How behavioural economics shape the financial decisions we make.
Dan Ariely says it best:”In 2008, a massive earthquake reduced the financial world to rubble”. This quote accurately describes the year of the global financial crisis.
If you have seen the movie ‘The Big Short’ it offers a glimpse into the sequence of events that reduced the financial world to rubble.
The sub-prime housing bubble caused world wide mayhem with stock markets crashing, banks in a liquidity crisis, long standing reputed companies collapsing, governments in overdrive, as people lost homes, job and their families, with some people taking their own lives unable to cope with the severe destruction.
What is Behavioral Economics?
Behavioral economics is the study of human behavior into how we make choices. Studies are conducted on humans within a controlled environment. It assumes that we act predictably, irrationally with a tendency to self-sabotage. The study of behavioral economics enables us to understand and influence human behavior.
Our financial decisions are largely determined by the way our choices are framed by either a sales person or ourselves when we envisage the outcome. He states: ‘We have two modes of decision-making; intuition and reasoning…our decision-making mistakes often result from use of the wrong mode’.
I would absolutely love to delve into the plethora of information I researched on behavioral economics, however, I would need to write a book rather than an article that takes between three to five minutes to read. Instead, let’s take a look at one aspect of behavioral economics to pique your interest in this subject matter.
At the center of behavioral economics is the ‘Prospect Theory’, which is a behavioral model that demonstrates how people make decisions between alternatives involving risk and uncertainty. When people make decisions regarding wealth, they focus on expected utility as opposed to absolute outcomes.
In general, people dislike losses therefore we go to extreme lengths to avoid a loss by taking risks. From a psychological perspective, studies have proven that losses are twice as powerful as the gain of any pleasure.
Fourfold Pattern Of Risk Attitudes
The fourfold pattern of risk attitudes was developed by Tversky and Kahneman (1992). The risk attitudes predicts the four patterns people follow when faced with a decision that involves risk and uncertainty:
1. Low probability gains – people are risk-seeking
2. High probability gains – people are risk-averse
3. Low probability of loss – people are risk-averse
4. High probability of loss – people are risk-seeking
Let’s look at an example. When teaching savvy entrepreneurs at The Entourage in Sydney, we play a game of quoits to ascertain their psychology around money. Each person is given two opportunities to get the rings over the pole at the end of the room.
They can choose to stand at the $1 mark, $10 mark or $100 mark to get the rings over the pole. The $100 opportunity is the most challenging position whilst the other two positions are closer to the ring.
Irrespective of the group size, one by one they persistently choose the same position being the $100 mark. Very few people have chosen to throw the ring from the $10 or $1 mark.
Although there is no monies exchanged, this demonstrates the fact that these entrepreneurs believe there is a low probability of achieving gains therefore they decide to seek risk as the fourfold pattern of risk attitudes suggests.
Valuable Financial Lessons
Life events such as the global financial crisis can be likened to the events that occur when driving a car; full of twists and turns, traffic lights, road rage, accidents, dead ends and no through roads.
We could view the lead of up to the global financial crisis as driving your black Maserati Ghibli on the freeway.
In January 2007, your cruising and on an emotional high, driving at a speed of one hundred and twenty kilometers.
In February 2008, traffic impacts your trip, you start to notice signs of a troubled economy as you reduce your speed to seventy kilometers.
Then in September 2008, you crash your car into a pole.
This was when the global financial crisis came into play. Felt by everyone around the globe, irrespective of whether you benefited, survived or lost the life you once knew.
The money game of quoits along with the movie ‘The Big Short’ offers us valuable life lessons.
1. Look Under The Bonnet
Before signing any financial agreement ensure you understand exactly what you are agreeing to unlike those consumers in the movie who signed up for mortgages they could not afford.
If you do not understand a document do not sign it, seek further assistance and advice from someone who has expertise in that area.
2. Be Careful Where You Service Your Car
Often, we have a tendency to place a high level of trust in people with certain occupations, trusted authorities or agencies such as the employee from the credit agency ratings or the mortgage brokers who were openly bragging about signing up people for mortgages they could not afford.
Be careful whom you listen to. Know who you are dealing with, do your research, and ask for referrals.
3. Drive The Extra Mile
Question everything! Ask as many questions as possible and do your own research before making a financial decision. Gather information from institutions, the internet, take a course, or speak to professionals.
Above all, trust your intuition as Michael Burry the stock market investor did and take the time to dig a little deeper and understand the real cost of your financial decisions.
This article originally appeared in Inc.com.