The filed of behavioral economics repeatedly shows that we are not as rational as we think when making financial decisions. No big surprise there. But can we become more rational with our money? We can if we learn to spot our irrational tendencies and correct them. Lets look at some examples.
The Sunk-Cost Fallacy
The idea of sunk costs in economics is that once money is spent it is gone and should no longer be a part of a rational decision making process. For example, if you have spent a thousand dollars repairing your old car, and it now has more problems, you are inclined to keep spending because of the money already invested. But that money is gone, and shouldnt be a part of the question of whether you should spend more on the car or just sell it.
You will likely feel you have to continue spending on the car, especially if you just spent a thousand dollars and the car could only be sold for $500. Scientists have studied this effect of sunk costs in a number of ways. In one experiment they found that people are much more likely to attend a concert or other event if they paid for tickets rather than getting them free – even though the objective value of a given event is clearly not changed by how a person gains admittance. Again, the money is spent and so rationally has no relevance to whether or not a person should attend. But we feel a greater loss throwing away tickets that are paid for than those we got free.
To get back to the car repairs, lets put some numbers to the scenario. Suppose you just spent a thousand dollars on repairs, and you just discovered that the car needs six hundred more in repairs. You could sell the car for five hundred dollars as it is. Do you sell or put more money into it? Most people would be tempted to throw another six hundred at the problem car so they dont lose the thousand already spent. But of course that money is already lost.
Think of it this way: if the car will still be worth just five hundred dollars when repaired, does it make sense to effectively buy it for eleven hundred? After all, thats what the five hundred you can get for it and the six hundred you dont spend add up to. You should be able to buy a car that is worth eleven hundred for eleven hundred, right? You can see that its easy to get sucked into the sunk cost fallacy, thinking you somehow can salvage money already spent. Watch for this in yourself if you want to avoid expensive mistakes.
Another of the many ways in which we act irrationally in the marketplace is through what economists call extremeness aversion. To state it simply, we have a tendency to avoid the extremes for no rational reason. In other words, we are more likely to buy something other than the cheapest or most expensive couch when shopping for furniture. This may not seem like a problem, but behavioral economics research shows exactly how pervasive and irrational this tendency is.
For example, suppose you are looking at patio tables and the store has four models, priced at $140, $170, $200, and $500. The chances are good that youll buy one of the ones that costs $170 or $200. But interestingly, the research shows that if the store owners want to sell more of the $500 tables, all they have to do is add one that costs say $900. Now you are more likely to see the $500 one as reasonably priced. The technique has been proven to increase sales. The $200 table is still the same, and will function the same, but suddenly the $500 one is more appealing. If the $200 one is sufficient and a good value, this tendency to value things by comparisons with the extremes can be expensive.
These are just two examples of the kinds of tendencies being explored by the science of behavioral economics. There are many more, and seeing how we really make decisions about money might just help us become wiser financially.