Beyond Rationality: How Cognitive Biases Shape Financial Decisions in an Imperfect World

Abstract

Conventional economic models consider how individuals choose the alternative that presents the highest expected payoff. While these models are useful for understanding the assumptions behind financial markets, they are limited in explaining the observed financial choices and behaviors of individuals. The choices individuals make are often influenced by several cognitive, emotional, and experiential constraints, and by the way information is presented to them. This paper studies present-biased discounting, loss aversion, overconfidence, mental accounting, and choice inertia in relation to saving, spending, borrowing and investing decisions. It carries out a comparative analysis of existing literature and secondary data from the OECD/INFE International Survey of Adult Financial Literacy and the World Bank Global Findex. The analysis indicates that financial decisions do not align with rational-choice assumptions. International survey data show a preference for short-term financial decisions. Experimental and field data show that overconfidence may lead to excessive trading and that loss aversion may influence financial decisions. Additionally, evidence suggests that commitment strategies can greatly enhance savings. These findings do not indicate that financial decisions lack reason. Rather, financial rationality is constrained by perceptions of risk and time, and by cognitive evaluations of decision outcomes and of losses. Recognizing these behavioral patterns can improve the design and implementation of financial policies and incentives.

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