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Problem 3: Not Looking at All Sides of a Problem

This problem is usually having a point of view on an investment situation where you may have taken someone else’s word on it or never really given the question serious thought. One common financial example of this the use of a financial advisor to assist you in buying and selling stocks, mutual funds, or other investments. Whenever I consider that advice from this kind of source, I ask several questions about the source of the advice. Some basic ones may include the following:

– Does this advisor have anything to gain or lose by my decision?

– Is this advice based on the advisors own expertise or on someone else’s?

– Is this person following their on advice on that issue?

– Is the advice based on a fair analysis or a biased analysis?

– Is it to my advantage to even consider taking this advice?

– If the advisor makes any performance claim, can the claim be backed up?

– Does the advice make sense?

– After further investigation and research on my part, does the advice still make sense?

– Does not following the advice make better sense?

The current rash of mortgage problems in the US, issues like short sales because of underwater mortgages and foreclosures, is one example of this kind of decision problem in action. Many people got into this situation because they didn’t think about the consequences of taking out a home equity loan to buy expensive toys, or the possible negative consequences of an adjustable rate loan.

There are many more questions that one can ask, but the basic point is that every decision can be looked at in more than one way. It is to your advantage to ask a few questions and do at least a little work to understand what may be behind a piece of advice.

Next Lesson: Being Overconfident In Your Predictions

Decoy marketing

This intriguing article discusses decoy marketing, a tactic marketers use to make their products look better by comparing them to inferior ones offered for a similar price. The author, Roger Dooley, discusses falling prey to this when shopping for shaving cream. First he stares at the shelf, trying to decide between dizzying numbers of options; then he sees that one variety has in its midst taller cans of the same product, but with 20% more for the same price. Instantly he buys, not one, but two of the bigger can, and goes on his way.

What happened? Essentially, his brain was tricked into redefining the situation. Instead of comparing several different products, his mind zeroed in on the very simple decision between products A and B, where they were identical except for the amount of product. This made the decision quick and easy: “B is the much better value!” and once the decision had been made, the other competitors had been eliminated without really considering their merits.

The key element here is that products A and B–the “real” product and the decoy–are almost identical except for the key difference that clinches the sale, in this case amount of product. Gentner and Markman (2006, Psychological Science) explain this forced easy decision this way:

[Comparing items] involves an alignment of structured representations yielding commonalities, differences related to the commonalities, and differences unrelated to the commonalities. One counterintuitive prediction of this view is that it should be easier to find the differences between pairs of similar items than to find the differences between pairs of dissimilar items. This prediction is particularly strong for differences that are related to the commonalities.

In other words, if two items are identical except for a couple of key points, it’s much easier to compare them (and thereby pick the non-decoy). And our brains are lazy. This laziness–among other things–is ripe for marketers to exploit to get us to buy their product. Decoy marketing works by exploiting one of the many shortcuts our brains like to take.

Letting fear act on you

“Should we buy more angelfood cake mix?” I wondered as my husband and I walked down the aisles of our local Kroger. “It’s only up twenty cents.”

“I’m not buying beef jerky,” my husband said several aisles later. “I can’t stomach paying that much for that little.”

“Eggs are almost as bad as back in Seattle,” I noted further down the store.

“We’ll never again see 4-for-$10 deals on pop,” he predicted, not stopping in that aisle.

“Floss is cheap; I’m going to get two,” I said. Then realized that floss wasn’t food and, unlike everything else in the store, its price probably wasn’t going up.

Psychological studies have found that fear works as a motivator–but only when the fear is accompanied by a message on how to avoid danger. Take global climate change, for example. People who realize that it’s a real problem and may in fact lead to disaster down the road are generally panicked and depressed, because there aren’t any clear messages yet on how to fix things. (We’re getting there, though, slowly.)

In the current economy, people who are afraid of rising prices but can’t think of anything to do about them are likely to be paralyzed, afraid but unable to act. People who can think of things to do–use coupons, buy store brands, skip luxury items–are very likely to do them, and by doing do, mitigating their fears.

