Home Mind & Brain How Behavioural Economics Affects Our Financial Decisions

How Behavioural Economics Affects Our Financial Decisions

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When it comes to making financial decisions, we often believe we are perfectly rational actors who weigh the pros and cons of each choice before making the optimal decision. However, behavioural economics paints a different picture of how our minds work when money is involved. This field examines how psychological, emotional, and social factors influence economic decisions. Understanding these sometimes irrational forces can help us become wiser financial decision makers.

One key factor is cognitive biases, which are systematic errors in thinking that affect our judgements. An example is confirmation bias, where we seek out information that aligns with our existing beliefs while discounting contradicting evidence. When investing, this could lead us to be overconfident in a certain stock due to selective attention to positive news about it. Behavioural economics aims to identify such biases so we can recognise when they may be influencing our money moves.

Emotions are another driver of financial behaviours. When we feel fearful, we may avoid risks even when they are warranted. Excitement may push us to act hastily when patience is needed. The field of neuroeconomics is studying how emotions are represented in the brain during decision making. By managing our emotions and recognising when they may be impacting judgements, we can add more logic and strategy to money matters.

Common mental shortcuts or rules of thumb known as heuristics also steer our financial behaviour. Examples include anchoring, where we rely too heavily on the first piece of information provided, and availability, judging the likelihood of events based on how readily examples come to mind. Relying on such shortcuts can fast-track decision making but also lead to suboptimal choices.

Behavioural economics considers how social forces like peer pressure and norms influence us too. Herd behaviour in investing is one example, where individuals irrationally follow the crowd. Targeting such forces for change can lead populations to wiser financial habits. For instance, automatically enrolling employees into retirement savings plans by default results in higher participation rates than requiring they opt in.

This field also draws on the concept of limited rationality, recognising realistic constraints on our time and mental capabilities. Having too much complex information to digest or too many choices to compare leads people to avoid deciding, default to a safe option, or rely on intuition. Simplifying the decision environment through smart framing of options, clear data displays, and limited choices can lead to better money management.

There are critiques of behavioural economics, including that it does not account for differences across contexts and cultures nor the malleability of human behaviour over time. It also focuses heavily on certain common biases while lacking a unified theoretical framework. Further, few behavioural interventions have robust long-term evidence of effectiveness.

The insights from behavioural economics have already influenced policies and programmes to improve financial well-being. For example, promoting savings among low-income groups through initiatives like Save More Tomorrow which utilises concepts like defaults and automated escalation of contributions. Its rise reflects recognition that financial decisions are often driven by less-than-rational forces. Paying more attention to our psychological quirks through practices like introspection, decision journals, and choice framing can lead to wiser money behaviours.

Sloane Mackintosh is a behavioural researcher and author based in London. She writes on the intersection of human behaviour, economics, and technology.

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