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The Neurobiology of McMansions

How Our Brain Structures Led to the Housing Crisis

McMansions.

That is the derogatory term that arose the last few years for the large cookie-cutter suburban subdivisions that seem to have sprung up everywhere. You may have driven through these subdivisions and, much like me, wondered where so many people found so much money. I know what I make. I know I’m in the top 5% or so of income earners. So why don’t I have a top 5% McMansion?

In retrospect, it has become obvious that many of these people could not afford what they bought. This leads to the question of why they bought houses that pushed the limits of what they could pay. Blame it on their brains.

It is a sad but true statement about the human race that we don’t care about absolute wealth. We care about relative wealth – how much wealth we have compared to other people. We don’t want a higher standard of living if everyone else has it too. Some books would say it is all a result of an elaborate mating game. Women and men, in an ever more intense race to impress each other, attempt to make it look as though their income and success are much higher than they really are. But it goes deeper than that. The problem with the housing market can be blamed on the ventral striatum.

Last year, the neuroeconomics lab at Bonn released the results of a study or reward that involved scanning the brains of participants. What they found was not just that brains responded well to a reward. They found that brains responded even stronger to a reward that was better than the reward given to others. The experiment involved pairs of male volunteers competing for prizes on the same task. The BBC article about the research explains it well.

Both “players” were asked to estimate the number of dots appearing on a screen. Providing the right answer earned a real financial reward between 30 (£22) and 120 (£86) euros. Each of the participants was told how their partners had performed and how much they were paid. Using magnetic resonance tomographs, the researchers examined the volunteers’ blood circulation throughout the activities. High blood flow indicated that the nerve cells in the respective part of the brain were particularly active.

Neuroscientist Dr Bernd Weber explains: “One area in particular, the ventral striatum, is the region where part of what we call the ‘reward system’ is located. In this area, we observed an activation when the player completed his task correctly.”
A wrong answer, and no payment, resulted in a reduction in blood flow to the “reward region”. But the area “lit up” when volunteers earned money, and interestingly showed far more activity if a player received more than his partner.

This indicated that stimulation of the reward centre was not merely linked to individual success, but to the success of others.

You may have heard about “keeping up with the Joneses.” This research shows that it isn’t just something that affects a few of the more shallow among us. It is a real human need with a deeply rooted anatomical cause.

So back to the McMansions… what is a man to do… let all of his friends have the bigger, nicer, newer house? It seems that the drive of the ventral striatum outweighed the rational thought process for many people. All the while, lenders and investors, whose ventral striatums were firing like crazy as they tried to rack up larger earnings and returns, respectively, played along to satisfy that same deep seated need to be better than the next guy. The irony, or perhaps the karma, is that most of them ended up looking worse.

Don’t Shop Till All Your Money Drops

 

Shopoholism is a condition where the mind pulls the trigger to shoot itself, the bank balance and the social life. Typically, a shopoholic shops till he drops and then he gets up again and keeps on going, and the cycle continues — yeah, shopoholism is a dangerous addiction that can end up ruining finances and isolating you from family and friends.


So, are you a shopoholic? Here’s a small test that can help you find out:

  1. Do you shop when you feel angry, nervous or sad?
  2. Do your shopping habits cause conflicts in your family?
  3. Do you get a sense of insecurity when you find you aren’t carrying a credit card?
  4. Do you buy anything on credit even if you have the cash to pay for it?
  5. Does spending money excite you?
  6. Do you feel ashamed and embarrassed after you’re done with your shopping?
  7. Have you ever lied to your family members about the amount of money you have spent on shopping?
  8. Do you keep thinking about money and shopping most of the time?
  9. Do you postpone important payments so that you can shop now?

If you exhibit any 3-4 of these behaviors, then, buddy, you are a shopoholic.
Causes of Shopoholism
No one knows what causes shopoholism — the easy availability of money (personal loans, credit cards, etc.) combined with the need to feel good and/or impress friends is the most likely cause. Scientists say that 10-15% of shopoholics are prone to addictive behavior due to their genetic makeup. When a shopoholic purchases something, he feels good because the opiate receptor sites in his brain get turned on, and that kind of spurs him on to shop again and again – and he goes for broke. No matter what the causes are — the effects of shopoholism are deadly and if you are a mild shopoholic, then it’s time to enroll with Debtors Anonymous and also see a credit counselor. If your shopoholism has got out of hand then it’s time to see a therapist who will put you on a cognitive-behavioral treatment program before you shop till you drop all your money, friends and happiness, and maybe even yourself.