Fear can be a very useful persuasive tool. Letting it work on you can achieve big changes–just make sure they’re ones that are good for you, not good for the ones using the fear as a message.

The Psychology of Budgeting

I confess, I am an optimist.

Not a wide eyed and naïve one, rather I am a cautious optimist who tries to plan ahead for things. Sadly, my optimism does someone lead me to underestimate things.

A recent study from the University of Southern California called “Will I Spend More in 12 Months or a Year? The Effect of Ease of Estimation and Confidence on Budget Estimates.” suggests I am not alone in letting optimism lead me to underestimate things, at least in the short term. The research indicated that consumers had a tendency to be over-confident when making estimates for short-term budgets. However, when making long-term budgets, consumers tended to be much more cautious in their estimates, as they acknowledge the greater potential for unexpected surprises.

The study does concede that monthly budgets function quite well for relatively predictable monthly bills, but when it comes to estimating more open-ended costs, our optimism can be our enemy.

Lead researcher Gülden Ülküman says, ‘When budgeting, it seems to be wiser to assume that one’s knowledge is unreliable.’ What are the applications of this? Well, as a starting point, you might see budgeting software asking you questions to make you question your assumptions and feel less confident about the estimates you make when compiling a budget. How can you make use of this knowledge? Well, to start with, let your inner pessimist come out and play when compiling a budget. We’re often taught that a negative attitude can cause us problems later on, but it appears that in this instance, pessimism is the winning strategy. As an optimist, I hate to concede them the point, but it’s hard to argue with science, especially when it matches what I have seen in the real world so very well.

Sunk costs don’t have to sink you

It’s finishing the $3 brownie that turned out to taste like chalk. It’s going to a Mahler concert, even though you hate Mahler, because you had season tickets to the symphony. It’s proposing to your girlfriend, even though you’re not sure you want to, because you’ve been together so long. It’s the sunk-cost fallacy, and chances are, you’ve been a victim of it.

The sunk-cost fallacy is the tendency of people to make decisions based on past costs and benefits rather than future ones. You’ve probably heard of throwing good money after bad: you’ve already put in this much time/money/whatever, and you don’t want to waste it, so you stay in a situation even though you’re not going to get anything out of it. Rationally, this doesn’t make a lot of sense; why put yourself into a situation that will yield nothing instead of making a better choice?

This recent study suggests that we do it more when we’re young. Strough, Mehta, McFall, and Schuller (Psychological Science, July 2008) asked young adults and senior citizens to evaluate how long they would watch a bad movie. Young adults said they would spend more time watching when the movie was one they had paid for, but the older adults chose to watch about the same length of time whether they had paid for it or not.

Strough et al. suggest that this is because older adults are more likely to look at positive aspects of situations, while younger adults pay more attention to negative aspects and therefore try to make up for their “lost investment.”

This argument may or may not hold water–personally, I find myself less likely to spend time doing any uncongenial activity as I get older–but the result is the same, no matter the reason: older adults are less likely to trap themselves in bad situations than younger ones.

This doesn’t mean that all we can do is wait to grow older. Larrick, Morgan, and Nisbett (Psychological Science, 1990) called the principle that we should be obeying–considering only future costs and benefits, not past actions, when making decisions–the sunk cost principle. They found that college students could easily be taught to apply this principle–a one-month checkup after a short training session found the students using it successfully. Essentially, the key is to treat whatever you’ve paid for–a movie ticket, a stock, a relationship–as if you hadn’t paid for it. Would you still want to keep it if it had been handed to you free that morning? If not, then it doesn’t make economic sense to spend any more money or time on it. We, too, can avoid sitting in the rain to watch baseball and keeping money in bad funds when all that’s motivating us is regret over a past investment that’s already irrevocably lost. Sometimes all it takes is a little knowledge.

Discretionary spending and financial illusions

Happy (late) Independence Day to our fellow American readers. I celebrated mine quietly by visiting my parents for a small barbecue (plus angelfood cake and home-grown strawberries). Once it got dark, we walked along the street to watch fireworks.

