The Investor: How the Lolly Choice has Changed
The economists have given up on the idea, and it’s time the rest of us did too. I’m talking about making financial decisions based only on the cold hard facts and numbers, and not taking into account emotional and psychological factors.
5 May 2012
Back when my biggest financial decision was whether aniseed balls were a better buy than licorice straps, the academics who studied the way people made such decisions assumed we were all rational.
© 2022 Mary Holm, NZCity
They might, for example, have told me to look at which purchase gave me more ounces of lolly to the penny. They might also have suggested I make an adjustment for which flavour I preferred. But they probably wouldn’t have allowed for the fact that it was much cooler to be seen chomping through a licorice strap.
Since then, though, behavioural economics and behavioural finance have emerged. Researchers have observed many tendencies - such as following the herd, concentrating on sunk costs, or paying too much attention to the recent past – that lead us to make financial decisions likely to leave us worse off.
It’s been quite a breakthrough. By being aware of these tendencies, we can watch the way we invest and – maybe - modify our behaviour. If we don’t modify what we do, we can at least be aware that we made a less than optimal decision and understand why.
Thus far, though, most of the research is about investing in shares, managed funds and the like. There’s not as much written about other financial decisions.
Two letters from readers at two different life stages got me thinking about this recently.
One letter was from a graduate wondering whether to repay his student loan quickly. He knows that, because the loan is interest-free, he would be better off earning interest on his spare money while repaying the loan at the slow compulsory rate. But he just wants to get the debt off his shoulders.
The other letter was from a woman wondering if she should move from a home that she loves and has worked hard to set up. The trouble is the neighbourhood is “slowly, ever so slowly sliding”. Also, “medical specialists are thin on the ground”, and she knows she’s going to need them. Should she move to be closer to them?
There’s no single right answer to either person. In the woman’s case, we don’t know whether she’s concerned that the value of her house might fall, perhaps reducing a legacy, or that she fears for her security.
If it’s the latter, she should probably get out. Home isn’t really home if you don’t feel safe in it.
But if it’s financial, it’s trickier. And the medical specialist issue probably comes down to money, too. Presumably the woman could use taxis to get to the doctors, if she has the cash.
My vote, in both cases, is to go with the heart, not the head. Be aware of financial issues, but don’t let them always dominate.
If the graduate would love to be debt-free, he should be. If he’s in a position to repay his loan fast, that suggests he is financially comfortable, so he might as well use some of that money to be emotionally comfortable.
Similarly, if the woman really wants to stay in her home, she should do so – and one way or another make the medical thing work.
I’m not saying everyone should spend money to feel good. Too many people do too much of that. But some people give too much weight to financial considerations at the expense of their general wellbeing.
You know who you are.