Why people make irrational financial decisions

Money is personal. How much we earn, what we have, and how we spend is often and easily tied into reflections of ourselves and, often in our culture, our identities. When it comes to something so intimate, we may know what decision logically would make the most sense, what action in concept we should be taking, the advice we would give our friend in a given situation; however, things can blur when they are that close and so entwined with so many facets of our lives, our safety, and our prosperity.  The big picture can be hard to see when the details carry deep significance to us and we can’t see the forest for the trees. It’s not a fault; it’s human nature—we are all affected by one form of bias or another. The path to overcome is to be able to recognize these patterns and pitfalls, to give them names, and to approach decisions critically and with awareness of our influences, knowing that what we know is often not what we do.

Our brains are amazingly complex, capable of processing vast amounts of information, about 11 million bits of information a second—with only about 40-120 of those being in the conscious mind. To handle this workload, we’ve evolved processes of subconscious thought patterns and background programs to alleviate the amount of information we must focus on. Behavioral economists have been studying human decision making to better understand the mental shortcuts—or heuristics—we use, as well as ways our emotions can warp our thinking, so they can anticipate where people often fall short of rational judgment.

Many of the greatest financial and investment mistakes occur due to investors acting from emotions or irrational thinking or by just ‘trusting your gut’ on something, by not looking at the situation with fresh critical eyes but relying on our imperfect and not always rational established shortcuts our brains have built. Those investors who understand behavioral economics and how to counter our human tendency toward illogic are better equipped to avoid those mistakes. The issue of irrational decision-making in behavioral economics arises when we are faced with complex decisions that are also mathematical and rational. Behavioral scientists have focused attention on “heuristics,” or cognitive shortcuts, that shape the unconscious processes behind our decisions. Understanding some of the most common heuristics can move us toward balancing those tendencies with our conscious processes when making investment decisions. Knowing the bounds of our rationality can help us overcome them.

Read or download Behavioral Economics – Why people make irrational financial decisions below to learn more about the behavioral biases that may be influencing your financial decision-making:

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