We individuals tend to pride ourselves on being rational, but that isn’t always, or even mostly, the case. Studies show that while we tend to think we make logical purchasing decisions, we oftentimes buy on impulse (emotion) and then afterwards, justify the purchase with logic.
A basic economic principle is that man will always act in his own best interest, but we know from experience that that isn’t the case. If it were true, then no one would eat or drink to excess and everyone would exercise and save an appropriate amount. So why, and when, do we tend to behave irrationally?
It seems that inaction is a dominant state amongst humans. Take the 401(k) plan for example. Previously, after satisfying the requisite waiting period, one had to request the paperwork from HR, determine how much was to be deferred, and choose where the deferral was to invested. Apparently, that was just too much for most people, as the majority of workers did not join.
Within the past few years, the dynamic has changed. Regulations now permit that employees will be automatically enrolled after the waiting period, unless they opt out. Apparently, opting out is too much work for most people, as the majority now enroll. Sunstein and Thaler cover this concept in detail in their book, Nudge.
Another concept that tends to diminish our rationality is relatively. We sometimes view things as percentages when we would be better served by viewing them as absolutes. Take the sale of a house, as an example. Let’s say the listing price is $500,000. You’re not desperate, but you want to sell it. If after being on the market for three weeks, someone offers $495,000, what would you do?
There’s no correct answer here, but many would accept the offer, rationalizing that it’s only 1% less than they asked for. And that’s true. But in this case, the 1% amounts to $5,000. How long do you have to work to earn $5,000?
Now compare that to selling (or trading in) your car. You want $25,000, but you’re offered $20,000. Same $5,000 difference, but a totally different reaction. Why? In theory, it should make no difference, as our net worth is impacted equally in both scenarios.
If we humans react so irrationally to such common items as these, you can just imagine the irrationality that abounds surrounding the purchase of a life insurance policy.
For those interested, Dan Ariely, author of Predictably Irrational, give an entertaining TedTalk on this topic.