Sometimes, though, instead of being rational, people are irrational—they make choices that leave them worse off in terms of economic payoff and other considerations like fairness than if they had chosen another available option. Is there anything systematic that economists and psychologists can say about economically irrational behavior? Yes, because most people are irrational in predictable ways. People’s irrational behavior typically stems from six mistakes they make when thinking about economic decisions. The mistakes are listed in Table 9-8, and we will discuss each in turn.

Misperceptions of Opportunity Costs As we discussed at the beginning of this chapter, people tend to ignore nonmonetary opportunity costs—opportunity costs that don’t involve an outlay of cash. Likewise, a misperception of what exactly constitutes an opportunity cost (and what does not) is at the root of the tendency to count sunk costs in one’s decision making. In this case, someone takes an opportunity cost into account when none actually exists.

Overconfidence It’s a function of ego: we tend to think we know more than we actually do. And even if alerted to how widespread overconfidence is, people tend to think that it’s someone else’s problem, not theirs. (Certainly not yours or mine!)

For example, a 1994 study asked students to estimate how long it would take them to complete their thesis “if everything went as well as it possibly could” and “if everything went as poorly as it possibly could.” The results: the typical student thought it would take him or her 33.9 days to finish, with an average estimate of 27.4 days if everything went well and 48.6 days if everything went poorly. In fact, the average time it took to complete a thesis was much longer, 55.5 days. Students were, on average, from 14% to 102% more confident than they should have been about the time it would take to complete their thesis.

As you can see in the following For Inquiring Minds, overconfidence can cause problems with meeting deadlines. But it can cause far more trouble by having a strong adverse effect on people’s financial health. Overconfidence often persuades people that they are in better financial shape than they actually are. It can also lead to bad investment and spending decisions. For example, nonprofessional investors who engage in a lot of speculative investing—such as quickly buying and selling stocks—on average have significantly worse results than professional brokers because of their misguided faith in their ability to spot a winner. Similarly, overconfidence can lead people to make a large spending decision, such as buying a car, without doing research on the pros and cons, relying instead on anecdotal evidence. Even worse, people tend to remain overconfident because they remember their successes, and explain away or forget their failures.

Unrealistic Expectations About Future Behavior Another form of overconfidence is being overly optimistic about your future behavior: tomorrow you’ll study, tomorrow you’ll give up ice cream, tomorrow you’ll spend less and save more, and so on. Of course, as we all know, when tomorrow arrives, it’s still just as hard to study or give up something that you like as it is right now.

Strategies that keep a person on the straight-and-narrow over time are often, at their root, ways to deal with the problem of unrealistic expectations about one’s future behavior. Examples are automatic payroll deduction savings plans, diet plans with prepackaged foods, and mandatory attendance at study groups. By providing a way for someone to commit today to an action tomorrow, such plans counteract the habit of pushing difficult actions off into the future.

Counting Dollars Unequally If you tend to spend more when you pay with a credit card than when you pay with cash, particularly if you tend to splurge, then you are very likely engaging in mental accounting. This is the habit of mentally assigning dollars to different accounts, making some dollars worth more than others.

By spending more with a credit card, you are in effect treating dollars in your wallet as more valuable than dollars on your credit card balance, although in reality they count equally in your budget.

Credit card overuse is the most recognizable form of mental accounting. However, there are other forms as well, such as splurging after receiving a windfall, like an unexpected inheritance, or overspending at sales, buying something that seemed like a great bargain that you later regretted. It’s the failure to understand that, regardless of the form it comes in, a dollar is a dollar.

Loss Aversion Loss aversion is an oversensitivity to loss, leading to an unwillingness to recognize a loss and move on. In fact, in the lingo of the financial markets, “selling discipline”—being able and willing to quickly acknowledge when a stock you’ve bought is a loser and sell it—is a highly desirable trait to have.

Many investors, though, are reluctant to acknowledge that they’ve lost money on a stock and won’t make it back. Although it’s rational to sell the stock at that point and redeploy the remaining funds, most people find it so painful to admit a loss that they avoid selling for much longer than they should. According to Daniel Kahneman and Amos Tversky, most people feel the misery of losing $100 about twice as keenly as they feel the pleasure of gaining $100.

Loss aversion can help explain why sunk costs are so hard to ignore: ignoring a sunk cost means recognizing that the money you spent is unrecoverable and therefore lost.

Status Quo Bias Another irrational behavior is status quo bias, the tendency to avoid making a decision altogether. A well-known example is the way that employees make decisions about investing in their employer-directed retirement accounts, known as 401(k)s. With a 401(k), employees can, through payroll deductions, set aside part of their salary tax-free, a practice that saves a significant amount of money every year in taxes. Some companies operate on an opt-in basis: employees have to actively choose to participate in a 401(k). Other companies operate on an opt-out basis: employees are automatically enrolled in a 401(k) unless they choose to opt out.

If everyone behaved rationally, then the proportion of employees enrolled in 401(k) accounts at opt-in companies would be roughly equal to the proportion enrolled at opt-out companies. In other words, your decision about whether to participate in a 401(k) should be independent of the default choice at your company. But, in reality, when companies switch to automatic enrollment and an opt-out system, employee enrollment rises dramatically. Clearly, people tend to just go with the status quo.

Why do people exhibit status quo bias? Some claim it’s a form of “decision paralysis”: when given many options, people find it harder to make a decision. Others claim it’s due to loss aversion and the fear of regret, to thinking that “if I do nothing, then I won’t have to regret my choice.” Irrational, yes. But not altogether surprising. However, rational people know that, in the end, the act of not making a choice is still a choice.