Behavioral economics: why we spend money unwisely and what to do about it

In 1989, the MMM company appeared in Russia, which was engaged in the sale of office equipment. Later, the organization changed its direction of activity more than once, and in 1993 it began to sell its shares - a total of 991 thousand were issued. Investors were promised big profits, stock prices rose. All this was fueled by a wide advertising campaign, the face of which was Lenya Golubkov, a character who either bought boots for his wife or went to the States with money from his contribution.

MMM planned to issue a new batch of securities, but the Ministry of Finance rejected the request. And then the company distributed the so-called tickets, which mimicked shares, but they were not. However, they still managed to attract investors, they were rapidly buying up these "assets". Later, the ticket turned into a souvenir for those who made “voluntary donations” to the founder of MMM, Sergei Mavrodi. It was assumed that when a person decides to withdraw his money, he will also receive it in the form of a donation from Mavrodi.

There is no intrigue here, "MMM" has become one of the largest financial pyramids in the history of Russia. About 10 million man, having lost 70–80 billion dollars.

It would seem that the Russians should have received a mass vaccination against similar schemes. But in 2011, Mavrodi announced the creation of a new MMM, and he did not hide the essence of the project. On his blog, he wrote: "It's a pyramid, if you like that word so much." And he also had followers.

How so? This seems illogical: in money matters, it is easiest to make rational decisions, because everything can be calculated. But alas, even where people strive for profit, they act irrationally. And science even knows why.

What is behavioral economics and what does it have to do with it

For a long time it was believed that any economic agent - from a company to a household and a single person - decision making is based on rational arguments and pursues specific goals. This is what classical economics suggests.

However, this did not quite fit in with practice, because the human factor interfered with the matter. In situations where a profitable decision was obvious and calculated, specific people acted quite differently. And then it became clear to scientists that psychology could not be excluded from the equation. The prerequisites for this appeared as early as the 18th century, when the economist Adam Smith wrote about the phenomenon that would later become known as loss aversion (we will discuss it in detail a little later). Other theories have also emerged.

However, the search for links between how financial decisions are made and psychology was taken seriously in the second half of the 20th century. The Israeli psychologists Amos Tversky and Daniel Kahneman (the latter even received the Nobel Prize in Economics in 2002 for this). They tested how economic models of rational behavior correlate with actions under risk and uncertainty. And, as you can guess, rationality lost in this battle.

It turned out that the way people deal with money is influenced by many different factors - cognitive, cultural, emotional, social. The science that studies this is called behavioral economics.

What makes us make irrational choices

We are not perfect and do not always act rationally - it doesn’t pull on the opening of the century, right? But why are we so surprised that even a few years after the exposure of Mavrodi, people gave him money? The fact is that we observe the event out of context and use completely different inputs. Inside the situation, a person also makes, in his opinion, the right, profitable decision - no one plans to burn out or stay in the red. Another thing is that the result may differ from expectations.

From the point of view of classical economics, people act based on all available information. And most importantly, they have unlimited time to think and calculate options. The reality is different: there is often no time to think, uncertainty puts pressure on a person, he risks his money or possible profit. And it is also influenced by many so-called heuristics - mental techniques that can lead to errors. The list is long, but here are some of them.

Loss aversion

Remember we already talked about this above? This principle of behavior is generally characteristic of people. The proverb about a bird in the hand, which is preferable to a crane in the sky, illustrates it very well.

So, Kahneman and Tversky spent experiment. Students were offered $10 for a chance to win some money. They agreed to risk only when the winnings were twice as much as the amount originally wagered. This is due to the fact that losses and defeats we perceive sharper than acquisitions.

That is, people are generally ready to take risks if they can get at least twice as much as a result.

This principle explains why someone spends years in a job they hate for the sake of a stable salary. After all, this money comes regularly, but who knows what will happen next. It also illustrates the desire of some people to invest in a financial pyramid over and over again. They promise high profitability there - what if it burns out? (Spoiler: unlikely.)

mental accounting

Paradoxically, we value hard-earned money more than easy money. And we spend them in different ways. What is obtained by the sweat of one's brow, it is a pity to lower it to "nonsense". It is unlikely that you will want to pay for the whole company in a restaurant with them or buy lottery tickets for them. But the amount won or donated can be spent overnight.

