Behavioral Economics: The Psychology of Financial Decisions

Strategic Planning

Behavioral Economics: The Psychology of Financial Decisions

In celebration of best selling author Michael Lewis’s new book, The Undoing Project (about the pioneers of Behavioral Economics), I felt it appropriate to discuss my favorite example of Behavioral Economics that I have counseled my business clients on to help boost their profits.

Behavioral Economics is the psychology of how financial decisions are made. Behavioral Economics states that at its core, the human mind is fallible. One of the core concepts of Behavioral Economics is that of “Anchoring” which is defined as decisions that are based on a reference point despite no relevance to the decision at hand. Anchoring is a great example of how the human mind is fallible.

To illustrate Anchoring, an experiment was conducted where numbers between 1 and 100 were drawn at random by a group of people. The group was then asked a question that very few people knew the answer; what percentage of African countries makes up United Nations membership? The result of the experiment was the irrelevant random number drawn had an anchoring effect on the answer to the United Nations question. In other words, people who drew higher random numbers guessed a higher African United Nation percentage and vice-versa.

A practical example of this is when a home is listed at an above market value price. If the buyer is able to negotiate the price down (even if still above the market price), the buyer feels he is getting a “good deal” since the negotiated price is lower than the anchor point (original over-inflated price) despite the irrelevancy of the original listing price. This is but one of the countless ways to employ the Anchoring effect in the business context.

This is a powerful tool I have counseled many of my clients to ethically utilize in their business practices. For savvy businesses, knowing the “true” anchor point is the result of researching multiple relevant benchmarks to achieve the desired result.

If you need counsel on how utilizing Anchoring for your business can boost your bottom line, feel free to reach out to my office to schedule a consultation. Remember, the purpose of a business is to turn a profit. Do you want to boost your profits?