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.
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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.
Why is changing undesirable financial behavior so difficult for most people?
Our brains are structured along multisystem lines. Most of what we think and do is automatic and below the conscious level, which is known as System 1, and the reasoning and conscious level is System 2. The part of our brain that's engaged in conscious thought isn’t totally aware of what’s happening at the System 1 level, even though that’s where most of our brain activity is taking place.
The way most of us operate is that our System 1 finds stimulus response patterns that work and, in the process, we get good at habits through repetition. It’s like digging a groove. The more you do it, the deeper the groove. And the deeper the groove, the harder it will be to get out.
So how can you overcome those patterns?
There is a great metaphor for understanding change. Your brain is like an elephant and its human rider. The elephant represents System 1, which is simple but powerful. He pulls the heavy load, but gets swayed by emotion. The rider represents System 2—the conscious, rational, deliberative part of you.
Since the rider is sitting on top of the elephant, he’s not going anywhere unless the elephant agrees. So you have to figure out how to motivate the elephant. If the elephant decides he’s just as happy sitting where he is now, there’s no hope.
Think of it as if Microsoft created our brains. They take their old software and add new features to it—and those new features are always buggy.
You also need the foresight to understand what the path will be like to your destination because elephants get distracted. If you don’t understand what the obstacles will be and how to keep the elephant engaged, you’ll only get partway to your destination.
Does that suggest some financial behavior is hardwired in our brains?
Yes, some behavior really does stem from evolution. Loss aversion was well-suited to some past environment in which we lived. Same with confirmation bias. But our environments have changed more rapidly than our brains have adapted through mutations, so we’re stuck with old software in a new environment.
Think of it as if Microsoft created our brains. The thing about Microsoft is they’re not the most elegant group of engineers. They take their old software and add new features to it—and those new features are always buggy. But they don’t go back to ground zero; they always add on to what was there in the past.
That’s how our brains are built—on top of lizard brains. It’s old software, and nature is always adding to it, so we’re stuck with all that stuff that was put there for a reason way back when, but we don’t necessarily need it now.
Can good financial behavior be taught?
Nature and nurture are both important, but nature is huge. One particular gene is especially important for good financial decision-making—and fewer than 1 in 4 of us has the variant of the gene.
Parenting and education can counteract nature to some extent, but there are big "but"s. We know that most financial-literacy education efforts have failed. But there is one thing that seems to make a difference: exposing kids to a stock market game. If you let students play this game in which they actively invest, there are huge spillover effects to other types of financial skills.
The reason is because of the way our brains work—you need to activate reward centers within the brain so that people want to do things. Kids get excited when they are competitive. So we know it's possible to make inroads with teaching better financial literacy, but we’re only beginning to understand what’s going on.
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Do certain strategies work better than others when trying to change financial behavior?
It’s typically very hard for many people to accomplish change by themselves—they need a program. So if you want to save more for retirement, for example, the kind of program that usually works has more than one step. But you want to make sure the program is voluntary—if people feel they’ll be locked in, they won’t want to start.
For example, step one can be to save through your employer, using a vehicle like a 401(k), so the money is automatically deposited for you. And step two can focus on taking additional savings increases out of pay raises, so that you don’t have to face smaller paychecks.
If your goal is to borrow less, step one is to find someone to help you structure a paydown plan. You also want to engage an ally that you respect to be your coach, so you can show them the progress you're making—and who will make you feel embarrassed if you pull out. This way you have a built-in motivator who will make you think twice before you go off the plan.
You also want to engage an ally that you respect to be your coach, so you can show them the progress you're making—and who will make you feel embarrassed if you pull out.
How does behavioral finance help us understand the financial crisis?
It tells us a lot about Wall Street and psychological pitfalls. The large financial institution UBS did a public mea culpa and released an analysis of the mistakes they made in the run-up to the financial crisis. Not only is it a very honest report, but it’s also a treasure trove for identifying the specific psychological pitfalls that afflicted decision makers.
For one, they were guilty of excessive optimism and overconfidence, which led them to underestimate the risks posed by financial instruments like credit default swaps. And confirmation bias helped blind them to information that challenged their view of the markets. So you can see just how pervasive and powerful these concepts are—and how dangerous they can be.
You’ve researched how financial professionals aren’t immune to psychological pitfalls. How so?
Most of us are overconfident about our abilities. It’s part of that old software legacy. It kills us to feel that we’re not above average, but half the population is below average.
For example, we know that there is far too much trading in the stock market. Part of the reason why? If you think you are above average, then you also think you can get in there and win. And if you think you can win, you trade actively. But if you trade passively, it’s like admitting you are no better than average. So this is something that is going to afflict professionals, as well as regular people.
Can technology play a role in promoting better financial behavior?
New apps that apply insights from behavioral psychology will be important in figuring out how to motivate the elephant into getting the job done. Apps will also be important if they can help make it easier for riders to figure out where to go.
So those things are moving in the right direction. We just don’t want to be overconfident and excessively optimistic about the degree to which technology can solve these issues.