Underpinning the field of traditional finance is the assumption that people, when faced with financial decisions, act like computers. They weigh all the available information, calculate the option that maximizes their interests and unemotionally implement their decision.
Another school of economic thinking known as behavioral finance which combines insights from economics and psychology, offers a different theory: While it accepts the premise that people try to make rational, informed decisions that serve their self-interest, in reality, they are subject to a variety of cognitive and psychological constraints that result in less than ideal choices and behaviors.
Among these constraints are three limitations in cognitive and behavioral abilities that prevent us from acting in a computer-like fashion. These limitations, or “boundaries,” in human decision-making, have spawned significant research into the areas of personal saving, spending and investing.
Bounded rationality. In the mid-1950s, Herbert Simon, a cognitive psychologist and Nobel Laureate in economics, introduced the principle of “bounded rationality." In simple terms, bounded rationality presumes that humans lack the mental capacity to solve complicated, real-life financial problems, meaning, some problems are simply too complex for individuals to solve quickly and correctly.
The implication is not that most people are unintelligent, but rather, even the smartest among us, when confronted with difficult financial situations and tight time constraints, often can’t collect the necessary data, assess it and make fast and accurate choices. Instead, they resort to “rules of thumb” and other mental shortcuts to simplify the process. The result tends to be a quick — but subpar — decision.
Bounded self-control. Another tenet of classical finance is that when people acquire new knowledge, they will change their behavior, if warranted. For example, if they recognize they are spending too much today and saving too little for retirement, they will reduce spending and increase savings consistent with that goal.
Research in behavioral finance however presents a strong argument, that in real-life, there is a disconnect between knowledge, intentions and behavior. Put another way, even when we know what we should do and what we want to do, we lack the ability to take action. Even when we do change our conduct to align with our understanding and desire, we eventually lose our resolve and revert back to our old ways. We experience this conflict between comprehension and action in virtually every aspect of our lives, from the way we treat our bodies (e.g., poor nutrition and lack of exercise) to the way we handle our finances (e.g., over-spending and under-saving). The reason? In a research paper published in 2000, titled Behavioral Economics, Sendhil Mullainathan, from MIT and Richard Thaler from the University of Chicago described this psychological disconnect as “bounded self-control," or, more simply put, a lack of willpower.
Bounded self-interest. Traditional economic theory assumes that individuals behave in a way that maximizes their own welfare and cannot be expected to sacrifice their own interests to help others. Thus, human beings are selfish rather than selfless. Behavioral economics and fortunately real life teach us otherwise. We see people every day acting selflessly, sacrificing their own interests including time and money to help others. In the same 2000 paper Mullainathan and Thaler put a name to this altruistic behavior, calling it “bounded self-interest." While acknowledging that many of us do try to look out for our own interests generally, the authors found that we are far more altruistic than traditional economists assume.
In future articles, we’ll dig deeper into these concepts of bounded rationality, bounded self-control and bounded self-interest and see how they apply to our own saving, spending and investing behavior.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions. John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com