Daniel Kahneman was a psychologist who won the Nobel Prize for Economics.
People behave rationally with their money, right?
Martin Hawes is fascinated by the power of behavioural finance.
Economics was founded on the idea that rational people make decisions after a great deal of thought and so their decisions are logical.
In fact, one of the really interesting developments in finance over the last few decades has been the development of "behavioural finance" which brings into consideration the fact that we are human and, therefore, do not always make rational decisions.
Popularised and led by Daniel Kahneman (a psychologist who nevertheless won a Nobel Prize for Economics), behavioural finance identifies some of the ways in which we use emotion (rather than logic) to invest and manage our finances.
Money is fungible: $10 is $10 no matter what category of expenditure we put it in. And yet, our minds play tricks on us and we can easily mentally account for spending in one area quite differently from another area. This means that we stress about expenditure in one category but blithely spend much more in another.
A personal example is that I can prowl the house turning off lights, and do so with a cost-saving zeal that is probably unjustified by the few cents that are saved. However, according to someone who seems to know, I can also pop out and add another $300 ice axe to my collection at a whim using a quality of self-justification that should come from only the most skilled politician. To my under-developed mind, a 50c electricity saving looms as a far greater financial issue than a decision to add to my climbing equipment.
Marketers know this of course and are good at getting us to focus on a headline sum of money and to ignore the real cost. A mobile phone on a plan may be "free" but we do not necessarily account for the additional cost of the plan that makes it free.
The problem is that subjectively we put each of our expenditure items into different categories and attribute a different value for $10 in each. As such, we may use the wrong form of measurement for expenditure: the cost of that pair of jeans may be high ($250!) but if we measure it on a cost per wear basis, it could be a lot cheaper than the $50 shirt we only wear twice. Mentally we often do our accounting by focussing on the wrong thing.
We also account for our investment performance in non-rational ways. For example, a $6 stock seems a lot more expensive than one at 35cents. That's true in absolute terms but it does not justify the purchase of the 35 cent company if, in percentage terms, the $6 investment has far better prospects, profits and dividends. Similarly, an investment that has gone up in value may seem highly profitable, but we do not always account for the fact that another one that has not gone up in value has given great income from dividends or rents.
Our economic decisions are not rational (even though we may think they are). Economist Richard Thaler showed that people will drive to another shop to save $10 on a $20 item but will not do the same drive to save $10 on a $1,000 item. Rationally, we know that $10 has the same value everywhere at every time but we need to be aware that our subjective mental accounting means that we may account for it differently.
Martin Hawes is an Authorised Financial Adviser and a disclosure statement is available on request and free of charge, or can be found at www.martinhawes.com. This article is of a general nature and is not personalised financial advice.
- Sunday Star Times
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