“Why do people, even with the best information, still seem to make ‘irrational’ decisions?”
All of us, even bankers, financial counsellors and finance lecturers, make poor financial (and other) decisions from time to time. Understanding the basis of our irrationality has always been important, but it has assumed greater importance over the last twenty to thirty years, which have seen the end of tight rationing of finance for housing, a relaxed attitude to debt, the widespread use of credit cards, government policies shifting some financial liabilities (such as higher education) to individuals, the phase-out of most defined-benefit superannuation schemes, the introduction of compulsory personal superannuation, and the introduction of many innovative investment products.
As the fragility of our financial system continues to be revealed, we must ask, “Are we equipped to make sound financial decisions in this brave new world?”
The discipline known as behavioural economics has strengthened our knowledge of consumer decision-making. It explains why we make certain, consistent departures from what is generally described as “rational” decision-making. These departures result from our use of short-cuts (“heuristics”) in situations where more deliberation would result in more beneficial decisions, from short-sightedness, and from innate concerns for fairness in transactions.
This paper begins with a brief outline of decision-making theory, then looks at the findings of behavioural economics as they relate to financial decision-making. It concludes with some modest, and in some cases tentative, suggestions on how we can improve our financial decision-making.