Why Many Personal Finance Decisions are Wrong

I regularly encourage Retirement Watch readers to fight their intuition when making personal finance decisions. The actions that people are most comfortable with and that are instinctive often are bad decisions. I know that from seeing the decisions people make and from conducting detailed, independent research before making a recommendation in the newsletter or web site.

There also is substantial academic and clinical research to support that view, including a Nobel Prize in economic science to Daniel Kahneman. Kahneman’s been conducting research on how people make decisions and concluded that most humans are “hard wired” to make the wrong decisions when following their intuition or instincts. He’s summarized decades of his research in a well-written book for the average reader titled Thinking, Fast and Slow. You can read a very good review of the book here. (Subscription might be required.) Take a look at it and see which of your own patterns you can identify. Recognizing a problem is the first step in fixing it.

This passage from the review addresses a topic that’s always concerned me: Drawing conclusions from limited data.

The first article they wrote together, titled “Belief in the Law of Small Numbers,” showed that even trained research psychologists had poor judgment about statistical inferences: The sample sizes of their experiments were often too small to support their conclusions. This problem, like so many others, had broad implications. Crucial policy decisions are often based on statistical inferences, but as Mr. Kahneman notes, we “pay more attention to the content of messages than to information about their reliability.” The effect is “a view of the world around us that is simpler and more coherent than the data justify.”

One major effect of the work of Messrs. Kahneman and Tversky has been to overturn the assumption that human beings are rational decision-makers who weigh all the relevant factors logically before making choices. When the two men began their research, it was understood that, as a finite device with finite time, the brain had trouble calculating the costs and benefits of every possible course of action and that, separately, it was not very good at applying rules of logical inference to abstract situations. What Messrs. Kahneman and Tversky showed went far beyond this, however. They argued that, even when we have all the information that we need to arrive at a correct decision, and even when the logic is simple, we often get it drastically wrong.