How do humans approach complex, sometimes stressful and emotional financial decisions?
Traditional financial theories are well constructed to make many calculated financial decisions. However, they have been unable to explain the seemingly irrational human disruptions in stock markets, stock market bubbles, market overreactions or under reactions and momentum and reversals against what would be considered objective evidence.
Behavioural Economics – A New Financial Frontier?
That’s exactly what behavioural economics – the study of psychology as it relates to the economic decision-making of individuals and institutions – seeks to answer.
We know that humans are emotional beings. These emotions are capable of influencing the decisions we make in our financial lives – often in unexpected ways.
Behavioural economics draws on insights from the fields of psychology and economics to explore why people make irrational decisions, and why behaviour does not follow predictions of ‘rational’ economic models. As humans are emotional and easily distracted beings, they make decisions that are not necessarily in their self-interest… which also shows a lack of self-control.
Professor Richard Thaler, the Nobel Memorial prize winner in Economic Sciences from the University of Chicago, inspired the creation of the term called ‘nudge units.’ This is the notion that there are many opportunities to ‘nudge’ people’s behaviour by making subtle changes to the context in which they make decisions.
Where Have We Seen ‘Nudging’ In Action?
An example of behavioural economics is an old policy McDonald’s runs, where customers are asked if they would like to super-size their order. As it turns out, they do, more often than not.
The Australia Institute – a public policy think tank – has examined how Australians approach financial decisions. Their research found that one of the major causes of financial stress was overconfidence. The study shows again and again that when asked to rate their relative ability in relation to financial decision-making, far more people believe they are above average, both in knowledge and behaviour.
However, the study also shows that only 6% of people with mortgages entirely stick to a budget.