Why Do Smart People Make Bad Financial Decisions?
- Feb 10
- 4 min read
By Dheeksha Dronamraju
Edited By: Aiza Shahzad
Traditional economic theory assumes that individuals are rational and act in their own best interests. Under this assumption, people carefully assess information and maximise their welfare. As a result, those with high intellect and education should consistently make good financial choices, but this is often not the case. Many intelligent individuals struggle with debt, fail to save for retirement, or make risky financial decisions, leading to financial loss. This suggests that intelligence alone is insufficient to guarantee sound economic decisions.
This article explores why smart people make poor financial decisions using behavioural economics and evaluates the strengths and limitations of this approach.
Traditional Economics and Rational Behaviour
Neoclassical economics assumes that consumers have full information and can process it efficiently.[1] In this model, individuals respond predictably to incentives; for example, higher interest rates should encourage saving. However, real-world behaviour often contradicts these predictions. Despite understanding the importance of saving, many people delay pension contributions or rely heavily on credit. This gap between theory and reality suggests that the assumption of perfect rationality is unrealistic. Behavioural economics argues that people face limits in decision-making, even when they are intelligent.
Bounded Rationality
A key concept in behavioural economics is bounded rationality, introduced by Herbert Simon.[2] Simon argued that individuals aim to make rational decisions but are constrained by limited time, information, and cognitive capacity. Instead of identifying the best possible option, people often choose one that seems satisfactory.
This concept helps explain why smart individuals make poor financial choices. For example, selecting a mortgage or pension plan involves complex information and long-term uncertainty. Rather than comparing every option, individuals may choose a familiar provider or delay the decision. Such behaviour reflects the complexity of the environment rather than a lack of intelligence.
Habits and Routine Financial Behaviour
Much financial behaviour is habitual rather than planned. Once individuals develop spending or saving patterns, they tend to repeat them automatically. For example, regularly spending money on non-essential items (like electronics or clothing) may become routine. Economists argue that habits reduce the mental effort required for decision-making, making them difficult to change.[3]
As a result, even academically gifted individuals may continue harmful financial routines, leading to significant losses.
Social Influence
Financial decisions are influenced by social surroundings. Individuals often compare themselves to others and feel pressure to maintain a certain lifestyle. For example, young professionals may overspend to match their peers’ consumption. Behavioural economics highlights that people do not make decisions in isolation. Social influence can encourage spending and borrowing, even when individuals understand the risks.[4] This explains why financial knowledge alone does not always lead to good choices.
Incentives
Incentives strongly impact human behaviour. Classical economic theory assumes that providing incentives will trigger rational behaviour, but behavioural economics shows this is often not the case.
In the finance industry, bonus schemes may encourage a focus on short-term performance rather than long-term stability, leading to reckless risk-taking, even among highly educated professionals.[4] Consumers may also act impulsively when offered attractive financial deals, such as introductory low interest rates. Poorly designed incentives, therefore, can lead to bad financial decisions, independent of intelligence.
Is Behavioural Economics a Valid Explanation?
Behavioural economics provides a more realistic understanding of human behaviour by recognising limits to rationality. It has influenced government policy; for example, automatic enrolment into workplace pension schemes has significantly increased UK saving rates.[5] It also helps explain financial instability, such as the 2008 financial crisis, where risk-taking, poor incentives, and social pressures played a major role- phenomena traditional models struggle to predict.
However, behavioural economics also has limitations. Behaviour varies widely between individuals and cultures, making generalisation difficult. Policies designed to influence choices may be viewed as manipulative or reduce personal responsibility.[6] Critics also argue that people can improve decision-making through education and experience, and that markets can correct poor choices over time.
Conclusion
Smart individuals make poor financial decisions not because of a lack of intellect, but due to bounded rationality, complex choices, habits, social pressures, and incentives. Behavioural economics provides valuable insights by challenging the assumption of perfect rationality. However, while it offers a more realistic view of human behaviour, its predictive power and policy implications are limited.
Ultimately, behavioural economics should complement traditional economic theory, providing a stronger explanation of why even intelligent individuals sometimes make poor financial decisions.
Bibliography:
1. Hal R. Varian, Intermediate Microeconomics: A Modern Approach, 9th ed. (New York: W. W. Norton & Company, 2019), https://wwnorton.com/books/9780393680613.
2. Herbert A. Simon, “A Behavioral Model of Rational Choice,” The Quarterly Journal of Economics 69, no. 1 (1955): 99–118, https://www.jstor.org/stable/1884852.
3. Daniel Kahneman, Thinking, Fast and Slow (London: Penguin Books, 2011), https://www.penguin.co.uk/books/103/1032106/thinking-fast-and-slow/9780141033570.h tml.
4. George A. Akerlof and Robert J. Shiller, Phishing for Phools: The Economics of Manipulation and Deception (Princeton, NJ: Princeton University Press, 2015), https://press.princeton.edu/books/hardcover/9780691168319/phishing-for-phools.
5. Department for Work and Pensions, Automatic Enrolment Review 2017: Maintaining the Momentum (London: UK Government, 2017),
https://www.gov.uk/government/publications/automatic-enrolment-review-2017-maintaini ng-the-momentum.
6. N. Gregory Mankiw, Principles of Economics, 9th ed. (Boston: Cengage Learning, 2020), https://www.cengage.uk/c/principles-of-economics-9e-mankiw/.
7. Richard H. Thaler, Misbehaving: The Making of Behavioural Economics (New York: W. W. Norton & Company, 2015), https://wwnorton.com/books/9780393352794. 8. Richard H. Thaler and Cass R. Sunstein, Nudge: Improving Decisions About Health, Wealth, and Happiness (New Haven, CT: Yale University Press, 2008),
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