Money and economics are cold, hard and bottom line—based 100% on facts, logic and rational decision-making. Right? So wrong!
History Repeats Itself
The Great Recession has, among other things, highlighted the way emotions, psychology and human nature lie at the root of our individual financial, and larger economic, relationships. Regardless of whether they should, they do. For example, logic did not dictate that Lehman had to fail while Goldman, AIG, and the others did not. Likewise, the equity markets of the last two years have been parodying Heidi Klum’s tagline from Project Runway—“You’re either in or you’re out.” Investors have swung wildly between their impulses of fear and greed based on the headlines of the day, rather than let the value of great companies shine.
It may not only be helpful, but essential, to understand more about human nature and ourselves in order to make wise investment decisions independent of market trends. In fact, an entire field marrying psychology with decision-making—behavioral economics—has become very hot in the recent years.
Although even Adam Smith and other “classical economists” acknowledged the role of the psychology in our economic behavior, neoclassical economics of the 1980’s dismissed such in the name of efficient markets filled with rational decision-makers. That was the economics I was taught, but it never felt like a science I could rely on. I saw too much “irrational” behavior as a young lawyer in the mergers and acquisitions space. And I certainly knew I sometimes made economic choices based on more than a simple cost/benefit analysis as well. But beginning in the 1990s, behavioral economics came into its own; some of the earlier thinkers made their way into the mainstream, joined by new voices.
Three Great Reads On Behavioral Psychology, As It Relates To Economics
If you only have time for a few quick, easy reads about the interplay between the human mind and economic decision-making, I recommend three: John Kenneth Galbraith’s A Short History of Financial Euphoria, Predictably Irrational by Daniel Ariely, and Brad and Ted Klontz’s Mind over Money.
The first offers a concise and insightful overview of why we never seem to be able to escape “bubble and bust” economic cycles. It comes down to human nature. We don’t learn from history because each generation—even knowing the history of the Dutch tulip bulb mania, the Great Depression, etc.—thinks it is different and smarter, thus incapable of falling into the very behaviors it recreates as it finds a pet idea, thinks growth can be infinite and then introduces more and more leverage. So we need to pass our decisions through a filter that asks whether the historic warnings are aligning and not try to rationalize how things might be different this time.
The second, Predictably Irrational, convincingly and entertaining informs how the human brain makes choices. You will never take a “free” sample again without remembering that free can often come with a very high price.
Finally, I recommend the third book, Mind over Money, to anyone truly interested in building personal financial skills. In a nutshell, Mind over Money argues that, no matter how much financial education you may have, until you understand your personal relationship with money you cannot make optimal investment decisions. So you should in effect put yourself through a bit of financial psychoanalysis.
According to this, the first question to ask for understanding your financial decision-making is “What is your first memory about money?” Did your family have to count every penny? Did your family make you feel secure about having provided for your future? Did your father make you feel guilty about spending money versus saving it? Do you buy things to make yourself feel valuable? How much of a “risk-taker” are you? Until you understand your own financial DNA, you can’t get outside yourself to make objectively intelligent investing decisions.
As I try to construct and diversify my portfolio in a way that is best for me in a world that hasn’t acted all that economically rational lately, these books offer key insights both globally and personally.
Tell us in the comments: How much of your financial decision-making is obviously controlled by your emotions?