Our choices are guided by instinct and knowledge
When choosing a TV series to watch or a sport to play, when shopping, as well as when investing or saving, our decisions are not guided only by rationality. Emotions and instinct also play a fundamental role in the choices we make every day. Feelings such as fear, greed, pride, have a concrete impact even on those decisions that should have a rational basis such as for example investments.
Everyone, even those who have good financial knowledge, can make mistakes because they are driven by the emotions of the moment and influenced by past experiences, the context and their beliefs. In fact, it is not easy to identify and counteract the preconceptions that lead to making sub-optimal choices.
Behavioral economics is based precisely on these principles. It analyzes how decisions are made and how everyone’s choices affect the performance of financial markets.
This branch of economic studies began to attract attention around the 1970s thanks to the studies of Nobel Prize winner Daniel Kahneman and Amos Tversky, two psychologists who examined the decision-making process in relation to money and financial markets. Their research has shown that the irrational factor has its weight in economic choices, contrasting traditional economic theories which instead envisage the use of rationality in decisions and financial management.
As Luciano Canova, economist, popularizer and teacher, also explains in the seventh episode of the podcast Mica solo parole, behavioral economics recognizes that people can be guided by emotions, prejudices, habits and other factors that influence decisions, making every choice guided by both rationality and irrationality.
A very famous economist, Robert Shiller, – who gave a beautiful exclusive interview visible in the Virtual Tour of the Museum of Saving, inside the “Learn” room – won the Nobel Prize for Economics precisely with the theory (resumed by the economist John Maynard Keynes) of “animal spirits”, i.e. those behaviors of operators on the financial markets that can determine waves of optimism and pessimism not justified by fundamentals and rationality.
Studying the error: what are cognitive biases
Behavioral economics investigates how decisions are made.
When investing, you collect a lot of information to make the best choice, but many times you have little time and too much complicated information to process. This is why we resort to mental shortcuts to make quick, but often incorrect, decisions.
For example, when talking about savings and finance, a common mistake is to think through stereotypes or imitation: seeing that a friend’s investment is successful does not mean that it is a decision that can be shared and imitated. Personal contexts and goals may be different from those of your friend.
In behavioral economics, shortcuts can be associated with so-called “cognitive biases“, systematic thinking errors that can lead to distorted judgments and irrational decisions.
There are different types of cognitive biases, but among the best known are:
- Loss aversion causes people to be more sensitive to the possibility of losing rather than gaining, thus leading them to embrace risk very rarely. It is due to the asymmetric perception that makes the pain of loss feel stronger than the pleasure of gain;
- Familiarity leads to making decisions based on patterns already explored and tested before. This cognitive error leads the individual to invest in securities that he already knows, often from his own country, excluding other types of securities or instruments, with a strong penalty in terms of diversification.
The herd effect, otherwise known as “herding”, or the tendency to follow the behavior of others. It happens, for example, when investors follow the behavior of other market participants because, although not consistent with the information, going against the market is very risky and may be subject to penalties by the company. It’s one thing to lose when everyone else loses, but it’s another thing to lose alone. Barbara Alemanni, university professor and author of the book Behavioral Finance. Discovering the errors that waste our time, delves into these and other cognitive biases in the episode “1 book in 30 minutes”, a series of live talks available on the Museum of Saving’s YouTube channel. You can catch up on the whole episode here.
How not to fall into mental traps
Behavioral economics leads to recognizing “mental shortcuts” and understanding how to overcome them by orienting ourselves more consciously in economic and non-economic choices, asking ourselves the right questions and evaluating pros and cons.
Knowing your biases can help you implement strategies to avoid pitfalls. For example, many times in the evening you set the alarm with the idea of going for a run and in the morning you change your mind due to lack of desire. Knowing that you are falling into this temptation, you can deal with laziness in different ways, for example by placing the alarm clock away from the bed. And this is a behavioral economics trick.
Or, in separate waste collection, all the images that indicate where to throw the rubbish are behavioral economics measures because they encourage you to make the right choice in a simple way and perhaps even using a game, such as the basket over the bin.
The public sector also often intervenes to help people behave more consistently with common objectives and to do so, using the principles of behavioral economics, implements nudging techniques, providing a gentle push to make the right decision. An example is that of adhering to organ donation, in the event of death, which is automatic with the renewal of the identity card unless expressly denied. Richard Thaler won a Nobel economics prize in 2017 partly for his work in codifying the theory of nudging, which is considered a useful tool for counteracting behaviors that are not fully rational.
Behavioral economics also offers many possibilities from a professional point of view. Behavioral designers are in high demand in companies dealing with digital platforms, for example. These figures, in fact, have the task of thinking about the context in which the user makes decisions and of structuring the experience for those who visit a website or watch a TV series, in the simplest way possible.
The behavioral analyst, on the other hand, extends the analysis of behavior to all economic areas that involve human relationships. His work is upstream from that of those who plan choice paths and is applied in various fields such as organisational, decision-making, educational and clinical. And this gives a good idea of how behavioral economics is an integral part of everyday life, even when you think it isn’t.