3 ways to make smarter choices, according to the Nobel prize winner in economics
Have a hard time keeping up with your New Year's resolutions? Find it impossible to pass up a good sale even if you're low on cash? Refuse to pay for an overpriced drink when you're thirsty? If so, you've effectively broken the laws of traditional economics, but you've also confirmed over 40 years of research by American economist Richard Thaler.
Thaler, who is considered the "father of behavioral economics," received the Nobel Memorial Prize in Economic Science on Monday for his work on integrating economics with psychology. Thaler's research has helped economists understand that "human behavior often contradicts traditional economic logic," reports a University of Chicago publication, where Thaler teaches.
In his award citation, the prize committee focuses on three aspects of human psychology that Thaler's work explores:
- "cognitive limitations," which keep people from acting rationally
- "self-control problems," which prevent people from following through with plans
- "social preferences," which dictate whether people act out of selfishness or selflessness
Harvard professor Brigitte Madrian, who researches behavioral economics and household finance, tells CNBC Make It that recognizing these tendencies is very important when making decisions about how to invest your time and money.
While it's hard to overcome some of these tendencies outlined in Thaler's research, Madrian says, "the key is to recognize your shortcomings and then try to set yourself up to limit their effects when you're not in a vulnerable situation."
"Knowing what some of the traps are so that you can avoid them might not solve all of your financial woes, but it can make things better," she says.
Here are three ways to overcome these tendencies in your daily life and make smarter decisions.
Realize when you are spending irrationally
Thaler says "economics is based on the assumption that everybody is super rational, has no self-control problems, never has a hangover, saves exactly the right amount [of money] for retirement and then invests it perfectly," on CNBC's Squawk Box in 2015.
But people often aren't rational actors. "In myriad ways, we do things because we're human and we do things that are predictably different from what economists expect us to do and that causes problems when we start to make predictions," he says.
Instead, they do a kind of "mental accounting," which, Madrian explains, is like using a set of virtual mason jars for budgeting housing, food and travel. Each jar is a separate "mental account" for one component of your budget.
Mental accounting can both help and hurt us, Madrian says. It helps us simplify decision making, but it isn't a perfect system.
"It's like auto-fill on my iPhone. A lot of the time it's great because it helps me type faster, but occasionally it really screws things up," Madrian says.
In his research, Thaler proposes that "money in one mental account is not a perfect substitute for money in another account." That's why spending someone else's money may seem easier than spending your own.
When asked what he would do with his 9 million Swedish kronor ($1.1 million) in prize money, the laureate himself said he planned to spend it "as irrationally as possible," because it's in a different mental account.
"Anytime I spend any money [on something] that's really fun, I'm going to say that came from the Nobel prize," he jokes.
Balance your goals with your actions
Whether it's sticking to your New Year's resolution or opening a savings account, Thaler's research shows people struggle with meeting these goals because of the "planner-doer model."
As Madrian puts it, that means people often make plans but then don't actually see them through because of a lack of self-control.
"In myriad ways, we do things because we're human and we do things that are predictably different from what economists expect us to do and that causes problems when we start to make predictions," Thaler says.
Thaler uses the term "nudging" to describe when organizations and governments prompt you in beneficial ways, like by automatically enrolling you in a 401(k) plan or creating an automatic transfer from your checking to your savings accounts.
"If you want to get people to do something, make it easy. Remove the obstacles," he says in his book, "Nudge."
Understand why you want to do something before you do it
Thaler's work finds that people care not only about themselves but also about themselves in relation to others, Madrian explains.
"They care about being treated fairly. They care about what other people think of them. They care about fitting in," she says.
Thaler calls these "social preferences."
For example, when a mother with two children doesn't cut the last piece of cake into two exactly equal slices, the child with the smaller piece of cake is more unhappy than if there had been no cake at all, Madrian says.
Madrian adds that social influence can improve our decisions in some circumstances but make them worse in others.
"Sometimes we do things not because we want to do them, but because of peer pressure. Or we don't do things because we worry what people will think of us," Madrian says.
Though it may be challenging to overcome these natural psychological tendencies, Madrian says that finding ways to slow down decision making can help.
"Adopt rules that give you more time to deliberate. For example, my parents had a rule against spending more than $500 without thinking about it," Madrian says. "Enlisting the help of family or friends will also help you follow through on good intentions."
"They key is to recognize your shortcomings and then try to set yourself up to limit their effects when you're not in a vulnerable situation."
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