As many of us know, bad spending and saving habits can often be notoriously hard to break.
Even when we want to save more for retirement or stop splurging on credit cards, our best intentions can get overtaken by impulses and old routines.
All of this comes as no surprise to behavioral finance experts, who make it their mission to study how psychology informs many of our less-than-rational money decisions.
That’s why we asked Dr. Hersh Shefrin, a pioneer in the study of behavioral economics and a professor at Santa Clara University’s Leavey School of Business, to explain how (and why) human behavior bucks economic logic—and to divulge the best strategies for overcoming those bad money habits.
LearnVest: What exactly do behavioral finance experts do?
Dr. Hersh Shefrin: They study how psychology affects the financial decisions that people make, and the impact those decisions have on financial markets.
It’s a relatively new field. Around World War II, economists got it into their heads that economics needed to be more of a “real” science, like physics. They figured they could mathematize the psychological elements of finance and economics, put them into things called axioms, and determine outcomes by applying mathematical models.
But it wasn’t until the 1970s that psychology became something that serious economists studied when it came to trying to make sense of the economic and financial world. There were only a handful of us working in the field then. Then it took off like a rocket in the late 1990s, and in the last five or six years since the financial crisis, it’s become especially hot.
What are some common ways in which human behavior can sabotage personal finances?
One is a bias to overweight the present and near future over the distant future, which leads us to not save enough for retirement, or to take on too much debt. A second bias is to be excessively optimistic, downplaying the extent to which bad things will happen. Of course, some people are excessively pessimistic, but within the general population, if there is a leaning, it’s in the direction of excessive optimism—leading people to think they don’t need life insurance, or that they aren’t at risk of crashes in the stock market.
There’s also confirmation bias—the tendency to turn off the hearing aid when someone tells you something you don’t want to hear and find inconvenient to change. So if someone says you shouldn’t carry such a high balance on a credit card, but you’ve done so for years and don’t feel it’s done you any harm, you won’t enact change.
Finally, there’s loss aversion—the tendency to experience a loss much more acutely than a gain of the same magnitude. That means when good things happen, we celebrate, but the things that really stick with us are the ones that went wrong. In fact, the average person experiences a loss two to three times more acutely than a gain of comparable magnitude. And that leads us to be shy about taking risks when it comes to money.