Despite the best efforts of economists to portray people as rational beings who make optimal choices, it is clear we have inbuilt predispositions to being the complete opposite. In their best-selling book Nudge (Penguin, 2008), Richard Thaler and Cass Sunstein outline situations in which people are least likely to make good choices.
Unfortunately, the free market and open competition allow companies to play on these human weaknesses to make more profit. Thaler and Sunstein argue that people need help to overcome their weaknesses and make good choices.
One key weakness arises where choices and their consequences (either good or bad) are separated in time. Spending less now to be able to spend more in the future and spending by going into debt are two examples of this. It is human nature to lack the self-control to manage these situations.
Another area of weakness relates to the degree of difficulty of making a decision or performing a task. We can easily learn tasks if we practise often enough, but we may need help with choosing the right mortgage structure.
Being able to forecast preferences for unfamiliar options is hard for most people. The simplest example of this is choosing from a menu in restaurant. Without knowing what each dish tastes like, it can be difficult to make a choice. Financial decisions are no different.
Choosing between insurance quotes or investment options is made harder by the fact that we can't experience the outcome in advance.
Thaler and Sunstein argue that people need to be nudged in the right direction with such things as incentives, feedback, and guidance towards the right decision through default options or structured choices. Human weakness means the free market is not perfect.
* Liz Koh is an authorised financial adviser. The advice given here is general and does not constitute specific advice to any person. A disclosure statement can be obtained free by calling 0800 273 847. For free e-books see moneymax.co.nz and moneymaxcoach.com