The psychology of financial decision-making and economic crises

September 22, 2010

How could the current financial crisis have happened? While fingers have been pointing to greedy banks, subprime-loan officers, and sloppy credit card practices, these are not the only contributors to the economic downturn. A new report in Psychological Science in the Public Interest, a journal of the Association for Psychological Science, examines the psychology of financial decision making, including the role of risk in making economic choices, how individuals behave in stock and credit markets, and how financial crises impact people's well-being.

Risk taking is a very important component of financial decision making--If we take out a big loan, will we be able to pay it back? Should we buy shares of a company that is unknown but has potential for great success? In this report, authors Tommy Gärling (University of Gothenberg, Sweden), Erich Kirchler (University of Vienna, Austria), Alan Lewis (University of Bath, UK), and Fred van Raaij (Tilburg University, The Netherlands) note that when it comes to making decisions under uncertainty, people tend to be more influenced by perceived risk than by objective risk. People who are extraverted and high in sensation seeking are likelier to take more and higher financial risks than are people high in conscientiousness and anxiety. "The general implication is that financial crises may have more serious consequences for people who are more likely to take financial risks," write the authors.

Efficient-market theory states that stocks should always be traded based on their real value. However, 5 minutes on the floor of the New York Stock Exchange reveals a different reality: Stock investors overreact to news (especially of events that threaten the world economy), selling winning stocks too soon while hanging on to losing stocks too long, and following other traders' leads in buying and selling stocks. According to Gärling and his colleagues, stock market investors are prone to cognitive biases (such as overconfidence), which are reinforced by affective and social influences and these may contribute to several phenomena observed in stock markets (e.g., volatility of stock prices, due to excessive trading).

Many people rely on credit, not just the plastic card kind, but also in the form of automobile financing and loans from friends. Credit use involves many different stages of decision making, including deciding whether or not to purchase a product using credit and determining a strategy for paying back the borrowed money. The authors observe that "many credit users are facing a complex task when they decide to take up credit and that they often fall prey to cognitive errors when anticipating their experiences with credit payback."

Financial crises take a large toll not only on people's wallets, but also on their behavior. Consumer confidence affects spending and saving. Individuals cope with financial crises in a number of ways, for example by shopping in cheaper stores and eating out less. Making lifestyle changes (e.g., selling the car, making their own clothing) is very difficult for most people and is often a last resort to dealing with economic troubles--these changes clearly signal to themselves and others that they are struggling financially.

Are financial crises inevitable? The authors argue that bringing about change in financial institutions may not be easy, but they offer suggestions for improving economic decision making. For example, educating consumers--by offering economics courses to children in school and teaching consumers how to appropriately handle credit--and by making financial institutions more responsible (e.g., banks offering Web-based programs to assist with budgeting).
-end-
For more information about this study, please contact: Tommy Gärling at tommy.garling@psy.gu.se.

Psychological Science in the Public Interest is a journal of the Association for Psychological Science. It publishes an eclectic mix of thought-provoking articles on the latest important advances in psychology. For a copy of the article "Psychology, Financial Decision Making, and Financial Crises" and access to other Psychological Science in the Public Interest research findings, please contact Keri Chiodo at 202-293-9300 or kchiodo@psychologicalscience.org.

Association for Psychological Science

Related Decision Making Articles from Brightsurf:

Knowing the model you can trust - the key to better decision-making
As much of Europe is engulfed by a second wave of Covid-19, and track and trace struggles to meet demand, modelling support tools are being increasingly used by policymakers to make key decisions.

Happy endings trip up the brain's decision-making
The brain keeps track of the value of an experience as well as how it unfolds over time; overemphasizing the ending may trigger poor decision-making, according to new research published in JNeurosci.

Automatic decision-making prevents us harming others - new study
The processes our brains use to avoid harming other people are automatic and reflexive - and quite different from those used when avoiding harm to ourselves, according to new research.

Mapping the decision-making pathways in the brain
Scientists at the Okinawa Institute of Science and Technology Graduate University (OIST) have identified a new area of the brain that could be involved in cost-benefit decision-making.

How the brain's internal states affect decision-making
By recording the activity of separate populations of neurons simultaneously, researchers have gained an unprecedented insight into how the 'waxing and waning' of our mental state influences the decisions we make.

Motherhood overrides the brain's decision-making
Motherhood takes over the brain's decision-making regions to prioritize caring for offspring, according to new research in rats published in eNeuro.

Get it over with, or procrastinate? New research explores our decision-making process
New research from the UBC Sauder School of Business may have figured out why.

Illuminating interactions between decision-making and the environment
Employing a game theory model, University of Pennsylvania researchers demonstrate how strategic decisions influence the environment in which those decisions are made, alterations which in turn influence strategy.

Lung cancer screening decision aid delivered through tobacco quitlines improves informed decision-making
Researchers from The University of Texas MD Anderson Cancer Center have shown that a decision aid delivered through tobacco quitlines effectively reaches a screening-eligible population and results in informed decisions about lung cancer screening.

A molecular map of the brain's decision-making area
Researchers at Karolinska Institutet have come one step closer toward understanding how the part of our brain that is central for decision-making and the development of addiction is organized on a molecular level.

Read More: Decision Making News and Decision Making Current Events
Brightsurf.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com.