Behavioral economics or understanding how consumers make financial decisions has become a very popular topic recently. Companies as varied as brokerages, auto manufacturers, and fast food restaurants are all trying to better understand how their customers make buying decisions. With this understanding, they hope to be better able to design products and set pricing policies.
This article addresses some issues raised in a book Why Smart People Make Big Money Mistakes – And How to Correct Them by Gary Belsky and Thomas Gilovich. Many of the conclusions of these authors may be applicable in managing your business and also in better understanding your financial decision making process.
The two basic principles discussed in this book are:
- Mental accounting – Even though a dollar is a dollar, we often put a higher value on some dollars and thus tend to waste the less valuable dollars.
- Prospect theory – How we frame financial decisions (or label potential outcomes) affects our attitudes toward risk.
Mental accounting
Our views of different types of money are often based on their source, relative size, and expected use. In one MIT experiment, students with credit cards would pay twice as much for basketball tickets than students using cash. Casino winnings are often bet more aggressively than gamblers’ own money. A $150 option on a $30,000 car seems cheaper than a $150 sweater.
From your personal financial perspective, it makes sense to remember that every dollar is really worth the same 100 cents, regardless of whether it is spending an extra $75 for a nicer hotel room or saving 10 cents a gallon on your next gasoline fill-up.
Prospect theory
We tend to put a greater emphasis on losses than gains. It seems the pain of a $1,000 loss is about twice as great as the joy of a $1,000 gain. This can result in different decisions depending on how the decisions are framed. We tend to be more aggressive when facing losses than when facing gains. Investors tend to hold losing positions too long, hoping for a rebound in the stock price, and sell profitable positions too early.
We also tend to keep things the way they are and to like what we have. The resulting resistance to change often results in missed opportunities and the anguish of regret.
Just think of how easy it is to delay taking the steps to having a better-organized financial situation. Reviewing your investment portfolio, setting up an estate planning meeting with your attorney, updating your business plan, or agonizing over the prospect of creating a household budget are all things we know we should do, but find easy to put off.