My parents live in a well-to-do neighborhood on the side of a hill. As a result, we were able to see dozens of fireworks at a time, both from neighbors down the street and from the residential areas in the valley below. It was beautiful. “Think how many thousands of dollars are going up in smoke and pretty lights,” my husband said.

This annoyed me quite a bit, because instantly I did, and the fireworks became so much wasted money, the red and green bursts ephemeral delights that could have been money in a savings account, dinners out, college textbooks. Independence Day became an orgy of frivolous spending on only a few seconds’ worth of pleasure, a symbolic representation of a nation dedicated to overspending on unnecessary luxuries.

But as I continued to watch, I began to enjoy myself again. I love fireworks, and the kids down the street were clearly having the time of their lives watching them. And the view from the hill became a celebration, a few hours out of the year when we put some of our hard-earned money into lighting up the night in joy. I thought of how I would like my future children to see a sight like this. Suddenly the expenditure (admittedly not mine) was useful and noble rather than wasteful.

You may have seen the dancing girl illusion on the Internet, in which a figure dances either clockwise or counterclockwise depending on how you look at it. (The “left brain versus right brain” bit attached to it means nothing.) This is exactly what my brain was doing while watching the fireworks: switching out one interpretation for another, without specific stimulus for switching. As in the dancing girl illusion, neither interpretation had any more basis in reality than the other; no one can measure what it’s worth to celebrate one’s pride in one’s country, or to be part of a tradition that millions of people are participating in at the same time, even though unseen.

Unlike the dancing girl illusion, the interpretation I choose to accept will affect whether or not I buy fireworks next year, whether I’m willing to spend money on Christmas decorations, whether I tell my children about Easter baskets or take them to our family’s graves on Memorial Day. Discretionary spending is just that, discretionary; I can choose to spend it on things that are important to me, or I can save it for things I feel are more worthy. Are fireworks on Independence Day worth the money, money that you might otherwise put away to earn interest or use to buy fancy food or new clothes? Only you can say.

Yoga for Financial Peace

Have trouble with controlling your shopping impulses?

As bizarre as it may sound, it just might be crazy enough to work. If we want to look at the background on it, we can compare financial health to physical health. Yoga has been cited as a beneficial action for weight loss and health maintenance. Not only does it help as an exercise, but through the movements of yoga you help to calm and focus your mind, promote inner contentment, reduce stress and anxiety, and promote a greater awareness.

Yoga is already being used as a contributing treatment for depression and anxiety (click here to be taken to an article from Psychology Today on the topic). As the very nature of this site suggests, how we handle our money is very much related to our state of mind. We can use shopping as a tool to feel better (such as retail therapy), we can avoid dealing with our financial situation (a cause of stress and anxiety for most people) which then compounds the situation further, or we can just not be aware of how the way we think can influence the way we spend money.

We are encouraged by the media to find the solution to our problems through “stuff”. However, if you can find that peace and satisfaction that we all crave WITHOUT spending your money, isn’t that a stronger position to be in?

Brent Kessel wrote an excellent article on this topic called “Can Yoga Make You Rich?” that was published on MSN Money (click here to be taken to the article). In it, he discusses how yoga can help you understand how you think, which is usually the first and most important step to regaining control of your finances. I highly recommend reading the article.

Obama, money, and the recency effect

Obama’s tactics this campaign season have mostly involved not addressing the rumors circulating the Internet and the country about his beliefs and background. But that’s changing (he recently put up a website to address them), and it’s a good move to increase his chances of winning the presidential race. This article discusses how it’s important for Obama to respond to smear tactics in the current presidential campaign because if he doesn’t, voters hear only the accusations, and will tend to give credence to them.

Why? Because people really do believe what they hear, especially if they’re predisposed toward it (such as the many people who don’t want Obama to be the next president). Almost everyone–mentally disturbed people are the biggest exception–assumes that what other people say is the truth. This is why it was so easy to alarm your mother by telling her you’d lost your brother on the way home from school, or get your friend to believe that you were only taking her to a friend’s house to pick something up, not to bring her to her surprise party.

