Can psychology explain our dumb financial decisions?

We can trick ourselves into thinking we are taking the right risks with our money(iStock)

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Kahneman was awarded a  Nobel Prize in Economic Sciences in 2002 for helping develop behavioural economics, a field of study that delves into the psychology that clouds otherwise rational economic decision-making.

People often confuse certainty and safety. — Harold Evensky

In his  popular writing, Kahneman, a psychologist by training, walks readers through the mental cues that help us make up our minds. When it comes to financial decisions, we can often be tricked (or trick ourselves) into believing that we are making the right choice with our money because we often base those decisions on rosy projections, past performance, linked events or even mushy things like emotion and sentiment.  But that rarely leads to smart decisions or financial gains when it comes to investments.

These insights are particularly important for financial planners, who often become voices of reason when we are faced with challenging financial or economic choices.

While Evensky won’t talk about his famous client’s financial tendencies, he spoke with BBC Capital about how he incorporates teachings from behavioural economics in his own work.

BBC Capital: What have you learned from Kahneman's academic discipline that either stands out to you, or that you use with your other clients?

Evensky: The first is managing expectations…to help clients understand how they handle issues in different situations. [Behavioural finance shows that] if you give someone a choice of, say, a 100% chance that they will get $800,000 or an 80% chance that they will get $1,000,000 and a 20% chance they get nothing, they take the sure thing. Turn that around, a 100% chance of losing $800,000 or an 80% chance that they lose $1,000,000 and a 20% chance of losing nothing, they gamble.  It’s exactly the same question, but it helps client’s understand the difference between being risk averse and loss averse.

People are used to thinking that they don’t want to take risk. The reality is that most investors don’t want to take a risk to get rich, but they will take a risk not to get poor. This helps frame why investors need to be in stocks and not 100% bonds. There’s more risk than just the market going up or down, it’s [the risk of] not having enough money to live off of.

BBC Capital: Is there any area where faulty logic like that comes up again and again?

Evensky: People have significant challenges when it comes to mental accounting, or mental math. One example is dealing with linked probabilities. If you have a chain of four events, each assigned a 90% probability of occurring, the actually likelihood of your expected outcome is actually 66%. Which number are you making your decision on — 90% or 66%?

Similarly, losses hurt more than gains. A client came in after the tech bust — a retired surgeon, the classic curmudgeon. He said, “I don’t get it, I was up 80% last year, but down 60% this year and I’m under water. Shouldn’t I be up 20%?” Mental math prevents you from realizing that the gain from one year and loss from the next are not on the same basis.

BBC Capital: Have you found that people’s behaviour outside of their finances is reflective of how they act with money?

Evensky: In our experience, there’s really no correlation. Someone may like to bungee jump, but that doesn’t mean that they wouldn’t be a conservative investor. Those deeply concerned with the high cost of medical care down the road [and the need to have money to pay for it], may be highly comfortable [with the risks in] the financial markets. And someone who’s not as concerned may be scared to death of taking risk!

BBC Capital: How do you respond to a client who brings you a hot tip or investment idea?

Evensky: In these cases, we utilise some of the concepts in behavioural finance, the first is framing. [I say]  “I don’t know anything about that, tell me about it.” Then we hear all of the great things that could happen to their money…and [we] probe more about what could go wrong. Then we go back through their financial plan — and look at capital needs. [Then I explain] If it works, you can take an annual cruise around the world. If it doesn’t work, you have to work three more years. This gives them completely different visions.

BBC Capital: What about the biases people have around what they see as obvious — but might be wrong about?

Evensky: People often confuse certainty and safety. If they tell me “I don’t want to take risk,” I say “Go bury [your cash] in the backyard, but let’s look at the consequences to your life style.” Don’t trust social security? Then keep working. There are consequences to conservative decisions that might make them anything but conservative [choices].

BBC Capital: How do you get people to focus on decisions that are decades away, like their estate?

Evensky: [The sentiment is:] ‘Who needs it? I’m not going to live that long.’ What they forget is that it’s not just about the probability. If you start giving everything away and don’t die early, you’re stuck. Like everything, there has to be a balance. If they want to give away a lot of money to avoid taxes down the road, we’ll walk them back. If you have enough money to do everything you want to do, that’s fine, but don’t take the risk of going overboard to avoid taxes when you’re dead and then not be dead.