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Sep 05

1992, an Apple or a Donut, and Irrationality

So if you’re anything like me, you started off your “connected” day checking your email and social media connections, like facebook and twitter. 

Well, on my News Feed this morning was a video from my friend Ed Conarchy that was not only cleverly constructed, but for me contained a message that struck home.  Ed’s not only a 20+ year mortgage professional, but he’s also a licensed financial advisor, which enables him use a holistic approach in helping his clients.  Ed not only insures that his customers get the right mortgage, but also helps them maximize wealth by addressing liquidity, diversification, rebalancing and long-term investing.

So back to Ed’s message.  Listen as he cleverly describes an economic scenario, eerily similar to the current environment …

More on what Ed had to say in a moment, but before I go there …

I recall a conversation I had with a good friend, Jim Campbell, back in San Diego during one of the more severe recessions that occurred earlier in my career.  Jim’s an incredibly talented cabinet maker and was noting how his business was off, because customers were concerned about the outlook for the economy.  It wasn’t that they didn’t need to remodel their kitchen, nor that they couldn’t afford to do so at the time.  It was just that they had lost confidence in the future, and were going to “wait it out.”

AppleOrDonut

Academia will refer to the study of consumer behavior as Behavioral Economics.  In her Summer 2009 article “An Apple or a Donut? How Behavioral Economics Can Improve Our Understanding of Consumer Choices”, Carolina K. Reid, PhD, Manager, Research Group, Community Development Department,  FRB San Francisco writes:

“ … Behavioral economists focus on research that explains why people often make choices against their best interests, even when they know better. This research is increasingly coming to the attention of policy-makers interested in influencing consumer choices in the financial marketplace, and many of the principles of behavioral economics are being used to inform everything from retirement savings programs to credit card and mortgage loan disclosures.

So what is behavioral economics, and how is it different from traditional economic theory? Simply stated, traditional economic theory generally assumes that individuals make rational decisions based on the information they have (e.g. knowledge about a financial product) and their situation and resources (e.g. income). This individual—homo economicus—makes rational, unbiased decisions that maximize his well-being, systematically evaluating risks and accurately assessing both short- and long-term costs and benefits. If consumers make a poor financial choice—for example, by taking out a loan they can’t afford—this approach would lead us to believe that they merely didn’t have enough information to make a good decision.


While financial knowledge is certainly important, it is also clear that it is not sufficient to ensure that consumers make good financial decisions. This is where behavioral economics steps in. Rather than assuming that people exhibit the perfect rationality of homo economicus, behavioral economists rely on insights from psychology to understand why people often make choices that do not align with a rational assessment of the decision’s consequences. This is not to say that people are “irrational,” but rather that there are systematic and predictable ways that people behave differently from what we might expect. In the area of financial decisions, insights into these behavior patterns can help to craft more effective and efficient policies to encourage savings or protect consumers from predatory loan products.”

… And from Duke University Fuqua School of Business comes this excellent video “What is Behavioral Economics?”  Regular or classical economics assumes that the consumer acts in a rational manner, where as behavioral economics recognizes that consumers can and do often react irrationally.  Emotions can sometimes cloud economic decisions … check out the reference to Homer Simpson.

Additionally, Ms. Reid also notes:

… Behavioral economists have also focused on how choices and information are framed—for example through advertising or disclosures—and are beginning to understand how even small changes may influence consumer decisions about financial products.”

And that is where I think that Ed made his message that much more powerful.  His framing … and I paraphrase … Today is not that different from earlier recessions.” … “It’s cyclical … “This stuff has happened before, and it will happen again.”  … made his message all that more compelling when framed by reading from the Times article from 1992, The Long Haul: the U.S. Economy.

Allowing yourself to be bombarded by a drone of constant negative news can suck the life out of you, and thinking that housing prices will drop forever, is irrational.  “We are a resilient nation and … great days are ahead.”  Thanks for sharing, Ed!

About Paul Donoghue

Husband, Dad, banker, real estate professional, delighted to call Cape Cod home. I'm blessed to be doing the kind of work that's provided the most satisfaction during my career ... helping clients improve their financial health and referral partners build their business. If you're interested in either ... or would just like a suggestion on what to do on your next visit to Cape Cod, then give me shout.

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