- Behavioral economics is the effort by psychologists and economists to create more realistic economic models that take into account people’s occasional irrationality when making choices.
Irrationality in Financial Markets
- Examples of irrationality can be found in the tendency of the stock market to go up on sunny days and down on cloudy days and to go up in a country whose national soccer team wins (and down when it loses).
- People tend to be risk averse for possible gains and risk seeking for possible losses. Framing choices as losses versus gains therefore yields irrational—or at any rate, inconsistent—patterns of choice.
- People are susceptible to the sunk cost fallacy. They are inclined to consume something (for example, go to a play or a sporting event), even when it no longer has positive value to them, in order to be "economical" and not "waste" the money already paid for the item.
- People keep separate mental accounts when they would be better off having a single mental account for all of their assets.
- Too many choices can result in decision paralysis. The more things you have to choose from, the less likely you might be to choose anything.
Getting Started on Your Own Financial Planning
- Some simple rules about money will have a big impact on your wealth: save early and often, diversify, invest in mutual funds rather than specific stocks or bonds, set up a payroll deduction plan, and for heaven’s sake, avoid paying the huge interest on credit card balances.