Unlike what classic economic models predict, people rarely make logical decisions that will help them to achieve a better economic outcome. Instead, people mostly make bad decisions when spending or investing their money. Moreover, any actions or thought that makes a consumer happy leads them to making bad moves with regard on how they spend their every cent.
It’s important to know which decisions are irrational to be able to influence economical decisions. Riachrd Thaler, who won the 2017 Economics Nobel Prize, has covered that subject in his studies extensively. Using Thaler’s understanding of our thought processes, which leads to bad economic decisions can help us to make sound financial decisions. The following are some of his findings that explain what drives people into making decisions that defy logic when it comes to spending money.
When the value of something goes up, it’s logical to increase it price as well, which is what classical economics dictates. However, consumers see increases in prices as unjustifiable and they may choose not to buy. A phenomenon that is known as the “endowment effect,” was explored extensively in a 1991 research paper Thaler coauthored with D. Kahneman, and J. Knetsch.
In one research, it was proven that people saw it unfair when the dealership raised their car retail price by $250. However, when the dealership removed a $250 discount it had always offered on that same car, the people felt that it was a fair move. Either way, the dealer increased the price of that car increased by $200 in both cases. However, raising the price made created the impression of taking more money, while taking the discount away felt of less a barrier because they believed it wasn’t something they actually had.
Thaler was able to demonstrate phenomena of valuing more something you already own using mugs. They randomly picked students in a group, and gave them free mugs. The students who got free mugs valued them much more compared to those who didn’t get one. The urge to pay more to keep ownership of something is among the things that drive us to make illogical decisions regarding money.
To take advantage of the endowment factor in running a business is coinciding increase of salaries with increase of retirement contributions. The workers will not feel they have lost something they already had when parting with an increased retirement fund contribution.
While funds are fungible, in that one dollar has the same value as other dollars, and is therefore interchangeable. However, people don’t view money that way in their mental accounting system. That leads them to make illogical financial decisions that disregard simple math.
Consumers have a tendency to categorize resources and utilize them only for the initial intended purposes, even when it’s uneconomical. In their paper, which Thaler published in 1985, he gave one such example. A couple took $15,000 they had saved for a retirement home they wanted to purchase in the next few years. They put it in a bank account where it earned them 10% interest. During the same period, they got a $11,000 loan from their bank, at a 15% interest to buy a new car.
A simple look at their decision tells us that they could have made a smarter financial decision to loan themselves the retirement home money. They could have ended up paying 5% less interest, but they couldn’t do that because in their mind, that money was meant for their retirement home and not the car.
Furthermore, even where money comes from leads people to categorizing funds into different categories. Most people for example would not spend their lottery winnings the same manner they would spend their salary. A person would spend $550 they won in a lottery to buy a fun gift, but they wouldn’t do the same thing with their $550 worth of wages. They would instead use the wages to pay a debt or buy groceries. While it’s the same $550, their mental bookkeeping system sees it differently.
In another study that Thales and Cade Massey did in 2005, they found that a team was willing to pay more for first round drafts, who were based on the team-scout’s supposed ability to pick a superstar. In contrast, they paid less for second round drafts, even though the second round drafts offered better value on average. Why do teams carry on doing that?
The explanation given by researchers is that the team spends lots of time and funds studying the players. They feel overconfident that based on their studies and findings, they know what they are doing and are indeed picking a champion. Overconfidence also leads customers to buy overpriced new tech-gadgets, and stock traders to buy stocks whose earnings and assets don’t match their prices.
Momentum is another factor that leads to people making the wrong decision. Most people would rather retain what they own, than risk dealing with changes.
A good example of how businesses use a status quo to sell their services is an opt-out magazine subscription, web hosting, or gym membership. First, you are given a teaser low priced membership. Once you subscribe, they charge you full price when it’s time to renew your membership. Since you are already enjoying the benefits, it’s unlikely for you to act to interrupt your membership by opting out immediately.
You may also use Status Quo to save money as well. If a new employee is automatically enrolled in a savings plan, the membership is actually double that of a savings plan where membership requires an initial action from the employee.
We hope that you have found this article to be informative, and it has helped you understand why people make poor financial decisions most of the time.