The human factors behind financial decisions

This year’s winner of the Nobel Prize in economics exposed and explored irrationality’s role

The human factors behind financial decisions
This year’s winner of the Nobel Prize in economics was awarded for his work to support a simple, universal truth: people are human. Put another way, they don’t make rational decisions — and that has wide-ranging implications for finance.

Before Richard Thaler’s ideas gained ground, models in financial literature assumed that people act perfectly rationally to get the most expected profit. But he pointed out that this isn’t reflected in reality, as Sergey Popov of Cardiff University wrote recently.

“For instance, people tend to be loss-averse,” Popov said in an article on The Conversation. He went on to explain how financial products like binary options appeal to this tendency by advertising that potential losses are limited.

Another concept Thaler championed is mental accounting, which deals with how people separate money based on its intended purpose and source, even if it’s not logical to do so. That leads them to make inconsistent financial decisions.

For example, people may want to compare different restaurants to save a dollar on a hamburger. But if they’re planning a holiday and could save the same amount by comparing different currency exchanges, they’re less willing to do it — even if comparing restaurants and shopping currency exchanges take the same amount of effort.

Thaler also did a lot of research exploring people’s failings at long-term financial planning. He proposed that each individual has two sides: one side is responsible for planning, and the other is responsible for action. Even if the “planning” side has done its job, the “doing” side might not follow through.

Understanding how people make decisions has also made governments more mindful of the way they formulate public policy — particularly by reducing the amount of effort people have to exert in making good decisions.

“For example, automatically enrolling people into pension schemes, making them opt-out instead of opt-in, has massively increased the number of people with plans, compared to if they had to actively elect into one,” Popov said.

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