What Makes a Rational Consumer (and Why Financial Advisors Should Care)

What Makes a Rational Consumer (and Why Financial Advisors Should Care)

7 MIN READ 

As a financial advisor, have you ever had a conversation with your client where you got the sense that they are attached to a specific security and you weren’t exactly sure why? In short, their response didn’t seem that rational?

It can be difficult to understand a person’s decision-making process, especially when their choices don’t make much sense to you. The goal of this blog is to alleviate some of that confusion and provide additional context about the characteristics to consider when attempting to understand your clients' decision-making.

What is Utility Maximization?

In economics, there is a generally accepted rule that humans always act in a way that will maximize their utility for the goods and services they consume. Utility maximization is commonly illustrated by a consumer looking to maximize their spending power by purchasing two apples for twenty-five cents rather than one apple for twenty cents.

This principle of utility maximization is expected of anyone who takes part in a free market economy. Economists argue that a utility maximizing individual is noted as a ‘rational consumer’ in the market. Someone is considered a ‘rational consumer’ because they are focused on their own self-interest; they maximize their utility in order to gain the most for themselves. As such, self-interest is the driving force of all decision-making.

I first found myself thinking about utility maximization after sitting in on my first economics class. I kept reflecting on this concept of consumers attempting to maximize their personal gain within every economic aspect they find themselves in. It seems like an intuitive part of being human, we want to find ways to benefit ourselves by getting the most we can within an economic situation. But is this really the main economic focus and consideration that people take into account when making decisions?

This perspective of what a rational consumer does within the confines of their decision making needs to be evaluated to think about what is considered a rational decision-making process.

Self-Interest vs. Collective Interest

In times of uncertainty, like the COVID-19 pandemic we find ourselves in currently, there is a natural tendency for humans to be instinctively driven to a stress response. When safety is threatened and survival is at the forefront of one’s mind, the primitive attributes of humans arise within a fight or flight response. In many ways we witnessed this stress response through media coverage to the coronavirus as it became more prevalent within our society. We saw this when people began purchasing an abundance of toilet paper and nonperishable goods. Our shopping habits highlighted that times of uncertainty lead to erratic behavior.

It is easy to look at a situation such as this and think that economists are right in viewing consumers as self-serving. People only look to maximize their personal gain. Although these acts were initially done for the sake of self-preservation, it is important to note that this immediate response led to us being able to collectively practice social distancing, which was done to prevent overwhelming our healthcare system. These are conscious efforts taken by citizens in order to do their part to participate in a collective act to aid our society.

We see similar acts taken in an attempt to help others in need by using social media to draw attention about consuming goods. One popular post was ensuring that food items that were food-stamp eligible were not purchased by those who were not on food stamps, even if it was the cheaper option to purchase.

Bringing awareness to these types of real-world examples, leads to altered purchasing habits and offers consumers the ability to reflect the choices they make. Beyond altering the types of goods that consumers choose to consume, we also see people supporting local businesses to help their community during this time of need. Local shops are delivering goods to their client’s front door and offering alternative options to better suit the new quarantine regulations.

We also see local businesses and community members using this time to make masks for essentials workers. These are all examples of people coming together in order to support and benefit the community over the needs of the individual. Humans are not capable of thriving independently, or at least not for long duration of time. By nature, we are codependent creatures who have evolved to learn how to work together and form communities in order to survive. We would not have survived as a species without working together in order to mutually succeed.

This in itself, is able to raise doubts about the perspective of viewing individuals as exclusively looking to act in one’s self-interest, since it is an instinctive part of being human that claims otherwise. If anything, exclusively thinking about the personal gain of an individual, is considered irrational in the face of the longevity of one’s survival and ability to thrive within society.

Wolfenschiessen

Although self-interest does play a role within our identity working as a collective group, whether that be a company, a community, or a country is seen as essentials to long-term survival, there are many aspects and attributes of humans that are not exclusively dominated by the economic perspective of self-interest.

There is a level of comradery that can be observed between people who come together for the common well-being of the greater good. This can be seen in acts of sacrifice or altering choices to better serve a community at large. One example of making economic decisions that are considered better for the greater good than the personal gain of the individual is the Swiss economic study, examined by the Harvard Philosophy Professor, Michael J. Sandel, in his book What Money Can’t Buy: The Moral Limits of Markets. As the title suggests, his book discusses the assumptions about the free market and provides commentary on the moral parameters that influence our economic system.

