Behavioral Economics and Financial Decision Making

Abstract

Behavioral economics provides insights into how people process information and make decisions. It also helps to explain why and how people tend to make decisions that are not in their best interest, as opposed to what rational choice theory would suggest. This chapter provides an introduction to behavioral economics and highlights its relevance to understanding and influencing financial decision-making. The chapter explores major cognitive biases that commonly lead to mistakes in financial decisions, such as confirmation bias, overconfidence bias, loss aversion, the endowment effect, and status quo bias. The chapter also highlights the challenges brought about by choice overload, that is the multiplicity of options that overwhelms people and undermines their ability to make appropriate financial decisions. The chapter then discusses how choice architecture and nudges can be used to address the limitations resulting from cognitive biases and choice overload. In particular, we examine default choices, pre-commitment mechanisms, framing, and priming approaches and discuss how these can foster positive financial behaviors. This chapter thus represents a useful starting point for researchers and practitioners interested in developing and applying behavioral economics principles and tools to prompt financial decisions that lead to long-run financial security.

Keywords: behavioral economics, cognitive biases, choice architecture, nudges, financial decisions

JEL Classification: D14, D90, D91, G41, G50