Foundations of Behavioural Science 

Are we rational?

The study of economics considers how people make choices between scarce alternatives to maximise their welfare. An underlying assumption is that we behave rationally, in the sense that the choices we make are logical and in our best interests.

We are assumed to be consistent in our decision making, so that if Alternative A is better than Alternative B and Alternative B is better than Alternative C, then Alternative A is preferred to Alternative C. We also efficiently trade-off current consumption against future consumption, to maximise well-being over our lives.

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But while this often maligned “economic man” (i.e. homo economicus) may be a reasonable description of how we should behave, over the last 50 or so years behavioural economists and psychologists have revealed that in many situations we (i.e. homo sapiens) do things that clearly contradict this view of the world and may contradict what is objectively in our best interests.

The behavioural scientists found that in many situations, rather than rationally weighing up alternatives, we use mental short cuts or heuristics to guide our actions. While appropriate under some circumstances, in others they result in very poor decision making and judgement.

These biases in our thinking cannot be totally eliminated, as most of them are the result of evolution and are hard-wired into our brains. However, if you want to make smart decisions on a consistent basis it is important to be aware of and compensate for these inbuilt “irrational” flaws that afflict us all.

Below, we discuss a number of the well documented psychological biases and preferences that may impede effective decision making. Knowledge is the first step to taking corrective action:

“All truths are easy to understand once they are discovered; the point is to discover them.”
Galileo Galilei

The discussion draws heavily on the work of psychologist, Professor Daniel Kahneman (Nobel Prize in Economics, 2002), particularly his paper, "Aspects of Investor Psychology". We also wish to recognise (and recommend) Jason Zweig's book, "Your Money or Your Brain", which is an excellent resource for those seeking more information on this subject.

Behavioural scientists have identified many psychological biases that may interfere with rational decision making. Go to Warning: Psychological biases dangerous to your wealth to understand a few of the more important biases and their implications for making smarter financial decisions. The biases and preferences discussed include:

  • Prediction addiction;
  • Hindsight bias;
  • Regret
  • Over confidence;
  • Herding;
  • Loss aversion;
  • Framing;
  • Undervaluing the future;
  • Mental accounting;
  • Anchoring.

We recommend a number of principles to practice to help overcome the behavioural biases that detract from successful wealth management. A list of these is shown below and can be read in detail by going to Behavioural science and successful investment practice:

  • Learn to embrace uncertainty;
  • Avoid focusing on short term movements in your portfolio;
  • Look at the big picture;
  • Avoid being over confident;
  • Don’t look back;
  • Learn to think independently of the crowd.

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