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.
What's the Big Idea?
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.
Watch the video:
"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
Swipe right to make the connections that could change your career.
Swipe right. Match. Meet over coffee or set up a call.
No, we aren't talking about Tinder. Introducing Shapr, a free app that helps people with synergistic professional goals and skill sets easily meet and collaborate.
The history of the Geneva Conventions tells us how the international community draws the line on brutality.
- Henry Dunant's work led to the Red Cross and conventions on treating prisoners humanely.
- Four Geneva Conventions defined the rules for prisoners of war, torture, naval and medical personnel and more.
- Amendments to the agreements reflect the modern world but have not been ratified by all countries.
Meanwhile, Spaniards are the least likely to say their culture is superior to others.
- Survey by Pew Research Center shows great variation in chauvinism across Europe.
- Eight most chauvinist countries are in the east, and include Russia.
- British much more likely than French (and slightly more likely than Germans) to say their culture is "superior" to others.
The Green New Deal is an ambitious attempt to fight climate change, but is it destined to hit the political skids?
- Recent protests by the Sunrise Movement have taken the Green New Deal from forgotten policy to trending hashtag.
- The Green New Deal aims to move the U.S. to 100% renewable energy within a decade.
- Proponents also hope to catalyze a top-down restructuring of the U.S. economy and advance social justice issues.
SMARTER FASTER trademarks owned by The Big Think, Inc. All rights reserved.