Behavioural Economics

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Behavioural Economics

Money is like a sixth sense without which you cannot make a complete use of the other five. (W. Somerset Maugham)

Emotions have powerful effects on decisions. Moreover, the outcomes of decisions have powerful effects on emotions. (B. Mellers, A. Schwartz & A. Cooke, Annual Review of Psychology, 1998)

For though with judgement we on things reflect, Our will determines, not our intellect. (E. Waller, Divine Love, 1650)

Behavioural economics has its intellectual foundations in both psychology and economics. It seeks to understand how people select, process and decide upon financial (and other) information. It offers profound and parsimonious information as to why so many seemingly educated and informed people make strangely illogical or irrational decisions with respect to all aspects of their money: borrowing, investing, saving and spending. Three psychologists (Simon, Kahneman and Thayler) have won the Nobel Prize for economics that all stress the above.

Economists have been challenged by certain economic behaviours which they have not found easy to explain: why do people tip?, why do they spend differently with cash than with a credit card?, why do people have savings accounts which don’t offer interest that even keeps pace with inflation?, why do we happily and enthusiastically spend more for a product when using a credit card as opposed to cash?

In a popular book entitled Why Smart People Make Big Money Mistakes, Belsky & Gilovich (1999) discuss seven typical issues:

1 Not all money is seen equally. This is also known as mental accounting or fungibility. It means people define and therefore use money differently. People spend £100 obtained from a roulette win, a salary, or a tax refund differently, even though that money is all the same. Mental accounting can make people at the same time both spenders and savers: reckless with certain ’types of money’, conservative investors with others.

2 We treat losses and gains quite differently. People’s decisions are powerfully influenced by how they frame and describe situations. The results are very clear: people are much more willing to take risks to avoid losses and much more conservative when it comes to opportunities for gain.

The same amount of pain and the same amount of pleasure have very different impacts. This is the psychology of loss aversion. Oversensitivity to loss means that people may respond quickly — even too quickly — to drops in the market. On the other hand the selling of a stock or bond (the pain of making a loss fund) makes some people more willing to take the risk of keeping the investment despite its continual decline.

Behavioural economists have shown how loss aversion and our inability to ignore sunk costs mean people often act unwisely. But they have also explained why people don’t act when they should. We sometimes get overwhelmed by choice; paralysed by having to make a decision, so we defer the actual decision. Decision paralysis happens particularly when we have too much choice. The more time we have to do a task, the more we procrastinate.

3 We are prone to inaction. We also opt for the status quo — doing nothing: a resistance to change, or an unwillingness to rock the boat. The endowment effect is particularly interesting. It means people over-value what they value. That is why organizations allow for trial periods and money-back guarantees. There are various tell-tale signs of this problem: having a hard time choosing between investment options, not having a pension, delaying financial decisions all the time.

4 The money illusion and the bigness bias. This problem classically arises when we confuse nominal changes in money (it goes up or down) as opposed to real changes, for instance as a function of inflation or deflation. The question is the current buying power of money as opposed to its actual amount. Related to this is the idea of base rate: the fact that people buy lottery tickets which, because of the real odds of winning, have been described as ’a tax on the stupid’.

5 Anchoring and confirmation bias. This is the common and strong tendency to latch onto some idea/fact or number and use it, whether relevant or not, as a reference point for future decisions. We are, of course, particularly susceptible to anchoring when we do not have much information about something (the cost of hotels in foreign countries, typical discounts etc.)

6 Overconfidence is a common ’ego trap’ that people fall into. Too many people don’t know how little they really know about financial issues. They feel that they can do things like sell their own house and pick great investments without specialist advice. Some people persist in the belief that they are beating the market, but don’t really know or understand their actual return on investments.

7 Getting information through the grapevine and relying too much on the financial moves of others is the final ’big money mistake’ documented. This is all about investing with the herd and (mindlessly) conforming to the behaviour of others. This is seen when people invest in ’hot stocks and shares’; you buy when stocks are rising and sell when shares are falling. This is about being too reliant on the ideas of colleagues, friends, journalists and financial advisers. The advice is ’hurry up and wait’; avoid fashions, ’tune out the noise’ and actually seek out opportunities to be contrarian.

Belsky & Gilovich helpfully end the book with ’principles to ponder’. Some are:

A. Every dollar/pound/Euro spends the same: it does not matter where money comes from, how it is kept or spent (salary, gifts, wins) — it is all the same.

B. Losses hurt you more than gains please you: we are all loss and risk averse.

C. Money that is spent is money that does not matter: mistakes from the past should not haunt the present.

D. It is all about the way you frame/see/look at things: the way we code potential losses and gains profoundly influences all the choices we make.

E. All numbers (amounts) of money matter even if you don’t count them: in the old jargon, look after the pennies and the pounds will look after themselves. Don’t underestimate small amounts of money.

F. We pay too much attention to money matters that matter too little: we tend to weigh some facts and figures too heavily.

G. Your money-related confidence is often misplaced: it is so easy and common to over-estimate our money skills and knowledge.

H. It is very hard to admit one’s money mistakes: this is about pride and hubris but also being very uncomfortable about self-criticism.

I. The trend may not be your friend: trust your instincts before you follow the herd when thinking about investing.

J. You can know too much: you can get overwhelmed by financial information, much of which is irrelevant.


Belsky, G., & Gilovich, T. (1999). Why Smart People Make Big Money Mistakes — and how to correct them. New York: Simon and Schuster.

Kahneman, D. (2014). Thinking, Fast and Slow. London: Penguin.