“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.
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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.
Ian McAuley is a contributing author to CPD’s recent publication More Than Luck: Ideas Australia needs now. Ian’s chapter Living off our resources looks at how we use our resources in an era where environmental capital is fast-becoming our scarcest resource of all. Ian lectures in Public Sector Finance at the University of Canberra. His research interests are in public policy, with a specialisation in health policy. His academic qualifications are in engineering and business management from Adelaide University and in public administration from Harvard University. Besides his academic work, he has assisted consumer and welfare organizations in financial and economic policy matters. He has been a strong advocate for integration of the components of health care into a coherent consumer-focussed system. He has been a critic of successive governments’ piece-meal approaches to health policy, particularly the government’s subsidies for private health insurance because they bring neither the benefits of market competition nor the benefits of strong government control. Ian is co-author of a number of papers for the Centre for Policy Development, including ‘Reclaiming our Common Wealth: policies for a fair and sustainable future‘, ‘A Health Policy for Australia: reclaiming universal care‘ and ‘You Can See a Lot By Just Looking: Understanding human judgment in financial decision-making‘.