In the last few years, watching the economy whip through its roller-coaster-like up and downs taught us that people don’t always make the most rational decisions about their money.
We know that people can be irrational, but it’s harder to accept that this effects important decisions about money and investing. In fact, behavioural economist Dan Ariely says that the recession in 2008 was caused by a build-up of all our small irrational thoughts.
Money is a motivator but it’s also a stressor, and for tough decisions people have little mental shortcuts we use to make our lives a little easier.
Everyone, including economists, suffers from the same biases, but by being aware of these human tendencies you can allow better control of them.
For example, the bandwagon effect often causes us to believe or do things because others believe or do them. Like when a lot of people invest in a particular stock because it seems everyone else has decided it’s a good idea. In this case it depends on how early on you jump the wagon whether it is a good idea or not.
We also determine what’s a good purchase or investment based our initial impressions. Often times what we want is determined by accident or habit because we value coherency of personality and decisions, frequently without taking in the nuance of how a current situation is different from the past. These first impressions or “anchors” serve as a reference point for all future evaluations.
Similarly when we’re making the decision to invest we may fall victim to the confirmation bias. This bias causes us to seek out and remember more associated facts that support our decision, than ones that don’t.
Similarly our belief regarding the value of the money we hold can be skewed. This is because it can be more damaging for us to lose what we have than not to gain assets – the thought of losing your money is a huge stress.
While rationally, a hundred dollar bill is worth exactly $100 whether it’s in your pocket or on the gambling table, people have the tendency to put twice as much psychological value on keeping their money than gaining more. This is called loss aversion.
In an experiment by Ariely people who were given a sum of money up front and could lose it through poor task-performance did progressively worse with the more money they could potentially lose.
In mental tasks, individuals who stood to lose up to five months pay (the condition where they stood to lose the most), couldn’t perform the task at all because they were shaking and couldn’t focus.
They were so wrapped up in the amount of money at risk, they couldn’t rationally work through the task at hand.
Taking a step back from important money decisions can help you consider the reason you want to make the investment and whether your personal life and account book can handle the potential consequences.
Jim Taylor “Economics: Economists are Irrational!” Blog: The Power of Prime. Psychology Today.
Lea Winerman. “A market for market psychology” http://www.apa.org/monitor/2011/09/market-psychology.aspx.
Peter Banerjee. “A scary picture that’s worth 1,000 words about saving” The Globe and Mail. Mon. Dec. 5, 2011.
Dan Ariely: Irrational Economics Video. http://danariely.com/
Patients in this story are a fictional composite of people who have sought help for this issue. Any resemblance to real persons, living or dead, is purely coincidental.
Dr. Eva Fisher is an Ottawa psychologist who has been providing psychotherapy for a variety of issues for over 20 years. Follow her on Twitter @drevafisher. Blog writing assisted by freelance journalist Sara Frizzell.
Copyright © Dr. Eva Fisher