Behavioral finance is the study of the emotional and cognitive biases that can lead to irrational financial decisions. While behavioral finance can help you make better decisions about investing your money, it can also be very helpful with respect to saving and spending. Nearly all aspects of financial decision making are influenced by emotions and biases embedded in the human psyche, and a good understanding of behavioral finance will help you optimize your personal finances.
You Probably Do Not Know the Odds
Base rate neglect, which involves ignoring underlying percentages, is a very good example of an irrational tendency that can lead to poor spending decisions. Assume that a man named Steve is “very shy and withdrawn, invariably helpful, but with little interest in people or the social world. A meek and tidy soul, he has a need for order and structure and a passion for detail.” Is Steve more likely to be a salesman or a librarian?
The instinctual answer is that Steve is more likely to be a librarian because the description fits the mental image of a librarian much better than that of a stereotypical salesman. Richard Thaler at the University of Chicago has asked this question to many people over many years; and, indeed, most people answer that Steve is more likely to be a librarian. In fact, Steve is 83 times more likely to be salesman than a librarian. There are more than 15 million salespeople in the United States and only 180,000 librarians; the fact that so many more people are salesmen as compared with librarians should be the biggest factor in your answer. But the brain does not function in such a logical way for most people. This phenomenon is often referred to as base rate neglect, or ignoring the base rate, and refers to the mind’s tendency to disregard the overall odds in a given situation.1
Playing the Lottery
It would be difficult to find a better example of base rate neglect than the lottery. Millions play the lottery in spite of odds that are overwhelmingly against winning the jackpot – about one in 40 million for the California jackpot. Headlines and news releases that feature exceptions to the overall odds are more memorable than the odds themselves, and the human mind’s over-reliance on memorable events can lead to poor financial decisions. This helps explain why the lottery is the most popular form of commercial gambling despite the fact that it has the lowest payout rate of any form of commercial gambling. The popularity of the lottery indicates that people do obtain value from playing, most likely excitement and entertainment. But research suggests that people do not account for the aggregate cost of playing over long periods of time. Participants tend to view each lottery ticket as an individual transaction, while ignoring the long-term cost of playing and the extremely low odds of success.2 This failure to recognize long-term costs is made worse by most people’s tendency to underestimate the time value of money. For example, over the course of 30 years, a $50 per month lottery habit costs more than $41,600 assuming a five percent interest rate with monthly compounding.
Base Rate Neglect in Action: Insurance Policy Deductibles
Insurance policies with low deductibles are an illustrative example of how consumers can routinely disregard the base rate. A homeowner’s insurance policy with a high deductible will generally reduce premiums between 10-25 percent. More expensive policies with lower deductibles are popular choices because many people fear paying a larger sum of money out of pocket in the event of a claim. That fact that is disregarded, however, is that the odds of filing a claim in a given year are only one in 10. Assuming that a consumer can save $125 annually by raising a deductible from $250 to $1000, total premium savings would amount to $1,250 over a decade. Even if a claim is filed during the 10 year period, consumers would still save $500 with the higher deductible policy ($1250 – the $750 difference between the deductibles). Many consumers pay far more for insurance premiums than would be considered rational in order to get low deductible policies. Higher deductible policies are even more beneficial for those that invest the money saved on insurance premiums.
Stay Focused on the Big Picture
A good understanding of the mind’s tendency to neglect underlying percentages can help you save, spend, and invest more wisely. Stay focused on the big picture; stop yourself from allowing instinctual impulses to make decisions that disregard the true odds involved with your situation.
1 Gary Belsky & Thomas Gilovich, Why Smart People Made Big Money Mistakes and How to Correct Them (Simon & Schuster, Inc., 1999), 111-112
2 Emily Haisley, Romel Mustafa, & George Lowenstein (2008) Myopic risk-seeking: The impact of narrow decision bracketing on lottery play
3 Gary Belsky & Thomas Gilovich, Why Smart People Made Big Money Mistakes and How to Correct Them (Simon & Schuster, Inc., 1999), 114
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, Calif. David serves as CFP Board Ambassador and Director at Large for the Los Angeles chapter of the Financial Planning Association.