From the outside it looks strange. After all, a thousand rubles is a thousand rubles. And if a cash-strapped person finds a bill on the road, it's more rational to take it to the grocery store, not to the bar. But in practice, few will make such a decision.

Mental accounting interferes with our spending on another level. Suppose someone earns a little and therefore leads home bookkeeping. He puts his hard-earned money into envelopes: part for food, part for vacation, part for entertainment. However, he may treat each of these categories differently. For example, limit yourself in everything in a supermarket, book the cheapest hostel for a vacation, but invite 40 people to a restaurant for your birthday. It would seem that invite 30 guests and settle in a hotel with three stars. These are not monolithic amounts, banknotes can be transferred from one envelope to another. But the different value of money, depending on the items of expenditure, does not allow us to do otherwise.

By the way, another Nobel laureate Richard Thaler is involved in the discovery of mental accounting - already an economist, not a psychologist.

Availability Heuristic

It is impossible to know everything, but also to remember. And therefore, when making decisions, we are based on the data that we have and that the brain carefully throws at us. And this applies even to people who are "in the know." For example, investors can buy and sell shares based on breaking news, and throw out other facts from the agenda.

Action bias

You don't even need to imagine anything to understand how it works. Suffice it to recall how in almost every crisis situation there is a queue at the ATMs. When trouble happens, people arises the impulse to act, to do something. This helps you gain a sense of control over the situation and believe that you are somehow solving the problem.

Accepting that you have no influence on anything, and waiting out can be much more difficult. This task becomes almost impossible if it seems that society expects some kind of body movements from you. At the same time, they will not necessarily be rational, it is important to do at least something.

Uncertainty aversion

People are more likely to choose the known over the unknown, including preferring certain risks over uncertain ones. This is confirmed by experiments. Yes, in front of a person put two bags containing 100 black and red marbles. It is known that one of the bags contains 50 red items. There is no information about the second one. A person is offered to draw one ball from any bag and is promised a reward if it turns out to be red. And people usually choose the first one. Although who knows (except researchers) what is the ratio of balls in the second - maybe almost all of them are red.

Why you need to know about behavioral economics

With so many factors influencing how a person makes financial decisions, it can be assumed that predicting someone's choices is unrealistic. The Great Random comes into play, there are too many options for the outcome. But it was not there.

Kahneman and Tversky succeeded in proving that people don't just act irrationally. Approximately at 70% cases they make the same choice.

It is important to understand that an irrational decision does not necessarily mean a bad one.

Say, in the 90s, your relatives listened to the words of a friend that the vouchers of a resource company looked more reliable than MMM. This choice cannot be called deliberate, it is based on someone else's opinion, and not on a wide range of facts. But it is unlikely that the family regretted this decision. Or, let's say you bought a product because you saw it yesterday in advertisingand he is really good.

However, understanding behavioral economics doesn't just help you understand what makes people tick (and maybe sometimes judge them a little less). This allows you to make more informed, rational decisions. Because if you're not interested in behavioral economics, it's still interested in you. Or rather, how to push you to one or another choice.

It was this topic that was explored by the Nobel laureate Richard Thaler, whom we have already talked about. In his opinion, since people make predictable mistakes, this can be used to your advantage. This approach is called the architecture of choice. Its essence is to offer a person such options and in such a way that he chooses the right one.

Clearly this opens up for marketers bright prospects to take your money. For example, one of the heuristics is that we often prefer not the profitable option, but the one that requires less effort from us. Subscription services take advantage of this: they simply turn on auto-renewal. To save money, you need to find time and energy and unsubscribe. If we are not talking about a large amount, many will simply forget to do it month after month.

But forewarned is forearmed. So you can easily resist the "architects" and make more informed decisions.

How to use your understanding of behavioral economics to your advantage

To begin with, it is worth remembering that an irrational step is not always wrong. And sometimes not much depends on the result of the decision. Let's say if you take pasta from the shelf, succumbing to the tricks of marketers, nothing bad will happen. Therefore, it is worth allowing yourself to choose impulsively, if we are not talking about something serious.

When it comes to important things (and not just financial ones, the principles of behavioral economics apply to any choice), the key to success is self-discipline. To make more rational decisions, you have to slow down and not act in a hurry. This will reduce the influence of emotions and other distractions.