Does Studying Behavioral Economics Improve Your Financial Decisions?

I hate behavioral economics. Not because I disagree with its’ theories or findings, but because it consistently reminds me of how stupid I am. I think I choose optimally – nope. I think I weigh all the options equally – nope. I think I am rational – nope. You get the idea, and if you’re familiar with behavioral economics, then perhaps you feel my pain.

I’ve been studying behavioral economics for a few years now. It started back in college with Dan Ariely’s Predictably Irrational, a book that really made me rethink a few things, and progressed with a few academic papers and blog posts. What exactly have I learned? Simple: we think about money relatively, not absolutely.

For example. Let’s say you are buying a stereo for $400 when someone tells you that across town is the same stereo for $300. If you’re like most people, you’ll drive across town and save the 100 bucks. Now, suppose you are buying a car for $30,000 when someone tells you that across town is the same car for $29,900. If you’re like most people, you’ll forgo the $100 discount and buy the car at $30,000. But given that each scenario is financially identical – a trip across town saves $100 – shouldn’t you respond the same? If you were rational, yes. But you aren’t, for some reason you feel that the $100 saved in the car scenario is less that the $100 saved in the stereo scenario.

Here’s one more example. Let’s say you are on your way to the theater with a ticket worth $20 and a $20 bill in your wallet. When you arrive at the theater you find that you’ve lost the ticket. The question is: Do you buy another ticket with your $20 bill? Most say no. Now take the same scenario but instead of having a ticket worth $20 and a $20 bill, you have two $20 bills. You arrive at the theater, but this time you’ve lost a $20 bill. Same question: Do you buy another ticket? Most say yes. Like the previous example, this make no financial sense because twenty dollars is lost in both scenarios. However, for some reason people feel that the lost ticket is worth more than the lost twenty. Point is, when it comes to money, we understand things relatively instead of absolutely.

Back to my hatred.

Here’s the worst part. Even though I’ve spent years reading about behavioral economics and studying scenarios like the ones I just outlined, I’m no better at deciding. So I keep asking myself: Does learning about behavioral economics improve financial decision-making?

Maybe a little bit, but in general, I think absolutely not. I know I should assess dollars absolutely, but I still assess them relatively. Put differently, I would never travel across town to save $100 on a $30,000 car because it just wouldn’t feel right. No matter what I learn, I just can’t seem to shake my irrationalities. There is a great quote, one I have used before, by Nassim Taleb that captures my point of view on evolutionary terms. He explains:

What are our minds made for? It looks as if we have the wrong user’s manual. Our minds do not seem made to think and introspect; if they were, things would be easier for us today, but then we would not be here today and I would not have been here to talk about it – my counterfactual, introspective, and hard-thinking ancestor would have been eaten by a lion while his nonthinking but faster-reacting cousin would have run for cover.

Taleb’s position is that when it comes to deciding rationally, our brains just aren’t up for the task. True, humans have the most sophisticated minds on the plant. But the mental mechanisms that biologically separate us from other species, those cognitive parts which permit us to assess the pros and cons of buying a stereo, new cars, or theater tickets are brand new; and like any first generation technology, they are prone to several systematic errors. As Jonah Lehrer says, “when it comes to the new parts of the brain, evolution just hasn’t had time to work out the kinks.”

This is precisely why I don’t think learning about behavioral economics, or the psychology of decision-making in general, helps me decide. No matter how much I learn, and no matter how educated I am, my brain will make the same mistakes over and over again because it just wasn’t designed with cars, stereos, and movie tickets in mind.

Don’t Blink! What Are Behavioral Studies Really Saying?

