We all like to think that we're rational…
Rational Financial Behavior
by Gary Foreman
How to Waste Money
Before You Buy, Think Different
Mind Over Money
We all like to think that we're rational human beings and our decisions are based on facts and logic. After all, that's what intelligent people do. At least that's what we think they do.
It turns out that there's a pretty healthy controversy about that. For years, economists at the University of Chicago have promoted the view that people consider all the relevant facts and then make decisions based on what serves them best. They've even reduced many decisions to mathematical formulas.
Other economists say that humans can't possibly include all the relevant information in their decisions. There's just too much data for any person to rationally evaluate.
I think that both schools may be partially right. Let me relate a recent personal shopping experience to illustrate. I was in the market for a TV. I spent part of an afternoon researching the different models and pricing available, using both newspaper ads and online tools. Then I headed out to two local retailers to see what I could find. With a little negotiation, I got what I felt was a pretty good deal with the second local store.
Was it the absolute best (i.e. most rational) choice for me? That's hard to say. It is possible that there was a cheaper price or more full featured model available somewhere, but spending more time and energy searching for it didn't seem worth the effort.
Rational? I had a pretty good idea of what I wanted and what I would have to pay to get it. I shopped and negotiated to get the best price possible. Seems rational.
Yet, there was an emotional element involved. I was anxious to replace the TV that had failed. It was one that I watched almost daily, so I really didn't want to be without it for very long.
Again, was it a rational buying decision? Probably so. Emotion was part of the choice, but it didn't dominate the decision. I might not have gotten the absolute best TV or lowest price, but was probably pretty close.
Let's ask a different question. Will everyone arrive at the same rational conclusion? Is it possible for something to seem rational to you while seeming irrational to me?
For instance, if you're struggling to pay the rent, does it make sense to have cable TV? Or why are most lottery tickets sold in low-income neighborhoods? Cable TV might seem like a luxury (and compared to food it is), but if you're unemployed, TV might be your only escape from troubling thoughts. Or that lottery ticket might be a way to keep hope alive for a family that's never had much money or hope.
Don't get me wrong. I'm not advocating cable TV or lottery tickets. Nor am I condemning them. Just trying to make the point that we won't all define rationality the same way.
OK, so what does this mean to me? How does this affect my daily finances? It's an opportunity to evaluate how you make purchases and other financial decisions. It's a chance to consciously choose what things to include in your decision making.
By doing so, you might find that some of your choices have been overly emotional. You might identify some patterns or emotions that lead you to poor choices. It's even possible that you'll take a second look at what should go into a "rational" financial decision.
You'll also want to consider the assumptions that you used to make a decision. For instance, as gas prices rise, you might think that getting a newer, more fuel efficient car would make financial sense, but a little math could show that it will take many years and thousands of gallons of saved gas to pay for the new ride. It might seem like a rational decision, but if you look at the underlying assumptions, you find it's not rational at all.
We all like to think that we're making sound, rational decisions, but the truly rational thing to do is to periodically take a close look at how you make decisions. And, in so doing, make sure that your decisions truly do take your best interests into account.
Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and CreditCards.com. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.
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