We can all feel in our bones how wrong it is to look at people as “rational agents.” We know people and we know we don’t work like this.
Let’s spell out what is happening.
There are six broad reasons why it fails so miserably.
We are not really calculating machines. We are creatures of habit. When we aren’t actively thinking, we fall back on habits that drive our behaviors.
Habits are built from multiple influences in our lives: our environment, our early hobbies and interests, our family and friend’s influences. In most cases, they don’t always have a logic or reason. They happen to us and we get comfortable with them. We do not deeply think about why we brush our teeth - we accept it makes sense and now we run on habit. We need to do it every day to feel complete.
Habits equally apply to the decisions we make with money. What we buy, when we choose to spend. How we think about savings and investment. Habits play a much larger influence in the decisions we have subconsciously made vs. actual conscious decisions that we actively make every day
We have each picked up certain behavioral biases in the course of our lives. Certain leanings in our behavior that don't have a strong justification or might not be in our interest. The source of these biases come from several different places: our childhood experiences, the influences of fashion and trends, the pressure of our friends, past mistakes and events that result in us over-compensating or under-considering in the decisions we make today because we experience too strongly the potential for things to go wrong or go right.
The perfect machine needs all the right data to make their decisions. As normal people, we just do not have access to all of the data we need.
To get a good budgetary decision, our data sciences team at Bright estimates an average person needs to work with 23,000 data points every day. There is no way that each of us can hold and work with that much data.
Even if we have all the data, can we manage the math? Absolutely not. The systems required to make the optimizations are way beyond a set of 2 simultaneous equations, which we would have learned how to solve in school.
Our data sciences team estimates that a person would need to solve 57 simultaneous equations with 45 different variables in order to make the best decision. Even someone with a mathematics PhD does not have the energy to perform this calculation every day.
We have to consider our future selves. What happens tomorrow and what we want. What happens next month. What happens in future years, and our wants and needs at this time.
Future states of our world involve risk and uncertainty. They come with probabilities and probability distributions. As human beings, we cannot get our minds around multiple scenarios - the hundreds of potential scenarios in our future - and the potential probabilities of each. But really good decision making would require us to consider this and plan for this.
Importantly, we just physically do not have the time in our day to do this. Our data sciences team computes it would take 990 hours each day for a person to do this. Clearly, not one of us - no matter how well intentioned and how disciplined - has this kind of time every day. Yet these are decisions that will affect our entire future lives - for ourselves and our families.
So if we’re expected to be this perfect rational optimizer, we as people will just get it totally wrong. For all these reasons above.
Thankfully, there has been a tremendous growth in the research and understanding of these forms of behaviors. It has been driven by psychologists and behavior economists such as Amos Tversky, Daniel Kahneman, Dan O’Reilly, and Richard Thaler.
Through our childhood and teenage years we each have built a personal psychology to money, which drives our inclinations and daily decisions.
Our personal psychology is our core beliefs about how to treat money, and what types of decisions we get pleasure from. Some of us see money as a resource that can be easily replaced - it should hold no more special purpose other than a way to get more of the stuff we really love. Some of us treat money as something with special intrinsic value - we get pleasure just from seeing how much is in our bank account, regardless of how we spend it.
Some of us get pleasure from spending everything we can to the maximum, because spending feels good. Some of us get pleasure from accruing a savings account and seeing our savings pot climb every week or every month.
There are 9 specific dimensions that define our money psychology - MoneyGraphics - which I’ll discuss in more detail later.
When we think about people who have money problems, we typically think of people who are spending too much, probably growing too much debt. Many people do struggle with these challenges. In the US, there are 100 million people carrying credit card debit of $5,000 or more, and paying APRs of 20%+ on this debt. 42% of US households are spending more than they are earning every month. Helping to manage through spending and debt is a huge need.
There is also a group of us who can manage income and spending well - just about balancing the budget - but might struggle because we do not have enough savings and investment put aside. 64% of American households do not have enough savings within reach for even a $400 emergency need. How savings and investments are planned and grown gradually through life is also a big need area.
However, there is also another group with a problem that we miss.
My parents were young immigrants to the western world from India in their twenties. They struggled with high expenses relative to their income, because they had so few stable assets or other sources for help. They were a couple alone in the UK without family networks and support. Any single month of too much expense, and it could have financially ruined them as a young family - and they were acutely aware of this.
They were faced with a real life-challenging risk. They cultivated a very conservative mindset - always ensuring they were saving at least something every month, growing some form of safety net for themselves. With a decade of living like this, it molded their money psychology. They constantly lived with a sense of fear of future expenses and risks, and they were perpetually saving.
There is certainly a view that they were ‘model financial planners’. Managing well and setting up their future. But they went too far. They over-saved and did not learn how to spend for themselves well when they had the additional cash. When they reached later, more successful periods of their lives, they were never able to unlearn their over-saving mindset. They never learned how to enjoy consumption and spending for themselves.
Life is enriching and more enjoyable when we spend well for ourselves, reasonably but well-managed in every decade of our lives. We need good spending in every decade just as we need good saving. Too much of either and our psychology is skewed too much one way or the other. The end result is a life where we have not actually spent to the full extent of our means, where we have never learned to enjoy consumption to the extent that our life can enable.
The moral of the story is that good financial planning and money management also means learning to spend and enjoy the finer things in life, to the right extent, with the right moderation and managing for now, as much as the future. An unrestrained mindset of excessive saving - and constant under-spending - has many many negative effects also. Ultimately it is a life with under-developed interests and a life that has not been as enjoyable as it could have been.
Money management solutions are needed for both sides of the spectrum to enable people to save well and spend well in the right balance for every decade of their lives.
In my next post, we’ll dive into the financial tools available to us today – and start to look at the need for new ones, given how differently we understand our decision making today.