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Understanding Why We Make the Financial Decisions We Do

12May 2010

There is a relatively new field of social science (i.e. the study of social behavior) called behavioral economics. It has been around for about 10 years formally. And two of the leaders in the field (Daniel Kahneman and Amos Tversky) received a Nobel prize a few years back. As a psychologist, initially I had a bit of a cynical view of the field — largely because the idea of economists telling us about behavior patterns struck me as rather ludicrous (economists aren’t known for being very accurate predictors of anything.) But, ta-da!!, it turns out that most of the leaders in the behavioral economics field are actually trained as psychologists (Kahneman, Tversky, and Ariely).

In the past, I have written on the psychology of investing and also the kinds of errors investors make (for example, pulling out your money after the stock market has dropped, and putting it back in after the stock market has already rebounded significantly — sounds like the fall of 2008 and spring of 2010).

Recently, Dan Ariely, a psychologist and behavioral economist at Duke University has been in the news. He has written a new book, The Upside of Irrationality and it was recently previewed in Forbes.

I have his previous book, Predictably Irrational, and thought I’d share a few of his observations and conclusions which I think are quite applicable in our daily lives.

Just to whet your appetite, here are some of the chapter titles:

The Fallacy of Supply and Demand
The Power of a Free Cookie
The Power of Price
The Cost of Social Norms.

The premise of the book is that people do not make rational decisions — especially with regards to money (spending, buying, saving, investing). And further, that we are predictably irrational — there are patterns that we follow.

Let me share from the section entitled, The Truth about Relativity. The main point is that “humans rarely choose things in absolute terms. . . Rather, we focus on the relative advantage of one thing over another. . . We are always looking at the things around us in relation to others. We can’t help it. . . (w)e not only tend to compare things with one another but also tend to focus on comparing things that are easily comparable — and avoid comparing things that cannot be compared easily. . . We like to make decisions based on comparisons.”

Ariel then cites a series of experiments that show a number of principles:

1. People like to make decisions by means of comparing choices (what clothes washing machine to buy, what job offer to take, who to date).

2. If a person does not have an alternative to compare to, they very likely will “pass” and decide “no”.

3. When there are multiple alternatives, people usually (not always, there are some other factors that can intervene) choose the “middle” option. They don’t want the most expensive and they don’t want the cheapest (items on a restaurant menu, clothing, professional services).

4. The downside to comparing, is that we often feel unsatisfied with what we have when comparing to those around us (feeling others have a better job than we do, a better car, took a better vacation, etc.) So comparing usually leads to dissatisfaction.

So here are some of my observations and applications.

a) Although it is good to differentiate yourself in the marketplace from your competitors, if you are too different, potential customers can’t compare you to the competition and they will not choose to use you.

b) When marketing goods or services, know who your competition is and what their price points are. Try to fall in the middle price range (but offer more value).

c) If you are offering a new or unique product or service, provide at least two options (a more expensive one and the one you really want to sell) so customers have a “choice”. [Ariely actually cited a study that demonstrated this application.]

d) If you want to limit your spending, surround yourself with individuals whose lifestyle is lower than yours — not higher. When you compare yourself to what car they drive, where they buy their clothes, and where they go on vacation, you will feel less pull to “trade up” and spend more.

e) When you are shopping, be aware that marketing departments of stores know about the tendency of people to choose the middle price option — often the lower price is actually a better deal.

Have a great week — and watch that irrational behavior!

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