For over two centuries, classical economists have considered humans to be fundamentally rational.
They believe we think through all available options and choose the course of action that we expect to result in the best possible outcome.
Most of us consider ourselves rational and often encourage others not to make decisions based on emotions, especially when it comes to money.
Behavioural economists Richard Thaler and Cass Sunstein disagree. In their best-selling book Nudge, they argue that we mostly adopt imperfect, but practical approaches.
We are influenced in our decisions by several factors, including our social interactions, the way information is presented to us and the emotions involved when decisions are made.
Take these examples based on famous behavioural economy (BE) findings:
Why do people spend more when they pay with a credit card than cash?
Why do people go along with the status quo or default option? That’s understandable when getting a new smartphone and choosing a screen background or ringtone. But when stakes are much higher?
We mostly stick with the default choices given by insurance companies, health providers and governments.
Our Relationship with Money
Thaler talks about mental accounting to describe how people treat money differently based on where money comes from and how they’ve decided to use it. Rarely do they treat it purely objectively.
That’s why seasoned investors often consider recent gains as disposable “house money” and use them for high-risk investments, losing sight of the bigger picture.
A related concept is the pain of paying, which comes into play at the checkout to balance the pleasure of purchase. Even shopaholics, who derive immense enjoyment from the act of purchasing, experience some pain when paying for their purchases.
That’s because humans are naturally loss averse. This pain reduces when paying with a credit card because people don’t see their wallet emptying, and payment is deferred to the future (along with the pain).
Treating humans as purely rational beings doesn’t take into account the fundamental role of emotions in how we make decisions.
Photo by Liza Summer
Just put yourself in this situation: during a mountain hike, a snake bites you, leaving you with a tiny (1 in 100,000) chance of dying. How much would you consider paying for an antidote to the venom? Keep that figure in mind and now answer this second question: how much would you expect to be paid by a pharmaceutical company asking you to be bitten by the same snake as part of the research for the antidote?
According to standard economic models, both answers should be the same, but research shows that for most of us, the second figure is much greater than the first. Why, since the probability of dying is the same?
That’s because we’re not always self-interested, benefit-maximising, and cost-minimising individuals with stable preferences. Our thinking is subject to lack of knowledge and feedback, inability to process information and the surrounding context.
We have so many choices today - just look at the number of TVs or laptops you can choose from. Even if we can access all the information, we have to compare dozens of options, research the specs and decide which one is best for us.
To overcome ‘analysis paralysis’, we try to make things simpler so that we can come to a decision.
Our memory can’t keep all the information we gain daily, and it is subject to distortion. We are also social animals, who want to trust other people, reciprocate favours and prefer fairness over dishonesty.
So what are our chances of always making the right decision?
In Nudge, Thaler and Sunstein say that experience, useful information, and prompt feedback help us make good decisions.
For example, smokers don’t see the effect of their habit on their cells and internal organs, and they only notice a deterioration of their health over time.
That’s why recent behavior change programs have started to use smartphone apps to provide positive and personalised feedback. Smokers using these apps receive notifications about the number of cigarettes not smoked, the money saved, how their health is improving and the diseases they’re avoiding.
This positive reinforcement creates the very emotions that support their actions towards a profound and long-lasting change.
5 Key Steps to Emotional Decision-Making
Want to make good decisions about money and get ahead in life?
Here is a simple process you can follow.
1. Embrace your emotional side
First, stop swimming against the tide and start accepting that we can all be irrational.
With this we don’t mean that you should squander a lifetime of savings on the impulse of the moment. Quite the opposite.
Humans outsmart every other species because we set goals, plan, think before acting, remember what works and what doesn’t, and update our behavior based on that information.
Photo by Andrea Piacquadio
We can also consider the consequences of our actions in our mind before playing them out in real life, which helps us to avoid future suffering.
Start with discovering your ideal state, i.e. the emotional place where you’d be at your peak.
2. Find your core values
Values are deeply connected with emotions. Your values define how you view the world and your place in it. That’s why when your actions are in line with your values, you feel balanced, at peace and rainbows and unicorns come out of your morning coffee.
When you’re aware of what you truly want from life, you don’t need to rely on willpower to control your financial decisions.
Your day-to-day choices naturally align with the plan you have chosen.
Take a moment to list out your core values - if you need a hand with it, just read this article.
3. Set your life goals
By now you’ve realised you are in the control seat, even if you’re not as rational as you thought before reading this article.
The process we’re taking you through doesn’t let others set your goals. Many people feel stuck on a global treadmill that pushes them to always make more money even if it's not what they want or need. Well, it’s time to come up with goals that are good for you and yourself only.
To find your real goals, translate the list of your core values into life goals.
For example, playfulness could take the form of a state-of-the-art music recording studio in your basement after retirement. Altruism might mean setting aside enough money or time to be of help to others throughout your life.
Make sure your goals are measurable. Making your goals tangible and specific will increase your chances of reaching them.
So if your goal is to retire early, think about when you want to stop working and how much you need to support yourself for the rest of your life. Once you have a clear picture, you can start taking action (such as saving or investing) to achieve your objective.
4. Give your goals the 'significance test'
Once your goal has taken shape (with numbers, timeframe, etc.) put it through the significance test to make sure it has an emotional hook.
Ask yourself: ‘If I achieve this goal, I will feel [insert emotion here] or will be able to do [insert life goal here]’.
This is the way to make sure your goal stays connected to your values and gives you that emotional incentive that will drive your actions.
Can you see we keep coming back to emotions?
5. Get an accountability buddy
To get frequent feedback throughout your journey, ask someone you trust to be your accountability buddy.
Choose someone who has good judgement and enough experience, and have regular meetings with them. You’ll find that having someone who keeps you on track makes all the difference.
Photo by Marina from Pexels
The Bottom Line: Be Human.
Don’t feel bad about being irrational. Emotions are the very thing that make us human.
At Life Sherpa, we don’t expect you to be a robot, and we will always respect your desires and aspirations.
In a world where everyone tells you what you should and shouldn’t do, we prefer to listen, help you understand what you really want, and guide you through the most important step: implementation.
Because money is not as complicated as many want you to believe. You just need some practical information (the right one of course), a bit of wisdom, and someone to keep nudging you on the way up Mount Happiness.
And remember, your Sherpa is here to help you get there.We’re just one phone call away.
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For 15 years, Francesco has approached communication from various angles: client-side advertising manager, agency account director, freelance photographer and content writer. Working for several global and Australian finance brands (Morningstar, CBA, American Express, uno Home Loans, OFX and InvestSmart) he has learnt to understand how people save, spend, invest and feel about their money. Today, Francesco develops online content that addresses the real needs and aspirations of Australians when it comes to personal finance.