Improve your day to day financial decision making with these 5 lessons drawn from Nobel Prize-winning economist Richard Thaler.
Richard Thaler, aka the “father of behavioural economics”, recently won the Nobel Prize for his seminal work that challenges the tenets of traditional economics and reimagines the way humans make financial decisions.
Thaler’s work, which combines economics with psychology and sociology, establishes that most of the time, humans make simple financial decisions like buying a Credit Card or investing in Mutual Funds based on their behavioural tendencies and not simple logic.
Thaler theorises that since humans don’t always act in their best interest, they don’t always make the soundest decisions when it comes to their finances.
While this certainly doesn’t mean that you throw all reason out of the window before making any financial decisions, there are some aspects of your behaviour that you need to be aware of, and perhaps, keep in check, especially if you’re considering a decision that has considerable financial implications.
Additional Reading: Solutions To Common Behaviours That Wreck Your Financial Health
Here are 5 lessons on the financial wisdom that we can draw from Thaler’s theories:
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When it comes to saving, nudging accomplishes more than nagging
Through a program that he and his peers devised, Thaler demonstrated that when it comes to saving, people who were auto-enrolled by their employers for a retirement plan saved over three times more than those outside it.
In fact, they didn’t opt out even when they had the choice. In other words, we are more likely to save when we’re nudged into doing so rather than being nagged or driven mad about it.
What this means for you: Take the case of an SIP. When you opt for a SIP for your Mutual Fund investment, consider signing up for a default step up in your SIP contributions every year by a certain percentage or a certain amount for a fixed tenure.
This way, you are not only likely to accumulate a bigger corpus before retirement, but also rein in your spending as your income increases over the years. According to Thaler, when you’re signed up by default for a financial plan, you end up saving more.
Additional reading: Smart SIP Strategies
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Keep it simple, silly
Thaler postulated that humans love things simple and uncomplicated. And this extends to financial decisions as well. Financial jargon makes humans confused and what makes all the difference is the way in which choices are presented to them. And we couldn’t agree more.
What this means for you: At BankBazaar, we spend hours thinking of ways to simplify finance for you so that you’re well-equipped to make informed financial choices.
That’s why, when you come to us to compare and buy Credit Cards or Personal Loans, you will find information on every reward, benefit or relevant detail presented to you in an unbiased and transparent manner so that you don’t have to waste a minute going through loads of confusing fine print.
Additional reading: Personal Loan Pitfalls To Avoid
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Embrace change
For long, classical economists based their theories on the concept of the “rational man” who gravitated towards the most rational, profitable and least expensive options.
Thaler and his peers noted that it is quite the opposite. Humans are creatures of inertia and procrastination. Thaler defines this as “the status quo bias”.
What this means for you: Inertia and numerous advantages like no penalty for withdrawals of funds and interest earned up to Rs. 10,000 being exempted from income tax may be pushing you to keep your money parked in your Savings Account for years on end, but there are better and more attractive alternatives to low-interest Savings Accounts that you should consider for better and quicker returns.
Additional Reading: Money Lying In A Savings Account?
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Endowment effect
Through an experiment in which half of the students in Thaler’s class were given free coffee mugs, which they were then free to sell, Thaler showed that students who had already been randomly allotted mugs, valued them at a far higher price than the students who were not assigned mugs.
Thaler and his colleagues showed how we tend to overvalue our own possessions and defined this as the “endowment effect”. The combination of the endowment effect and loss aversion make investors “hold on too long to stocks that have gone down, hoping they will rebound so they can sell without realising a loss”, believes Thaler.
What this means for you: As an investor, the “endowment effect” can have negative implications for you. If you rely on your gut more than actual analysis to guide your investment decisions, you might end up with a portfolio that is in desperate need of reorganisation.
However, you need to first admit to yourself that your portfolio isn’t working as well as it should be. Consider consulting an online investment expert to identify areas in your portfolio where you might be bleeding money and follow these tips for ideal portfolio diversification.
Additional Reading: Eye-Opening Financial Advice For Different Types Of Investors
5. Mental accounting
According to Thaler, we mentally categorise our money, and that our spending and saving behaviours differ depending on what we are buying. We treat two expenditures as different “accounts”, even though they come from the same source.
For example, we limit our weekly spends on dinner take outs, but splurge on our morning breakfast. We treat the cash in our wallets and cash in our bank as different accounts.
What this means for you: Because of “mental accounting”, people planning and saving early for their retirement might be predisposed to think of their retirement fund as their safeguard when it comes to taking care of post-retirement expenses.
However, you could consider diversifying your risk exposure by investing in options like SIPs that might be slightly risky, but offer great returns. Don’t invest all your savings in one single financial product.
Additional Reading: Your Guide To Retirement
Thaler’s theories show that there’s more to making a financial decision than a simple gain-loss evaluation and when we let our emotions take over, we become prone to making financial errors.
When you realise that the behavioural tendencies described above dictate your actions while making a financial decision, take a moment to stop and think. Use these lessons from Thaler’s work to let your money do the hard work for you.