If Big Mama couldn’t afford something, no pleading or peer pressure could change her mind. Debt was to be avoided as much as possible. Living above your means was illogical.
In a small rowhouse in Baltimore with just a high school education, my grandmother was to me what Daniel Kahneman was to behavioral economics — a world he helped pioneer.
Kahneman, who died this week at 90, was a psychologist whose work “integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty,” according to the citation for the 2002 Nobel Prize in economic science he shared with economist Vernon Smith.
Kahneman and his research collaborator, Amos Tversky, did groundbreaking work upending the notion that economic decisions are governed by logic. Tversky died in 1996, and the Nobel is never awarded posthumously.
In his 2011 book, “Thinking, Fast and Slow,” Kahneman wrote that his aim was “to present a view of how the mind works that draws on recent developments in cognitive and social psychology.”
We are — because of our biases — often irrational beings.
I regularly work with people trying to recover from financial disasters brought on by poor decision-making. They buy a $50,000 vehicle because they don’t want to pay $1,500 to repair their car, which, when fixed, will last for years. Or they have $20,000 in a low-yield savings account but are carrying $10,000 in credit card debt at a 20 percent interest rate.
One key to a better financial life and security is having a system to guide your decision-making.
Even if you are not a student of Kahneman, here are six steps to better decision-making.
What are you trying to accomplish? State it clearly.
This first step in the decision-making process may seem obvious, but it often isn’t. People let their emotions lead rather than examine a choice based on economics.
My husband and I teach a marriage and money class at our church. During one session, a couple wanted our opinion on their decision to upgrade to a bigger home. They had determined they needed more space.
It turns out that the wife was pushing for the purchase because she wanted more room for her clothes and shoes. They were already deeply in debt, and taking on a larger mortgage would not have been in their best interest.
They were about to make an irrational decision because the wife had unresolved issues in her life that led to her overspending. They stayed put.
2. What’s the need or want behind the decision?
This is the why question. For example, “Should I replace my clunker of a car?” Be honest with yourself. Is it truly a need or a want?
Need: You are frequently stranded without warning because various mechanical issues.
Want: The repair expenses you complain about pale compared with the cost of buying a new vehicle. You’re just tired of driving your hoopty. So, you rationalize that it’s must be time to purchase a new car.
3. What are your non-negotiables?
What are you not willing to compromise on if you decide to act on this decision? For example, the cost must be within the budget. The house must be near a good school district. The car must be electric/hybrid or at least fuel-efficient.
4. Identify and assess all alternatives
Have you carefully considered other options? Don’t rule anything out before you’ve evaluated all possible choices. Once you’ve identified the alternatives, scrutinize each one.
Yes, your older car is increasingly in need of repairs. But if you can plan the repairs so you aren’t stranded, it’s still probably cheaper than buying another car. Is public transportation an option? Do you absolutely need a car?
5. What’s the cost, and can you afford it?
Calculate the price of each option. Don’t just focus on the short-term outlay. Are there other costs you should consider?
How will the decision affect your relationships or your mental/physical health?
What is the opportunity cost? This refers to a benefit you miss out on when making a particular decision. For example, will this decision impact your ability to build wealth?
If you purchase a car with a $1,000 monthly payment, can you still build an emergency fund or save for retirement?
Once you’ve identified the alternatives, sift through each one.
Slow down your decision-making, but also be careful of “analysis paralysis.”
Overthinking the decision or succumbing to the fear of making a wrong choice can prevent you from taking a course of action.
If you can say with certainty that you have followed the previous five steps, then go ahead and move forward with confidence, knowing you did all that you could do. Then, don’t look back with regret.
Kahneman, the grandfather of behavioral economics, asked in his book, “How can we improve judgments and decisions?”
His answer: “Little can be achieved without a considerable investment of effort.”
