The Nobel Prize and Your Bottom Line: Predictable Irrationality

October 15, 2017

 

 While the news has been filled with natural disasters, political disasters, and gun violence, I hope to bring something to the forefront that can be easily overlooked. That is, this year's Nobel Prize winner for economics, Richard Thaler, and why it's such an important message to all of us. The focus of his life's work is behavioral economics. Through his work we realize that personal finance, for the large majority of people, is not a rigid set of optimized strategies, but rather a stream of irrational and mostly emotional choices that lead to sub-optimal results at best. 

 

Let's look at some common examples of predictable irrationality in our finances. See if you can identify with any of these.

 

Example 1: Chris must pay $400 for car repairs. Should he use Cash? Or credit?

 

1. Let's say he has $500 saved in the bank and also access to a credit card. He is more likely to use a credit card and pay it off over time instead of using his reserve money.


2. Now let's say there is no money in the bank at the time he incurred the expense, but he still has access to the credit card. If he was suddenly offered $500 after he incurred the expense, he will likely use the cash to pay, even if he still has access to the same credit card.

 

The only difference is when he got the cash...

 

Example 2: I want to buy a $100 ticket to a concert

 

1. If I lose the $100 that I was planning to spend on the ticket, then I can't go to the concert. 

 

2. However, if my stock portfolio drops by $100 on the same day that I planned to buy the ticket, I still buy a ticket.

 

The same amount of money is at stake, yet depending on seemingly unrelated circumstances, we tend to behave differently.

 

This  parallels directly with what we have said all along, that wealth-building comes from mindfulness and intentionality about your goals and how you modify your behaviors to reach said goals. For a long time, economists studied the subject of economic well-being as a simple function of fluctuating supply Vs. demand, and income Vs. expenses. However, Thaler and other economists in his field observed and documented just how irrational people are.

 

He also noted that we can "nudge" ourselves in the right direction by causing our irrationality to work for us. This can be done by encouraging businesses to automatically enroll employees into retirement plans (that they can opt out of) because people are less likely to do the paperwork required to opt into something.

 

An example you can use personally, is to have a goal to meditate for at least 1 minute each day. 1 minute doesn't sound like a lot, but you are more likely to keep this goal and you will find yourself meditating more than you would if you had set a goal of 30 minutes each day. The same is true for saving. Commit to something, even if it's insanely small. The benefits will make you want to invest more and will lead to good saving habits. And before you know it, you're a savings pro... no matter how irrational your path to get there was.

 

 

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