SML Planning Minute
Behavioral Economics, and How it Affects Your Financial Decisions Revisited
Behavioral Economics, and How it Affects Your Financial Decisions Revisited
Episode 306 – Behavioral economics has become a buzzword over the last few years. But understanding its role in making financial decisions can lead to a better outcome.
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Transcript of Podcast Episode 306
Hello, this is Bill Rainaldi with another edition of Security Mutual’s “SML Planning Minute.” In today’s episode, we take a look back at one of our favorite previous episodes. What is “behavioral economics,” and can it help you figure out how to make financial decisions?
Behavioral economics became a buzzword in 2017 when Richard Thaler, a professor at the University of Chicago, won the Nobel Prize for Economics. The concept is a simple one: investing is not a purely mathematical decision. Psychology plays a role in the economic decision-making processes of individuals and institutions. If you understand the psychology, you’ve got a head start when it comes to financial decisions.
Behavioral economics tries to explain why, when it comes to financial matters, an individual might make irrational decisions, and why their behavior doesn’t always follow the predictions of economic models. Decisions such as what kind of car to buy, how much to save for retirement, or whether to eat that last piece of chocolate cake are all influenced by behavioral economics. Behavioral economics seeks to explain why an individual selects one option over another. People sometimes make decisions that are not actually in their own self-interest, simply because people can be emotional and easily distracted.
There are some basic applications of behavioral economics that you can see in your everyday life. Here are a few of them.
Availability Bias
Availability bias states that our decision-making process is most strongly influenced by events closest and most available to us. You are more likely to buy a snow blower after a major storm than you are in the middle of summer.
How does this apply to investing? One of the effects of availability bias is what’s known as “FOMO,” or fear of missing out. A stock may seem overpriced to you, but the price keeps going up. If you pass on this stock at $500 per share, you might worry that next year it could be $1,000.
Anchoring
Anchoring is something that can lead to bad results when you’re investing. Let’s say you find a stock that had been selling for $100 a share, but after a few months, the price has fallen to $80. You may be hesitant to sell that stock at $80, $90, or $95 simply because you bought it at $100. This has nothing to do with what the company is actually worth.
Be aware that corporate America understands this, and they are using this type of behavioral economics to market their products. Technology companies use anchoring all the time. You often see this when the latest smartphone is introduced. Let’s say the new phone initially cost $800, but it’s now selling for $500. By introducing the phone at a higher price and then reducing it, consumers will tend to believe they’re getting a good deal, even if the plan all along was to sell the phone at $500.
Confirmation Bias
Confirmation bias occurs when we pay more attention to the things that support our pre-existing ideas. We tend to rationalize our opinions, and pay less attention to things that contradict those opinions. Almost everyone does it, and it can be dangerous when we’re investing. If you like a particular company’s product, you might ignore any red flags or risks the company is facing.
The Gambler’s Fallacy
What if you were betting on a coin flip, and “heads” came up five times in a row? According to the gambler’s fallacy, your next bet would be tails, simply because you recognize how unlikely it is to get “heads” six times in a row. But the truth is that the odds are always 50-50. The previous five flips have no bearing on the sixth.
The same phenomenon occurs when we invest. People tend to commit to the gambler’s fallacy when they see a stock that has gone up or down for several days or weeks in a row. This can lead to an unfortunate situation where you buy low and sell lower.
Herd Behavior
Herd Behavior is something you see in many places. When people line up at a food truck for some tacos, others tend to go along and line up with them. The rationale is that since the line is long, the food must be good. Herd behavior happens in investing as well. When everyone buys a stock, there is a subtle belief that it can’t go wrong since everyone is buying. Herd behavior can be the cause of exuberance, overvaluations and price bubbles.
Present Bias and Auto Enrollment
Present bias provides a good explanation for why people tend to be bad at saving. In a trade-off situation, it is simply the tendency to settle for a smaller present reward than to wait for a larger future reward.
In recent years, understanding present bias has led to at least one concrete change in the way people save money. It is the more popular use of “auto-enrollment” in company pension plans.
The introduction of auto enrollment was a result of the work done by behavioral scientists, including Richard Thaler. And that research showed that you were less likely to do something, such as save money using a 401(k), if you had to take action in order to participate.
Studies by Allianz Global Investors, among others, have shown that saving increases when an employer moves from an “opt-in” retirement plan—where the employee has to affirmatively choose to participate—to automatic enrollment. Thus, the concept of auto enrollment emerged and became part of the Pension Protection Act in 2006.
Under the Pension Protection Act, automatic enrollment allows an employer to enroll its employees and make salary reductions without having to actually complete the enrollment process. It’s simply easier to participate now, and more people are saving money as a result.
Conclusion
Behavioral economics shows how people too often make poor decisions based on biases of which they may not even be aware. Biases affect our decision-making, including financial decisions, when we least expect it. They can undermine our rational thought process and lead to poor conclusions. I hope today’s podcast helped to raise your awareness of those biases, so you can keep them in mind when making important financial decisions and formulating protection strategies.
Contact your local Security Mutual Insurance Advisor today to coordinate your financial plans and help you achieve your goals and objectives.
Sources
Benz, Christine. “Behavioral Finance Research in Action.” morningstar.com, Nov 17, 2010. Accessed April 7, 2021. https://www.morningstar.com/articles/360350/behavioral-finance-research-in-action
ChangYueSin. “The 8 Key Concepts of Behavioural Finance.” TheAncientBabylonians.com, July 14, 2019. Accessed April 7, 2021. https://www.theancientbabylonians.com/the-8-key-concepts-of-behavioural-finance/
Kenton, Will. “Behavioral Economics.” Investopedia.com, updated September 28, 2020. Accessed April 7, 2021. https://www.investopedia.com/terms/b/behavioraleconomics.asp
Miller, Terin. “Behavioral Finance: Concepts, Examples and Why It’s Important.” TheStreet.com, March 28, 2019. Accessed April 7, 2021. https://www.thestreet.com/personal-finance/education/behavioral-finance-14909070
Samson, Alain. “An Introduction to Behavioral Economics.” behavioraleconomics.com. Accessed April 7, 2021. https://www.behavioraleconomics.com/resources/introduction-behavioral-economics/
The University of Chicago Booth School of Business. Richard H. Thaler Biography. ChicagoBooth.edu. Accessed April 7, 2021. https://www.chicagobooth.edu/faculty/directory/t/richard-h-thaler
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