Discover why people often make irrational financial decisions and how understanding our biases can lead to better financial planning and decision-making.
Rational choice theory is a common framework used by economists to understand why people behave a certain way when it comes to their purchasing habits. It assumes that all humans are “rational actors” who make calculated decisions based on an analysis of all the factors in a given situation. The basis of this theory is that all humans are looking out for their own self-interest, and therefore will make choices that they’ve carefully determined will maximize their advantages in life.
However, we don’t live in a perfect, predictable world. We're full of unconscious biases and guided by a myriad of psychological factors. Given the extremely busy lives most of us lead, we also often don’t have time to consider all the information presented to us before coming to a decision.
Our psychology has a major impact on our decision-making, leading us to be, at times, irrational. So what can we do about it?
Scott Mackenzie, MBA, a Certified Financial Planner, Certified Investment Management Analyst, and founder of wealth management firm PFW Advisors shares his expert insights on why we may make irrational financial decisions, and how understanding our own irrationality can actually help us make more rational financial decisions and sculpt a better financial future for ourselves.
Scott Mackenzie: “We don’t make rational financial decisions.
That is a strong statement to make, but I feel it is pretty accurate. We are all busy. Work, kids’ activities, caring for a house, spending time with family and friends and planning our next vacation along with hundreds of other things all take our focus away from our finances.
Taking the time to map out your finances and plan for the future is not something that anybody wants to do, or has been trained to do. Plus, people’s circumstances and preferences change over time. Personally, many things I wanted but thought I could never afford to do in the past are now a possibility, so my future plans have shifted over the years.
Life changes can make your financial plans something of a moving target. You have to continue to reevaluate and reshape your plans over the course of your life. Finding time to do this regularly can feel impossible and even pointless - faced with the seemingly endless choices we have about how to spend our money, and the unpredictable nature of life in general, why bother even trying to plan it all out?
Life has a tendency to throw curveballs, forcing us to change direction when we least expect it. When we don’t have time to consider all the information and have to make a decision now - which, let’s face it, tends to happen in the majority of our daily decisions - we have to take mental shortcuts to get to a quick solution.
Our brains are uniquely made to be able to help us take shortcuts. The experts call these heuristics. They help us handle the vast number of decisions that we face on a regular basis and avoid cognitive overload.
When, for one reason or another, we can’t consider all the information about a decision we have to make, we’ll use knowledge gained from past experiences and the preconceived generalizations we’ve formed about the world to come up with our next move. This decision may not be the most optimal, since it’s based on potentially unfounded assumptions about the decision’s outcome, but in most cases it ends up being good enough.
Heuristics are representative of one of the most amazing functions of the brain - that once we think we know enough about something, we have the ability to shift into autopilot and jump into gear. But while this ability saves us time, it can sometimes lead to negative consequences when it comes to our financial situations.
One example of a heuristic as it relates to finance - and one that can come back to bite us - is the concept of recency. If an event or action we’ve recently taken, or watched someone else take, has led to a specific outcome, we may think that this outcome is likely to happen again the next time. So if someone invests in a stock in a specific industry and it performs well, the person may assume that they should continue investing in that industry without considering additional factors.
I have seen so many examples of heuristics leading to negative consequences throughout my career, but there is one that stands out. Back in the 1990s, dot-com stocks were on fire. Everyone was talking about what was happening in the stock market. Social gatherings commonly involved discussions of which dot-com stocks were the best to invest in. Stock market discussions were so prevalent that many financial experts at the time spoke about how their cab drivers and waiters were telling them what to invest in.
The frenzy surrounding the dot-com bubble was based partially on the concept of recency, but it also was motivated by our instinctual desire to “follow the herd”. When everyone is talking about doing something fun, a natural response this evokes in most people is the desire to join in. This is called herding. Thousands of years ago our instinct to follow the herd was something that helped keep us alive. If everyone was eating a certain food or avoiding a certain area, then by going along with them you would likely have a better chance of survival. If we see a large number of people behaving a certain way, we have an instinctual desire to copy them, especially if we observe that behavior having a positive outcome for others.
When it comes to investing, following the herd has risks. In the dot-com era, that risk came in the form of company valuations. A large number of dot-com companies, even ones without any profits, traded at unbelievable valuations purely because they were dot-com companies and investors were following the herd. The more people invested in and discussed dot-com stocks, the more that herd mentality grew and roped in even more people, causing stock-related discussions to become even more popular, further herding additional people, and so on. This cycle continued, driving dot-com companies’ valuations beyond what Alan Greenspan, the Federal Reserve chairman at the time, called “irrational exuberance.”
Then, all at once, the bubble popped. Valuations dropped. Even great companies with amazing futures, such as Amazon, fell from lofty valuations. The biggest pain was felt by people who invested in companies that had absurd valuations despite zero profits. Many of those companies disappeared, making their stocks entirely worthless. People lost tons of money.
The human brain is an amazing organ capable of making 30 to 35,000 decisions a day. But because of the volume of decisions it makes, it has its limitations. That is the root of why people don’t make rational decisions - our brains need to take shortcuts to be able to handle such a high volume of decision-making.
When it comes to decisions about your financial situation, it can be difficult to make sure you’re always acting rationally. Our busy lives can keep us from seeing our finances objectively. That’s where a financial advisor comes in.
Optimizing your finances means working with a professional who understands not only your current circumstances but also your future goals. Reach out to PFW Advisors today to connect with an advisor who will take a holistic approach to your finances, ensuring you can build the financial future you want.
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