ITHACA, N.Y. -- The science of economics explains how money behaves (as if rational people were handling it) but not the details of how people behave around money (sometimes unwisely).
That's why we need the emerging science called behavioral economics, says Thomas Gilovich, co-author of the first layman's book on the subject.
"We're pretty good at making rational, consistent, self-interest decisions about many issues in life," says Gilovich, a specialist in human decision-making and judgment, and co-author, along with financial journalist Gary Belsky, of "Why Smart People Make Big Money Mistakes" (Simon & Schuster, 1999). "But a number of faulty mental habits lead us astray -- and cost us dearly."
His new book, Gilovich says, "is about the cognitive and motivational shortcomings that make even smart people act unwisely with their money."
Ever the academic, Gilovich contributes to the book a mercifully brief history of conventional economics and of the newer behavioral economics, which has coalesced in the last 10 years with a literature of its own, but which so far has failed to reach the money-muddled general public. Behavioral economics, Gilovich says, helps us understand how such human foibles as "loss aversion" and the "sunk cost fallacy" lead people to throw good money after bad. Or why tendencies like "anchoring" and "confirmation bias" produce dumb money decisions based on unimportant information.
Conventional economics, with its expectation that people make money decisions in their own self-interest, has trouble explaining one of the most common human behaviors: People giving money away, without a clear obligation to do so, to people they will never see again in places they probably will never revisit, for a level of service that may not have even pleased them. It's called tipping.
"Yet, more than 95 percent of us tip food servers, so there must be more than pure economics at work," Gilovich says.
A dollar here and there add up, of course, but the authors are equally concerned with the big-money boo-boos. (See "Four Lessons from the New Science of Behavioral Economics," attached.) Why, for example, do so many investors sell stocks just before the share prices skyrocket or hold onto lousy stocks until they plummet?
A fundamental misunderstanding of how numbers work probably explains why many workers are happier with a 10 percent raise when the inflation rate is 12 percent than with a 3 percent raise in years of 4 percent inflation, according to the Cornell psychologist. And simple arithmetic and risk-analysis should guide people to bank the extra insurance premiums they pay for low deductibles, ignoring the fact that a couple of years' worth of saved premiums would more than cover any loss. But they don't.
Gilovich and Belsky fill their book with anecdotes about seemingly smart people they know who made bad money decisions, supplying self-tests to help readers apply behavioral economics to their own decision-making.
"This isn't 'Economics for Dummies,'" Gilovich says. "Some of these principles
are counterintuitive, and even many experts who should know better -- myself
included -- sometimes misunderstand or fail to apply them." He offers an
exercise in probability theory from the television game show "Let's Make a
Deal":
Game show host Monty Hall offers a choice of three doors, advising that two doors conceal goats and only one has a valuable automobile behind it. You indicate Door Number One, and after doing so, Monty Hall opens Door Number Three to reveal a goat. He asks: "Now, are you sure you don't want Door Number Two?"
"You'd be smart to switch to Door Number Two," Gilovich says. "Your original choice gave you a one-in-three chance of landing the car. Because Monty would never open the door concealing the car -- that would end all suspense -- your one-in-three odds still apply. But you win, 67 times out of 100, if you switch."
When that solution was published in "Parade" magazine, numerous professional mathematicians protested. Closer examination showed them to be wrong, Gilovich says. Even the experts can be confused by the laws of probability.
The Cornell psychologist uses similar examples, including deceptively simple coin-toss exercises, to make a point in the university classes he teaches in social psychology and statistics. His research on decision-making and the fallibility of human judgment was published in an earlier book, "How We Know What Isn't So" (Free Press, 1993).
A knowledge of numbers helped Gilovich earn extra money for graduate school as a professional gambler, using the card-counting technique at the blackjack table. He doesn't recommend that any student follow his financial-aid strategy. But if someone insists, the gambler-turned-professor has one piece of advice: Refuse the free drinks that casinos offer to high rollers.
"The way numbers work is confusing enough," he says. "You need a clear head to play with money."
Four Lessons from the New Science of Behavioral Economics
from "Why Smart People Make Big Money Mistakes"
by Gary Belsky and Thomas Gilovich
-- Raise your insurance deductible. The tendency to overweight memorable events, like the time the tree fell on the garage, and the failure to understand the odds of potential hazards, lead people to overestimate the likelihood that they will have to file an insurance claim.
-- Pay off credit card debt with "emergency" savings. The average interest on credit cards is 16 percent -- much more than savings accounts or money markets pay. If an emergency comes, the credit card company will be happy to lend you money.
-- Switch to index funds. A failure to understand the odds against beating the market -- and overconfidence about their abilities to do so -- causes many investors to pick their own stocks.
-- Keep track of the nickels and dimes. One of the best ways to understand the behavioral-economic factors that affect the way you view and handle money -- especially the ways in which the bigness bias leads you to pay too little attention to small numbers and amounts -- is to track your spending.
Related World Wide Web sites: The following sites provide additional information on this news release. Some might not be part of the Cornell University community, and Cornell has no control over their content or availability.
Simon & Schuster: http://www.SimonSays.com
Cornell Psychology Department: http://comp9.psych.cornell.edu/
Thomas Gilovich: http://comp9.psych.cornell.edu/faulty/people/Gilovich_Thomas.htm