Several years ago, Malcolm Gladwell’s book Blink described several interesting accounts of how we make decisions not on reason, but on what is called, ‘rapid cognition.’ For example, Gladwell explained how small adjustments in how a product is presented can greatly change its sales:

“Christian Brothers, wanted to know why, after years of being the dominant brand in [brandy sales], it was losing market share to E&J. Their brandy wasn’t more expensive. It wasn’t harder to find in the store. And they weren’t being out-advertised.  “The problem [was] not the product and it [was] not the branding. It [was] the package.” Christian Brothers looked like a bottle of wine: it had a long, slender spout and a simple off-white label. E&J, by contrast, had a far more ornate bottle: more squat, like a decanter, with smoked glass, foil wrapping around the spout, and a dark, richly textured label. To prove their point, Rhea and his colleagues did [a] test. They served two hundred people Christian Brothers Brandy out of an E&J bottle, and E&J Brandy out of a Christian Brothers bottle. Which brandy won? Christian Brothers, hands-down”

Gladwell’s brandy story is an example of sensation transference, which is a fancy phrase that describes people’s tendency to unconsciously assess a product through emotion or sensation instead of reason. Since Blink was published, behavioral economic studies like these have become more popular with the public and academia. Many of them illustrate how the cognitive mechanisms that constitutes our decisions are out of our consciously control.

One of my favorites is a well known study by Eric Johnson and Daniel Goldstein. In it, they found that the tendency for people to sign up for an organ donation program in several European countries was largely a function of how a question was presented. The countries with nearly a 100% sign up rate used forms that read, “Check the box below if you don’t want to participate in the organ donor program.” The other countries with no more than a 28% sign up rate used forms that read, “Check the box below if you want to participate in the organ donor program.” As the graph illustrates, a simple change in words can have a huge influence.

Then there is the fly in the urinal example, another favorite of mine. At the Schiphol Ariport in Amsterdam authorities etched tiny images of flies in the urinals in attempt to, shall we say, improve aim. It worked, and spillage reduced by 80%.

As I said, behavioral studies like these are becoming commonplace as more and more psychologists publish books. But as cool as behavioral studies like these are, their honeymoon phase is ending. Now, psychologists are trying to figure out what to do with them. So far, there have a been a couple of different routes that they have taken. They are used to…

•  Improve policy and business decisions: Ariely’s The Upside of Irrationality: The Unexpected Benefits of Defying Logic at Work and at Home and Thaler and Sunstein’s Nudge: Improving Decisions About Health, Wealth, and Happiness. 
• Improve well-being: Martin Seligman’s Authentic Happiness and Flourish, and Jonathian Haidt’s The Happiness Hypothesis
• Improve decision-making at the individual level: Carol Tavris and Elliot Aronson’s Mistakes Were Made, Jonah Lehrer’s How We Decide, and Kathryn Schulz Being Wrong.

However, if you read these books closely, you’ll find many overlapping points, like these two:

We travel to France, meet a couple from our hometown, and instantly become touring buddies because compared with all those French people who hate us when we don’t try to speak their language and hate us more when we do, the hometown couples seems exceptionally warm and interesting… But when we have them over for dinner a month after returning home, we are surprised to find that our new friends are rather boring and remote compared with our regular friends.

And…

In Barcelona… I met Jon, an American tourist who, like me, did not speak any Spanish. We felt an immediate camaraderie… Jon and I ended up having a wonderful dinner and a deeply personal discussion… we exchanged e-mail addresses… [and] about six months later, Jon and I met again for lunch in New York. This time, it was hard for me to figure out why i’d felt such a connection with him, and no doubt he felt the same. We had a perfectly amicable and interesting lunch, but it lacked the intensity of our first meeting.

Pretty similar right? The first is from Daniel Gilbert’s Stumbling on Happiness, which discusses “how well the human brain can imagine its own future,” and the second is from Dan Ariely’s Predictably Irrational, which outlines detriments to everyday reasoning. Their similarities aren’t a huge surprise, though. Both books exist in roughly the same area of study – the psychology of decisions-making/behavioral economics. However, they raise an important question: how are we treating behavioral psychology data?

On the one hand, you could say that psychologists – at least those who write popular books – are being a bit trigger happy when it comes to discussing the implications of behavioral studies. It is a fair point, and one that comes up often. On the other hand, you could claim that it is a good thing that these studies are being so widely applied – they are getting the public and academia (especially economists) excited about psychology.

Keeping both points in mind, I encourage psychologists and lay readers to keep their skeptic caps on at all times. In the mean time, psychologists will have to figure what all their data is really saying…