Why We Make Bad Decisions About Money (And What We Can Do About It)

Even the smartest people make irrational choices, says Daniel Kahneman, a Nobel prize-winning psychologist. Here's why -- and what you can do about it.

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Why does it feel better to be paid hourly than to receive a salary? Why are we willing to gamble, even when we know there's a house advantage? Why would anyone buy stock in Blockbuster or Borders? (Respected financier Bill Ackman owned 10.6 million shares of the latter on the eve of the company's bankruptcy.)

If you've ever looked back at a rash decision you made and wondered what was I thinking? take heart: you're not stupid and you're not alone. Even the smartest people make irrational choices, says Daniel Kahneman, a Nobel prize-winning psychologist. "There is no question... this is the way we live" -- especially regarding money. So what can we do about it? It all comes down to mental accounting. 

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"We all keep our money in different mental accounts for which we have different rules," he explains. "People... spend their spending money, but then there is a hierarchy of the accounts that they will touch." For instance, most of us are more willing to spend money that we're saving for a vacation than to spend money allotted for a child's college education. So far so good.

More foolishly, when we invest in the stock market, we see each stock we buy as a mental account that we should sell as soon as it's a winner. This means that investors end up selling their winners and hanging on to their losers, which, in the long run, makes them poorer than if they'd just kept the winners.

There are two major reasons for these recurring patterns of behavior. First, people often see their choices narrowly, attacking a problem as if it is singular and unique -- as if this is the only time they will ever encounter this specific situation. Usually, "it's a better idea to look at problems as they will recur throughout your life, and then you look at the policy that you’re to adopt for a class of problems," says Kahneman. So instead of saving and borrowing at the same time, treat your whole portfolio of assets holistically.

Another mental trap we can fall into is hazy generalizing. We all have an abstract awareness of the fact that we're being charged compound interest on our credit cards, but taking the time to actually do the math and integrate the interest into one's budget can be a deciding factor between having an empty bank account at the end of the month, and having savings. "Numerate people" -- people who make data-driven decisions -- "have a significant advantage over those who are not."

So do people who are able to frame things broadly and keep their emotions in check, according to Kahneman. We're not machines. We all have thoughts, feelings, and personal circumstances swimming around in our heads all the time, whether we're at work or at the bank or in the middle of a negotiation.

Gains and losses can take on an entirely different meaning depending on the weather, whether you got in a fight with your partner earlier that morning, what's on the news. "Most of us tend to respond to gains and to losses, to changes that happen in our lives," says Kahenman, but you're always better off trying to maintain a sense of perspective. 

The attitude that leads to the best decisions? "You win a few, you lose a few." Keep that in mind the next time a hair-splitting, nail-biting choice comes your way.

Image courtesy of Shutterstock.com

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