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Measuring Irrationality in Finance Is Rational Behavioral Finance

Understanding how irrational financial behavior works is only half the job. You also have to determine the value of irrationality. That is to say, you must figure out how much your own inherent irrationality costs you (and your company) financially.

Consider how you might measure the cost of satisficing behavior:

One person goes to the store, intending to purchase ten boxes of cereal.
Store A has only five boxes at $2 per box.
Store B has ten boxes at $1 per box.
The person spends $1 in fuel each direction getting to and from store A, not knowing that store B has more of the cereal at a cheaper price. So he goes to the store twice, buying five boxes each time.
The person has spent $24 on cereal plus travel. Had he gone to store B to see what it had, he would’ve spent only $10 for the cereal, $2 for fuel, plus an addition $1 for going between stores.
The cost of being lazy (er, satisficing) in this example is $11.

Satisficing isn’t the only behavior that has a measurable influence on finance. Although some are easier to quantify than others, all behaviors are measurable, but not all of them necessarily have a negative influence.

For instance, a person who was too worried about his finances to invest in an Internet company may have saved himself from the crash in the late 1990s, giving that behavior a positive value. Does that mean it was a good behavior?

No, because it was still based on irrationality. Since the decision to refrain from investing was based on an emotional response rather than a calculated determination of the level of risk, the decision was just a lucky one that could’ve just as easily resulted in the person’s missing out on an important investment opportunity.

After identifying the role that an individual plays in the financial world and recognizing what behavioral anomalies each individual is subject to, you can make estimates on the cost of behavioral anomalies and take steps to mitigate the risk that such behaviors will occur.

Formalizing and quantifying the role of human behavior in causing deviations from rational financial decisions is a relatively new but very important step to not only understanding but also improving upon the current financial infrastructure of organizations.

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