A picture is worth a thousand statistics

Several years ago, a friend of mine put two thousand dollars into Owens-Corning stock. Not long after, he took out his original investment, leaving what he had earned; a year or so after that, he took out twenty-five hundred dollars of pure profit. “I want to do that!” I thought, and bought some stock. It tanked. What did I do wrong? Partly I didn’t research my choices enough; but mainly, I used my friend’s experience to decide my actions when I should have thought harder about the numbers involved.

People are much more likely to die in a car crash (or on a bicycle) than in a plane crash. But after 9/11, more than a million people decided plane travel was too risky, and many of them drove instead of flew–and some of them died. (See this article on how driving fatalities increased after September 11, 2001.) Most people, if pressed, know that driving is more dangerous than flying. Most of the people who decided not to fly after 9/11 probably knew this too. Why did they make the choice they did? For the same reason I bought stocks without studying how they were likely to do: the base-rate fallacy.

The base-rate fallacy is a cognitive heuristic, a rule of thumb for making quick judgments. We use cognitive heuristics for processing information in fast bursts. This was good for us back when we were living in the wild in small groups, surrounded by threats; it’s not as useful now, when we live in modern, safe, diverse civilization. We have a whole new set of problems. But cognitive heuristics are hardwired into our brains, and they haven’t caught up with modern times.

The base-rate fallacy means that people don’t pay real attention to probabilities or base rates–even when they know they’re important. Instead, we care about dramatic events, pictures or visceral moments–like seeing a plane crash into the World Trade Center. One picture is worth a thousand statistics.

In essence, we like faces better than numbers. This makes sense considering our primate roots: immediate, dramatic events, especially events happening to other people, are important and will probably affect us; abstract ideas probably will not.

But in today’s modern life–and especially in the realm of personal finance–it’s important not to let this fallacy trip you up. Maybe you just read an article about someone who bought Google as a penny stock and is now a millionaire, but that doesn’t mean you should buy penny stocks from Unknown Company X–or that you should put money in the stock market just because your friend did. The image of being like that millionaire is a pleasing one, but the numbers are against you.

How do you fight the base-rate fallacy? Take a moment to think, rather than react, and remember that–adages aside–personal influence will lead you awry more often than statistics will. If you’re finding it hard to concentrate on the numbers, try to think about statistics in a visual, relevant way. You have a 1 in 17 million chance of winning the lottery? If you drove through the entire state of Florida and personally saw every person who lived there, only the last person you met would be a lottery winner. Your bank is offering a 5% five-year CD? If you invested your $10,000 savings, the extra money will pay for a month’s lease of a Lexus or two nights in Las Vegas (one if you gamble it away).

Our brains are good processing machines–sometimes too good. But that doesn’t have to hold you back. Pay attention to events, to people, to the stories that grab you; but don’t forget that the numbers will tell you the truth–and the truth is more important than a story.

Do Trading Systems Work?

Spend any time on the Internet researching investment ideas and you are going to run across myriads of websites trying to sell you their program, book or advice to trade stocks, options, commodities or currencies. Type a phrase into Google similar to the following: “options trading”, “commodity trading” or “Forex trading” and you will get an untold number of hits promising you easy riches of you just buy and follow their trading program.

The websites promoting these programs do an excellent job of feeding our biases and disrupting the critical thinking process. One example is FXCM.com, which provides an account for simulated forex capital markets and online training resources. For me the strongest bias I fell when reading the ads is the self fulfilling prophecy. The idea is there has to be a program out there that can make it easy for the novice to build enough knowledge to have the confidence to risk their hard earned money.

There are many ways to make (and lose!) money in the market and short term trading is one of them. Trading hits us with the promise of quick wealth, while many of the other ways take time and discipline. The truth is, learning to be a profitable trader also takes a lot of time and discipline. The successful traders I know of spent many years learning their profession and are very disciplined about their approach. The successful trader has developed his own personal system that works for him. Trading is a very individual pursuit and the herd instinct eventually leads many to crashing the market (think about housing) as more and more investors pile onto the same trading strategy. Remember the professional trader from the French bank, Société Générale, who lost his employer over $7 billion making “safe” currency trades.

The answer to the headline question is No, but with reservations. Each of us must find an investment philosophy and style that fits our personality, from buy and hold blue chip stocks or broad based mutual funds to trading coffee futures in the CBOT pits. If you decide being a “trader” is something to pursue remember these few things:

  1. No trading system will work as well in the future as it did in the past.
  2. No one can predict the future.
  3. Do not use leverage. When someone goes completely broke, it is almost always because they used borrowed money.
  4. Don’t let anyone make your decisions.
  5. Don’t ever do anything you do not completely understand.
  6. Speculate only with money you can afford to use.