In one of the examples put forth by Sandel, he provides the opportunity to evaluate and contrast the significance of self-interest with that of the greater good through the example of a nuclear waste site. In 1993, the government of Switzerland was attempting to find the best place to house the country’s nuclear waste. After deliberation, the Swiss government decided that the small town of Wolfenschiessen was the most beneficial spot to house the byproduct.

The town, which had a population at the time of 2,100, was surveyed by economists to see how the residents would respond to a nuclear facility being opened in their community. When asked if they were in favor of housing the waste near the edge of their town, the surveyed citizens agreed to house the waste with 51% of the population in favor. After the results of the comprehensive survey, the economists went back and re-surveyed the town again, but this time they asked the residents if they were in favor of the waste site if they also received a monetary payment of about $8,700 per person. After the second round of surveying, the response of those in favor of moving the waste site to their town dropped from 51% to 25%.

If the argument of maximizing one’s personal utility is the predominant deciding factor within the decision-making process, then providing compensation to the residents would have increased their incentive. It would have been in their best interest to receive financial compensation for the inconvenience of having to live next to a nuclear site.

If we consider the economic assumption about consumer’s being rational and wanting to maximize their personal gain, then adding a financial compensation should have seen an increase in acceptance of the site. Does that mean that the entire town of Wolfenschiessen was being irrational when they declined the money?

No.

If anything, the initial offering of having to be close to the nuclear waste site appealed to other aspects of their civic duty and the realization of doing their part for the greater good of Switzerland. Either way, the suggestion that monetary benefit is the main focus of consumer behavior is something that should be considered when evaluating the other attributes that make up the identity of a consumer, and this study is a prime example of such acts.

The Role of Human Traits in Consumerism

When thinking about what it means to be a rational consumer, it is important to consider the other traits that make us humans. Traits like our personalities which consist of our experiences, opinions, and overall backgrounds all play a role within our decision-making. The benefit of considering these attributes is that it can round out a person and clarify who they are and how that dictates the choices they make.

More often than not, these personality traits expand the parameters of decision making beyond maximizing utility. The residents of Wolfenschiessen chose not to take financial compensation for their sacrifice, because that choice appealed to other qualities of their identity like their pride in being residents of Switzerland. Past experiences and memories can even influence decision making on a smaller scale.

For example, I like to purchase Jiff peanut butter when I bake peanut butter cookies because it is the same brand that my grandmother purchased when she baked those same cookies. Perhaps that is not the most rational qualification that I need to consider when purchasing peanut butter. I could purchase a healthier alternative or a cheaper option of peanut butter and get the same end result. But that emotional attribute exceeds the need to be a rational consumer when it comes deciding what peanut butter I want to purchase.

At this point and perhaps as we continue to progress through this new, uncharted territory of a post-coronavirus world, there will be a need to evaluate what it means to be rational. This is the time when more people are seeking out financial advice from professionals about how to navigate the new landscape of the market. With more prospects comes more perspectives that might not make much sense. The concept that a rational consumer exclusively thinks in a way to maximize their own personal gain is not entirely accurate and can lead to misunderstanding between you and your clients.

We all have an interest and desire to maximize our own personal standing, but that does not supersede the influence of other characteristics that make up decision-making. By being able to broaden the idea of what a rational choice is, it can lead to building stronger relationships with your clients and provide additional context for how to interpret your client’s needs. At the end of the day, clients want to be heard and understood by their advisor. If you are able to reevaluate your own opinions about what rational choices look like, you will expand your scope for providing advice to your clients.

Sources

Sandel, Michael J. What Money Can’t Buy: The Moral Limits of Markets. Farrar, Straus and Giroux, 2012.


Lillie DelaneyAbout the Author
Lillie is a Platform & Operations Specialist for XY Investment Solutions (XYIS), a wholly-owned subsidiary of XY Planning Network, which offers a turnkey asset management platform for XYPN’s 850+ advisor community specifically built to support next-generation clients still in the early stages of accumulation.

 

 

 

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