How to avoid the financial pitfalls of miswanting

Test-driving their preferences could help people avoid spending on things they don’t actually want

How to avoid the financial pitfalls of miswanting

As students of psychology and behavioural finance know, people are irrational decision-makers; they often end up making unwise long-term choices to satisfy short-term desires. And as it turns out, they may not even know what they really want to begin with.

According to Dr. Shlomo Benartzi, professor and co-head of the behavioral decision-making group at the UCLA Anderson School of Management, people’s tendency to not know what they really want can have huge implications for their financial lives. They might assume they want an expensive condo or build an aggressive investment portfolio, only to realize later on that they were wrong.

“I propose that we borrow an essential tool used by the most successful technology companies, such as Amazon, Google and Expedia: the A/B test,” Benartzi wrote in a recent piece for the Wall Street Journal.

An A/B test for financial decisions, he explained, would involve trying out one of two simple alternatives in a financial choice. The test should be done as many times as possible; in each repetition, the option to be tried should be randomly selected. Finally, the results of the test should be tracked over time.

Applying the concept to investments, he suggested that people compare their emotional and physical reactions upon checking their portfolio multiple times a day through an app, versus when they just check on their quarterly paper reports. “While some people can benefit from continuous digital feedback … others find it too stressful,” ge saud, “This means that we need to fine-tune the amount of information and updates we get.”

In the case of retirement, Benartzi noted that people would often assume the amount of money they’ll need based on their current standard of living, while financial advisors typically recommend that they replace only 70% of their income in retirement. People who follow the wrong assumption could end up setting aside money they could be spending more productively today; alternatively, they could enter their retirement years with not enough money to sustain their desired lifestyle.

“To figure out which projection is correct, people should experiment with higher and lower amounts of spending during their working years,” he suggested. “In this experiment, the A condition would involve cutting 40% of your discretionary spending for a month or two, while the B condition would involve cutting just 10%.”

He also observed that many people are so tempted by the prospect of enjoying their retirement that they retire too soon; shortly after that decision, they find themselves bored and opt to re-enter the workforce. Benartzi suggested that those contemplating an early retirement test-drive their preferences by planning an extended vacation beforehand.

“[R]esearch shows that many of us don’t actually know what makes us happy, so we end up pursuing the wrong things,” he said. “The good news is that self-experimentation can help us figure it out, allowing us to pursue the right things before it’s too late.”


Related stories:
What does wealth mean to the ultra-rich?
How stress management can change your relationship with work