People get nutty when it comes to money. Traditional economics assumes we follow proven, rational rules according to our financial best interest — but we don’t!
Behavioral economics is that combination of economics and psychology that focuses on how we really make decisions around money versus what we “should” do.
Dan Ariely’s bestseller Predictably Irrational, Revised and Expanded Edition: The Hidden Forces That Shape Our Decisions, describes our financial behaviors as emotional, not rational, and identifies patterns that make our irrationality predictable.
Because we make certain types of decision errors over and over again, we can try working with our patterns instead of against them. I’ll cover two of our many potential decision errors here.
The first involves being too optimistic. We might falsely attribute lucky investments to skill, keep a low emergency fund or none at all or ignore the need for insurance.
Second, a practice called anchoring causes decision errors with price perceptions. Anchoring is taking a certain price or value as a norm that influences what we’ll pay in the future. If bread is $5 where the cost of living is high, we might accept higher bread prices where it’s lower.
Anchoring can cause problems when negotiating prices, making large, infrequent or unusual purchases, or assessing an investment’s value.