Standard economic theory assumes we’re rational consumers, making decisions and buying things that maximise our individual self-interest. But another strand of economics, behavioural, looks at what happens in the real world and finds we often make financial choices that don’t make much rational sense.
“For a long time, the consensus of belief among economists and financial experts was that poor decision making is a random and unpredictable departure from rationality,” said Ian McAuley, lecturer in Public Sector Finance at the University of Canberra, and a Centre for Policy Development Fellow. “Systematic observations of behaviour, however, reveal some distinct and consistent patterns in our poor decision-making … behavioural economists refer to these patterns as ‘behavioural biases’.”
So where can we see irrational decision-making and behavioural biases at play, and what can we learn from them?
Real-world examples of irrational behaviour
Advertising The way ads and their wording are framed affects our decisions and perceptions. We’re much more likely to buy a food item advertised as “95% fat free” than one that “contains 5% fat”, even though both products are identical.
Insurance We find it hard to compare risks that have a low probability of occurring. Consumers may give as much attention to an event that only has a one-in-a-million chance as an event with a one-in-a-thousand risk. As a result, we tend to over-insure against certain risks and leave ourselves overexposed in others. Sometimes we’re overly optimistic, thinking an event will never happen to us, while other times we buy unnecessary insurance against risks for which we can easily cover ourselves, or against events which may be dramatic in impact but with very low probability, such as aircraft accidents.
Disclosure Aside from leaving consumers confused, the trend towards greater disclosure of the fees, risks and commissions associated with financial products can increase our trust, even when what’s being disclosed should set off alarm bells. For example, when sales agents disclose their commissions, behavioural economics says consumers make assumptions about the agent’s trustworthiness. Increased disclosure can also deflect consumers’ attention from what is most important. A US study found that disclosure of mortgage brokers’ commissions distracted mortgagees’ attention from the total cost of their loans.
“Confusopoly” Behavioural research shows that having too many options can lead people to make no choice at all. The advent of superannuation choice in 2005 gave investors the choice of hundreds of super funds. But fewer than 10% of those eligible have made an active decision, instead accepting their employer’s default super fund. “Confusopoly” leads us to stick with what we have or make no decision. The results of one experiment found that when presented with a choice of six different jams to taste, 30% of people went on to purchase one of them — but when faced with a choice of 24 jams, only 3% bought one. When faced with too much choice, we’re more likely to walk away and make no decision, or if we have to choose, take either a random pick or the default.
Mortgages and borrowings We tend to think only about immediate outlays and costs, while ignoring or discounting future financial commitments. In addition, we may be overconfident about our ability to make repayments in the future. These biases lead us to over-commit in borrowing. “Teaser” or “honeymoon” interest rates, and “repayment holidays”, exacerbate the problem.
Cashback A cashback voucher is seen as a gift; an offer of “$1000, with $100 cashback” seems more attractive than simply $900. So cashback can influence where we shop, what we buy and how much we pay — a concept well understood by the marketing industry.
How can we make better decisions?
We all make poor financial decisions from time to time. The best we can do is stop and take time to think about the way our choices are framed by salespeople as well as our own perceptions and biases.
“Possibly the most valuable quality we can draw from education, particularly early education, is scepticism, not only of the claims of salespeople, but also of our own impulsiveness,” said McAuley. “Behavioural research shows that when we stop and think, our decision-making generally improves … our errors arise not from ignorance, but rather from haste or more generally from using the wrong decision-making processes.”