Thanks to Thomas Smiklas and his excellent investing blog for the above rules.

To be an investor that beats the professional money managers is an individual pursuit. It takes time, study, dedication and effort. Even then results are not guaranteed. It is easy to let our biases color our beliefs about our investment abilities and the best tool is to know ourselves well.

On Declining Savings Rates

In the times of our parents and their parents, the need to save money was taken for granted. Debt was something undertaken for big purchases, such as houses, cars, and appliances. Most importantly, and this is something you’ll see if you watch an old movie, people stopped going out socially when they ran out of money.

Now, in the miracle age of convenience, we’re not troubled by many worries. It’s become more and more convenient to access our money and credit. In fact, it’s so convenient that retailers seem eager to subtract as much unnecessary waiting as possible, and that includes the time we used to use to think.

That’s right; our brains are an obstacle in the ultimate retail equation.

As a society, we recognize that impulse buying can be dangerous. Many states and countries have waiting periods for the purchase of firearms and other weapons. We know that an impulse purchase of a gun while in the wrong state of mind can be dangerous for a person and society in general. But, when we look at the catastrophe that sub-prime mortgages have caused, where people have bought houses that they truly couldn’t afford, can we honestly say that guns are the only purchase that can damage society?

It used to be that to spend money, we’d need to stand in line at the bank to withdraw what we’d want, or right a check and balance our checkbook. Now, it’s as easy as whipping out a card. They’re making it easier too! I just received a credit card with a microchip that means I won’t even need to sign many receipts.

Many marketers and retailers appeal to our basic impulses rather than our sense of logic. This isn’t deceitful; it’s just how they’ve chosen to market their goods. While it might feel good to satisfy your immediate impulse while shopping, you ultimately benefit more by thinking in longer terms. Here are a few ways to defeat the urge to impulse shop:

1. Shop with a list. Your brain can also be satisfied with the hunt for items. If you go in with a list and then leave, you’ll find that you get less temptation than a wander through store aisles might provide. Shopping with purpose cuts through most impulse urges, while shopping as a distraction opens you up to them.

2. Leave your cards at home. If you don’t have access to money, you’re less likely to spend it. Bring enough to get what you need. Some people actually freeze their credit cards in a block of ice. It ensures a waiting period before use.

3. Do your research online. If you know what you’re looking for and know the details, you’re less likely to be swayed by a last minute deal or a good salesperson.

Remember, while satisfying an impulse might feel good for a moment, being in complete control of your finances feels good for a much longer time. So control your money, don’t let it control you.

When facing a loss, sometimes it’s logic that gets lost.

My wife and I were thumbing through our first quarter financial statements recently and like many people experienced a rough first quarter. In our 401(k) accounts, we each have our share of investments that are in the red for the year. For my wife, one of those investments is a mutual fund that she just bought recently. She’s a bit of an emotional investor and like a lot of people who have experienced an immediate loss in one of their investments, she’s ready to sell. What she said to me was representative of what I think too many people in this situation feel – “Once it gets back to what I paid for it, I’m going to sell it.”

So let me get this straight. She doesn’t like the investment, doesn’t want to be in it, but is willing to hang on to it long enough to get back to the point where she bought in (which could take weeks, years, or may never even get back to the original purchase price). Why would she do this?

It’s what psychologists refer to as “loss aversion”. The concept is that individuals will much more strongly prefer to avoid losses than achieve gains. In the mind of the investor in this circumstance, selling at a loss is the equivalent of admitting a mistake and for many admitting they made a mistake is a difficult thing to do. For my wife, the aversion to loss is so strong that she would rather hold on to an investment that she dislikes (and could consequently be accepting inferior returns for) than sell and move that money to a different investment.

Traditional finance theory would argue that my wife should base her decisions in the context of our entire portfolio as well as our current circumstances and goals and ignore cognitive biases such as loss aversion. After all, if the fund she wants to sell is still a logical fit in our overall portfolio and is still considered a quality investment, why wouldn’t she contemplate hanging on to it despite its recent losses?

The answer, of course, is that people are not logical. They make emotional decisions that can potentially derail a good long-term plan. It’s only when people can understand and overcome these biases that they truly can become better investors.

Welcome to Money and Minds

Welcome to Money and Minds. Our goal is to take you on a tour of personal finance from the perspective of your brain. We follow neuroscience research, cognitive psychology, neuroeconomics, and other similar fields to determine which ideas can apply to your daily financial decisions. Send any ideas or links to us.