Behavioral Economics is the study of the psychology behind the economic decisions a person makes. Economists want to know why we make the financial decisions we make. Why do we go to the grocery store and spend $150 on food for the week then go out to eat that night? Why do we travel further to get something on sale? Let’s take a look at three situations in which behavioral economics plays a role in how we spend and save our money.
Who do you go to for investment advice? You go to someone you trust that you consider to be a knowledgeable person. But what credentials do they have to advise on investments? Your butcher is probably great at selecting the cut of meat you are requesting and knows which piece of meat to use for the dish you want to prepare. He’s very knowledgeable…about meat. It is not uncommon for folks working at the grocery store who respect the butcher as a successful person to go to the butcher for investment advice. Is that really a good idea?
A common mistake people make regarding investing is when they invest in and/or divest from the stock market. People tend to only want to invest when they feel it’s safe. This means the markets is at a high which leads to a higher cost to invest. People also tend to divest when they feel unsafe; when the markets are low which leads to a low rate of return on the money invested. This is a great way to lose a lot of money. Wall street doesn’t care because they make money whether your or gaining or losing. The key is developing an investment strategy for you based upon your own risk tolerance, the liquidity you need, and whether you enjoy a long-term outlook or you need a short term outlook. Whatever your situation, research shows that your result is better with a good financial advisor guiding your decisions.
Most Americans have credit card debt. May people say to pay off (or focus on paying off) the credit card with the lowest balance first. This gives a sense of accomplishment. However, this is not your best plan. Financially speaking, it is better to pay off (or focus on paying off) the credit card with the highest interest rate since the high interest rate is causing an increased debt.
A common mistake is to have a savings account with enough money in it to pay off a credit card but not doing so. The interest rate on the credit card debt is much higher than the interest earned on a savings account. For example, if your credit card balance is $5,000 and you have a savings account with a balance of $5,000. The average credit card interest rate is about 16% and a savings account at a bank may earn .75% interest. The credit card is costing $66 each month in interest and the savings account is only earning $3.75 each month. By keeping the $5,000 in savings and not paying off the credit card, you are losing $62.25 each month. There are times when you need extra savings in the bank, but it can result it keeping you in debt much longer.
Using Round Numbers
For unexplained reasons, people tend to deal in round numbers. They prefer 5, 10, 15, 20 to 4, 8, 12, 18. When choosing the amount to contribute to a 401k or IRA most people choose 5%. However, many companies will match 6%. That’s throwing away free money. You lose out on the extra 1% that your employer will give you.
Behavioral economics is such a fascinating and complex field. If you understand why you make the decisions you make, you can work to change those and better plan for your future.