The up-and-coming field of neuroeconomics combines both neuroscience and economics, focusing on refining economic theory using research about how our brains work. Robert Shiller, a professor of economics at Yale University, says that understanding the neural processes behind our individual and collective financial behavior could “shake economics to its foundation.”
The economic theory under the most scrutiny by neuroeconomists is utility theory, which claims that individuals are rational human beings and will therefore make decisions to increase, enhance, and (perhaps mathematically) perfect their happiness and well-being. As rational beings, we’ll always be looking to “maximize” our utility, making decisions solely on the basis of which potential option is “best.”
Unfortunately, that’s not always the case. Neuroeconomics has uncovered fundamental flaws in the theory, but also offers explanations for these cases of irrational decision-making.
Financial Decision Making: Risk
Economists talk about “risk” as a state of uncertainty regarding a set of possible outcomes in which the probability of each outcome occurring is known. In Economics, “Utility Maximization” theory claims that we – us rational human beings – should always opt for an outcome with high potential and low risk. For example: It would make sense for us to choose a $40 reward instead of gambling for the potential of $100.
Neuroscience disagrees, admitting that risk is not a uniform beast. That is to say, we all perceive and conceptualize risk differently. Part of this is unavoidable: some people are inherently risk-seeking, others risk-averse. Some people would rather gamble for $100 than accept $40 up front.
Additionally, we’re pretty bad with probability. We rely on certain heuristics to determine these “known” probabilities; and while this can be a useful way to rely on what is known to determine the unknown, it can also lead to counterproductive cognitive biases.
Determining whether or not your naturally risk-seeking or risk-averse may help you better understand why you can’t climb out of debt, fix your budget, or make progress building your emergency fund; and being as honest with yourself about “realistic” outcomes and opportunities can help you better assess the risk behind your financial decisions.
Affective Forecasting and Intertemporal Choices
One assumption of utility theory is that we make decisions based on what will make us happy, and affective forecasting is our ability to judge our emotional states at some point in the future. Just like probability, we’re not very good at it. (And many of those cognitive biases are to blame, such as the impact bias.)
Many of the financial decisions we make everyday have long-term consequences, sometimes intentionally and others not. Economists study these choices using “discounted utility,” which assumes our preference for events or outcomes is not reliant on when they occur. Under this assumption, if you’d rather have 2 candy bars than 1, it shouldn’t matter when you get them.
But again, that’s not the case. Interestingly, one study showed that participants who preferred to receive 1 candy bar today instead of 2 candy bars tomorrow would rather have 2 candy bars in 101 days instead of 1 candy bar in 100 days. Patience, apparently, is relative and time sensitive.
Separating Financial Decisions from Emotions: It’s Harder than You Think
Part of the reason why affective forecasting has been implicated in intertemporal choice is at the very heart of neuroeconomics: the brain area associated with these intertemporal choices—the limbic system—is highly involved in emotional processing. So even when you think you’re making unemotional decisions about long-term financial choices, you’re still using the same part of your brain.
Instead of trying to remove emotion from your financial decision making, try being even more cognizant of your emotions. It’s hard – if not impossible – to eradicate your own emotions (unless your Dexter Morgan); instead, treat them kindly.
Think about why you want a certain item, what emotions you’ve attached to it, what emotions you expect to feel as a result of it, what emotions you expect to feel without it. If you truly consider your emotions without just acting on them, you might find that they’re a much better guide than anyone would let you know.
Brain science ain’t easy. Neither is economics. But understanding your financial behavior is as easy and as difficult as understanding yourself. If you watch for your own patterns, consider your own behavior, and try to learn from yourself as much as you can, you’ll find it’s easier to adjust your finances than you think.
How much do you think psychology plays a role in your spending and saving? How do you think about this impact? Share your own psychological musings in the comments below.