The study of human behaviour, which has traditionally come under the umbrella of psychology, would seem to have little relationship with economics.
But, as we learn more about how the brain works through the dual disciplines of neuroscience and psychology, there is an increasing marriage with the field of economics, in order to better understand how people make financial decisions.
This has evolved considerably in recent years and is an emergent field that deserves a little introduction and explanation.
The traditional view of economics and financial decision-making
It is sometimes forgotten in economics that the field is meant to be about the behaviour of people when making financial decisions.
The traditional economist’s view is that the world is populated by unemotional, logical, decision makers, who always think rationally in drawing their conclusions. This view is underpinned by the understanding that human behaviour displays three key traits: unbounded rationality, unbounded willpower, and unbounded selfishness.
This has always flown in the face of the findings of cognitive and social psychologists, who questioned these assumptions as far back as the 1950s.
With the rise of behavioural neuroscience since the 1980s (especially Kahneman’s work) providing more insight into the workings of the brain, we are now more sure than ever about the role that emotion and bias plays in all decision-making: from simple day-to-day decisions like which dress to wear, through to larger decisions that may affect many people.
Overconfidence and optimism are two examples of behavioural traits that may lead to sub-optimal financial decision-making, and divert from the traditional model used. People have also been shown to make poor decisions, even when they know it’s not for the best, due to a lack of self-control.
So this is where behavioural economics has been able to step in and modify many of the beliefs of the traditional economic views.
What is behavioural economics – and how can it help?
Behavioral economics and behavioral finance study the effects of psychological, social, cognitive, and emotional factors on economic decisions.
This may apply to individuals or institutions, and involves looking at the consequences for market prices, dividends, and resource allocation.
Of the three traits of human behaviour included in the traditional model outlined above, unbounded rationality has received special focus, with new understandings in the field resulting from neuroscience.
Understanding better how people arrive at financial decisions can help in many areas: from personal finance to organisations shaping products and trying to get more customer sign-ups; and from the vagaries of stock market trading through to governments and how they formulate financial legislation.