Knowledge versus Behaviour
Are classical economic theories more valuable than behavioural finance models for your own financial planning?
Reading time: 5 minutes
If you've ever wanted to invest in the stock market but haven't for fear of losing your money. You aren't alone. Your cognitive bias has probably messed up your decision-making process.
"A cognitive bias is a repeating or basic misstep in thinking, assessing, recollecting, or other cognitive processes".
Every hour, we make 2,000 decisions, equivalent to 34,000 decisions a day. That’s a lot of decisions! Instead of spending all our waking hours weighing choices, we've developed mentalities shortcuts, including biases, to help process thoughts faster and make decisions quicker.
When it comes to personal finance, there are two types of planners:
the people who believe classical economic theories alone are enough to both understand and act upon their own finances. They usually act rationally and do not require any external help.
the people who believe both classical economic theories and behavioural financial models (aka psychology behind money) are required to understand and act upon their own finances. They usually act irrationally and require external help.
In this article, I'll walk you through how behavioural finance was born amongst classical economic theories and then compare the two theories using real-life examples. Finally, I’ll answer whether classical economic theories are more valuable than behavioural finance models for your own financial planning.
From classical economic theories to behavioural finance
Originally, economic theories assumed humans as homo economicus, i.e. capable of making rational decisions for their own sake at all times.
However, we all know that's a utopia.
The study of psychology in finance has always existed because, simply, humans are far from being rational. We can trace those ideas from the early 18th century in Adam Smith's textbooks.
It was only in the 80s that Daniel Kahneman and Amos Tversky, Nobel-prize economist and psychologist respectively, popularised this field of study and, in particular, the notion of cognitive bias.
Behavioural finance was born.
It's natural to have biases in the world we live in. Indeed, many life decisions lead to a potential gain or a potential loss. We need to decide which potential outweighs the other in every situation. Therefore, we've developed those automatic mechanisms over centuries mainly for survival reasons.
Let's take an example with a recurrent one, named loss aversion.
The initial observation: individuals react differently to negative and positive changes.
The theory: people feel the pain of loss twice as intensively as the equivalent pleasure of pain.
The consequence: individuals are more focused on the losses rather than the gains, which means losses loom larger over gains.
The simplification: in other words, not losing $100 is better than potentially winning $100.
Life example: people who refuse to try a new restaurant for fear of not liking it.
Financial-related example: people who avoid buying stocks prefer not to lose their money rather than potentially earn more.
Like all biases, loss aversion helps us simplify existing options and make decisions faster. They might have helped us survive, but it doesn't make us better planners or investors.
Today, there are over 200 types of identified cognitive biases. They are more or less intuitive. But, if they are that common, do we need new theories to claim those statements?
Are behavioural finance theories more beneficial than classical economic ones?
To answer this question, I'll compare the two models to the triptych (ideology, evidence and practice). Finally, I'll answer the question: what's more valuable for planning your personal finances? (Hint: it depends on your personality!).
Ideology
The classical economic theories are vital for understanding how the economy and finance world work. Regardless of which category of planner you're in, you ideally need a fair understanding of know what it's going on and what you're doing. [Note that some individuals invest through their bankers cluelessly, which it's not recommended].
We now know that classical economic theories assume that individuals act rationally at all times.
And, it's true: it does exist a minority who acts very rationally when it comes to their personal finance. Those people are exceptions. As a former financial advisor, I only met a handful of individuals who are fully proactive with their finances and do not panic when the stock market crashes. You will be surprised by the amount of bankers and traders who do NOT plan or invest for their future.
The rest of us? We fall into the category of not acting rationally.
For those who are less rational (i.e. us, the majority), behavioural finance plays a key role in your (in)actions. As knowing economic theories or the investment market will not automatically translate to an active personal financial planning, behavioural finance is as important as economic theories.
Evidence
Using different research methodologies, some findings overlap between classic economic theories and behavioural studies models (e.g. utility maximisation versus satisfacing behavioural).
On the one hand, behavioural economic models emerged from social-psychological studies and observations. Recurrent challenges include research discrepancies and the lack of representativity of the actual population. Indeed, volunteering participants are usually Western, educated, industrialised, rich and democratic (aka WEIRD).
On the other hand, classical economic theories rely on observations made on past events; therefore, they are less subject to partiality and study errors.
Yet, psychology is directly influenced by external factors: lifestyle, social and cultural environment. Therefore, not having an inclusive study tells only one truth of a story.
Going back to our example of loss aversion: when running a test of potential loss versus potential gain by betting an amount of US$10 or US$100, the answer will be different according to the household income or the number of dependents.
In that case, classical economic theories are more “reliable” than behavioural finance models.
Practice
As a more holistic study, behavioural finance-related findings are "attractive" to a larger audience than classical economic theories, therefore they are more likely to be relayed by the media.
Note that the classic “Thinking, Fast and Slow” by Daniel Kahneman is the non-fiction bestseller on Amazon at all times (yes, the one who popularised "loss aversion").
While behavioural finance mainly aims to better understand humans, behavioural interventions aim to create nudges to influence individuals to act. However, nudges are tricky because they are a double-edged sword: they can be used for a greater cause, or they can also be a tool for manipulation.
Let's see two opposite examples to illustrate the potential outcomes:
"Bad" nudges: online gambling companies want to increase conversion rate and limit customer churn.
The nudge: limit unsubscriptions by hiding the access to the "deactivation account" button while making a user-friendly experience to sign an account up.
"Good" nudges: people don't necessarily commit and plan to invest toward their future financial goals or old age (partly due to their "loss aversion").
The nudge: contribute to a mandatory retirement scheme for all citizens that guarantees a minimum pension.
The seductive study of behavioural finance makes it more accessible to the public, but perhaps it became too public. Nudge’s ethics are questionable. At the end of the day, who are we to decide for others?
What about financial planning?
To summarise:
Knowledge = Action
Knowledge + Behaviour = Action
There is no right nor wrong within the two type of planners.
The experts, who don't believe in behavioural finance study, are most likely to belong to the first category of people, i.e. they are homo economicus: they are rational towards their personal finance. Therefore, it's challenging for them to understand the other party, and they tend to be sceptical about the need for behavioural finance.
If you fall into the first category, congrats! You're one of the lucky ones capable of rationality when it comes to personal finance. Economic theories are compelling enough for you to manage your finances single-handedly.
However, as you're reading this newsletter, you're more likely to fall into the second category. You know basic economics and finance, but you're still reluctant to act. To circumvent those biases and be active in your financial planning, you must take a step further by mastering your relationship with money and nurturing your money mindset.
“Each person holds so much power within themselves that needs to be let out. Sometimes they just need a little nudge, a little direction, a little support, a little coaching, and the greatest things can happen.” Pete Carroll
Finally, if you're like me, I'll add a twist to the above equation:
Knowledge + Behaviour + Nudge = Action
Awareness alone is often ineffective. Behavioural finance is understanding human psychology and behaviour. Yet, awareness doesn't necessarily equal action. Hence, the need for behavioural interventions, aka nudges, to help you do what's best for you.
Do you need help budgeting? Saving more? Investing? Tracking your debt management? Or even someone who holds you accountable?
There are plenty of existing nudges out there (online resources, financial advisor, financial coach, a well-intentioned and knowledgeable peer...). All you need is to find out which one resonates the most with you to get your started!
So now, which category do you fall into and what's your nudge(s)?
The article was originally published on the Money Blueprint newsletter.
