|Why We Predictably Make Irrational Economic and Investment Decisions…|
|While the most influential document of 1776 for Americans is certainly the Declaration of Independence, for the rest of the world it may very well be Adam Smith’s book The Wealth of Nations.
In it Smith laid down the major principles that today are responsible for the free flow of capital in our vibrant global economy. One of those is that, in general, people will naturally act with “enlightened self interest” when making economic decisions.
This seems self-evident. Everybody wants to get the best deal. And for many decades this assumption was built into classical economic models.
But the more economists studied how people actually behave with their money the more they saw that, given the right circumstances, people often act against their own self-interest. In the 1960s this lead to an entirely new field of study called behavioral economics.
It’s not that people are likely to abandon their self-interest out of altruism, but they tend to let their emotions outweigh logic and fool themselves into thinking they’re getting a better deal than they actually are. Author Michael Lewis points out that used car salesmen knew about this long before the behavioral economists.
Showing How We’re Predictably Irrational
Last year Chicago University professor Richard Thaler won the Nobel Prize in Economics for his work showing that not only do people regularly make irrational decisions about money, but they do it for predictable reasons.
Three of the factors he found that tend to skew our decision-making are ownership, confidence, and a sense of fairness.
Ownership: We assign a higher value to something if we happen to own it. Therefore, being told that something we own (i.e., an investment) has lost value is emotionally painful.
Confidence: The more information we have about a decision, the more overconfident we become. Given enough data, we persuade ourselves believe we can accurate predict essentially unpredictable events like future market movements or the trend of a particular investment.
Fairness: We often set the value of things based on a strong sense of fairness, even though we don’t have a specific definition of what is fair. So, for example, if the price for something goes up because demand has gone up, we think, “That’s not fair. That’s gouging.” But it’s really just the market at work.
Prudence and Discipline vs. Irrationality
The fact that we’re quite capable of convincing ourselves to behave against our own economic interest doesn’t mean that we should stop investing altogether. It just means that we should be keenly aware of those potential urges in advance into and plan ahead to counteract them with prudence and discipline.
So when there’s market volatility and we feel the need to “do something,” even though that may lead to long-term losses, we should have already decided what we’re going to do (or NOT do). This helps prevent us from acting purely on emotion.
One of the most important roles your trusted advisor can play is that of an experienced, dispassionate counselor–somebody who can help you see what’s in your best interest when you can’t. After helping you determine the long-term plan that will give you the best chance of retirement success, they can hold you accountable to stick with it for the long haul when your gut is trying to tell you otherwise in the short run.