additional dollar hurts progressively less. As a result, the small frequent costs that come with deductibles are more painful than high premiums with a greater overall cost, because the cost of annual premiums is irrationally discounted.
SHOPPING: Why do we invest in extended warranties?
Our emotions lead us astray when considering add-on insurance offers like extended warranties and collision insurance on rental cars. These types of offers are almost pure profit for the vendor. Most of us have already been warned, yet we continue to buy them.
The behavioural explanation isn’t stupidity, but emotionally intelligent “regret avoidance.” Consumers realize that they will evaluate their decision in hindsight based on what actually happens, instead of based on the available information at the time of the decision. By purchasing the add-on insurance, we are getting a bad deal, but we avoid any potential regret.
This behaviour is a form of emotional risk management, and we do it all the time. Sometimes we even use emotional hedges, buying more insurance than we need for low-value items, like in the case of extended warranties, and as a counterbalance, less insurance than we need for severe but infrequent losses, such as fires or theft.
Understanding how our emotions bias our decisions toward deductibles and extended warranties may help us make smarter decisions in the future. The solution? Never buy an extended warranty unless you’ve heard from many friends that it saved their bacon for a particular appliance or technology device.
MORTGAGES: Why do we buy mortgages from the same old suspects?
If you are looking for a mortgage, it would help to not only evaluate all available options, but also remember that there are cognitive biases influencing your decisions.
First is the presence of “choice overload” in the marketplace. Because of it, the average borrower tends to explore the few lenders they are familiar with. While you might save time going with a firm you already know, doing your due diligence by researching a number of mortgage options from different lenders will serve you better in the future.
Borrowers are also vulnerable to “optimism bias.” The amount of money a lender offers you doesn’t necessarily reflect what you can afford. Sure, you want a big house with a gorgeous modern kitchen. But understand your starting point and remember that we are usually unaware of how our emotional states (for example, wanting to impress others) make us more likely to ignore evidence that goes against our expectations.
We can also be subject to planning fallacy and fail to develop an adequate mortgage plan that serves us both immediately and over the long term. To address this, think about how your future self will benefit (or not) from the decisions you make today. Take advantage of any analytical tools and reports that your lender may offer to stay on top of your plan.
Lastly, don’t fall victim to the “status quo bias” by sticking with your mortgage plan just because it is what you originally chose. Continue to research options like refinancing, which might yield significant savings – some of which you could put toward the modern kitchen you always wanted.
Dan Ariely and Nina Mazar are partners in Toronto-based BEworks Inc., which provides analysis and advice to corporations and governments to help their customers make better decisions.
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Photo courtesy of Carl De Torres: This is your brain on behavioural economics