Looking for Sound Financial Advice? Look to Psychology

Behavioral economics helps people make better choices with their money, including saving for retirement.

Findings

Psychologists, such as Nobel laureate Daniel Kahneman and the late Amos Tversky, laid the foundation for the new science of behavioral economics with their work on human judgment and decision-making. They explored phenomena such as "loss aversion," decision "framing," and overconfidence, which can lead people to make self-defeating financial choices.

One area of behavioral economics that is playing an important role is in the study of financial markets, according to Cornell psychologist Thomas Gilovich. In his 1999 book with journalist Gary Belsky, Why Smart People Make Big Money Mistakes and How to Correct Them, Gilovich explores how informed people might make more rational investment decisions through behavioral economics.

How well does the average investor perform when picking stocks? Until recently, Gilovich says it was impossible to know. But over the past few years, with the cooperation of a large discount brokerage house, behavioral economist Terrance Odean has cast some light into this dark corner of personal finance. In one study, Odean and his frequent collaborator Brad Barber looked at the buy and sell decisions of 78,000 households over a five-year period in the 1990s. When they divided the investors into those who traded more and less frequently, they discovered that "trading can be hazardous to your wealth." Those who bought and sold most often earned a net annual return of 11.4 percent, whereas those who traded least often earned 18.5 percent (remember, the period studied overlapped with a significant bull market). Barber and Odean note that the typical investor trades frequently, turning over 75% of his or her portfolio annually. They attribute this fact, and its unfortunate effect on the bottom line, to profound overconfidence on the part of individual investors. Picking winners is much harder than it appears to the average investor.

Behavioral economics doesn't just help those with stocks. This new way of thinking about economics can affect the choices people make in a wide range of areas, including credit-card use, financing a home purchase, and planning for retirement. In a 2004 study by Richard Thaler of the University of Chicago business school, behavioral economics was the driving force behind a program to get workers at a manufacturing company to save more for retirement. Workers that participated in Thaler's "Save More Tomorrow" program went from saving 3.5 percent for their retirement accounts to 13.6 percent over the course of 40 months. This increase was made possible by convincing workers to commit in advance to allocating a portion of their future salary increases toward retirement savings. The plan - which workers must opt out of if they don't want to participate - targets people who want to save more but have a hard time putting their desire into action because of procrastination and other factors. The plan also capitalizes on the human tendency to be overly optimistic (a tendency that can often prevent people from saving) by getting people to commit to saving more in the future.

Significance

Economics is a science that does a good job of explaining how money behaves if all of us made rational financial decisions. Behavioral economics is a new science that recognizes we don't always make rational decisions and helps explain how real people behave around money, which in turn, can help people avoid unwise money moves.

Practical Application

Behavioral economics is helping people get the most out of their investments in the stock market. Two guiding principles follow directly from Odean and Barber's research, including following the "buy and hold" strategy instead of buying and selling frequently in an effort to find the next Microsoft. The second principle, according to the behavioral economics research, suggests it's not a good idea to try to beat the market; a tie is good enough. By investing in "index funds," mutual funds designed to match the overall performance of the market (or market segment), one can realize the gains to be had from becoming a part owner of a broad range of companies.

Dr. Thaler's program to increase workers' savings is now being offered to 80 companies and 200,000 workers. His study involving workers at a real manufacturing company showed that participants could more than triple their saving rates by putting in use the same behavioral tendencies - such as procrastination - that lead people to postpone saving indefinitely. There is reason to believe that putting similar principles to work can be used for other forms of social good. For example, Eric Johnson and Daniel Goldstein recently showed that it is possible to increase dramatically the rate at which people agree to become organ donors by making donation the default (so that people have to take easy but active steps to take themselves off a default list - rather than having to take easy but active steps to get on). Behavioral economics can help save lives as well as money.

Behavioral economics can also help us understand the less than logical money decisions we sometimes make in our everyday lives. For example, many people wouldn't think twice about driving to a distance store to save five dollars on a small purchase but wouldn't think of traveling the same distance to save the same amount on an expensive item.

Cited Research

Altman, M. (2004). The Nobel Prize in behavioral and experimental economics: a contextual and critical appraisal of the contributions of Daniel Kahneman and Vernon Smith. Review of Political Economy, Vol. 16, No. 1, pp. 3-41.

Barber, B.M. & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. Journal of Finance, Vol. 55, pp. 773-806.

Belsky, G., & Gilovich, T. (1999). Why smart people make big money mistakes-and how to correct them. New York: Simon & Schuster.

Johnson, E. J., & Goldstein, D. (2003). Do defaults save lives? Science, Nov. 21, Vol. 302, pp. 1338-1339.

Kahneman, D. (2003). A perspective on judgment and choice: Mapping bounded rationality. American Psychologist, Vol. 58, pp. 697-698.

Thaler, R. H. & Benartzi, S. (2004). Save More Tomorrow™: Using behavioral economics to increase employee saving. Journal of Political Economy, Vol. 112, No. S1.


American Psychological Association, February 19, 2004