Aside from people’s tendency to be credulous, the recency effect is also in play. The recency effect is the phenomenon that people tend to remember the last few items of a long list best. Its corollary, the primacy effect, states that people tend to remember the first few items best, and which one predominates depends on the situation. Sometimes it’ll be both. But when it comes to persuasive arguments, one or the other generally wins, and the recency effect comes out on top when there’s an appreciable delay between the first message and the second–such as when campaign ad #1 runs on Thursday, discussing a candidate’s platform, and campaign ad #2 runs the next Tuesday, smearing that candidate and calling his or her platform a lie.

How does this apply to personal finance? Don’t let yourself be swayed by whatever you hear, especially whatever you hear last–especially when it’s from a salesperson or someone else who stands to gain by your decision. There are many places this can happen, and many topics. It’s best to invest in foreign markets; it’s best to invest in domestic markets. You need to keep six months’ salary in your emergency fund; you only need three months. It doesn’t make sense to make high-interest payments on a big-screen TV; but the payments are only $80 a month.

How and when you receive persuasive messages will affect how much they affect you. Pay attention to how information changes your opinions. If you find yourself being swayed too much, try reviewing what you know of each of your issue’s positions in the same interval, then decide what you think is fact and what is only opinion, salesmanship, or fear-mongering.

The psychology of gambling

Gambling is a bad financial decision. Most of us know that it’s a game that–at least in regulated places such as casinos–you can only win if you happen to be lucky. The odds are always against you. So why do people love it? In essence, because our brains are programmed to.

Psychology has examined how gambling, and the pursuit of rewarding activities in general, works. Just as there are different types of reward (and punishment), there are different schedules for doling it out: fixed interval, fixed ratio, variable interval, and variable ratio. Consider a rat that gets a food pellet sometimes when it presses a lever. In fixed interval, its gets a pellet every half-hour, say, no matter how many times it’s pressed the lever. In fixed ratio, it gets the pellet every ten lever presses. In variable interval, it gets the pellet after a random amount of time has passed, and in variable ratio, it gets the pellet after a random number of lever presses.

Researchers have used just this sort of setup to find out which type of schedule creates the most addictive behavior. They delivered the reward according to whatever schedule that rat was assigned to. Then, when the rat understood the setup, they stopped delivering the reward.

Rats in the variable ratio schedule pressed their levers the longest after the rewards stopped coming. If you think about it, it makes sense. If you know you’re supposed to get a reward after thirty minutes, or after thirty lever presses, you’ll stop. But if you think that just one more lever press might do it, you hang on longer.

This is exactly why gambling is so peculiarly addictive. It’s not like, say, constructing model airplanes, where if you know if you put in the time you’re sure to be rewarded, or like unpaid overtime at work when you know you won’t. The sweetness of gambling is the unexpected payoff. If you stop, you’ll never know if the next lever press, or hand of cards, would have rewarded you.

There’s a physiological reason that that unexpected reward is so appealing, and why we’re willing to give up time and effort and money for the chance of getting it. I’ll write about that. Sometime in the next few posts.

On looking poor

Smart Spending recently discussed a Saving Advice post on how looking poor can benefit you. The comments are great reading; a lot of the readers have anecdotes on how some snobby salesperson missed out on a great commission by passing over a person who didn’t look like he had much money to spend. There are definitely advantages to looking poor–or at least not looking rich. The original poster, Shannon Christman, lists some: it can help you negotiate, it can net you freebies and like-minded acquaintances, it can make you feel good to laugh up your sleeve at an unsuspecting salesperson.

So why don’t more people do it? Because we don’t; we go to the bar with friends when we really can’t afford it, we buy a new dress for our friends’ weddings because people we know will be there, we send our kids to school with lunch money when we should be getting financial aid.

Generally speaking, people don’t like to look poor. We like to keep up with the Jones, to look like we’re winning at life–to socially conform. “Normative influence” is the pressure we feel to be like others so that we’ll be accepted. If we look poor, we won’t look like everyone else, and then they might not accept us.

Blunt Money posted on this a while ago, saying, “For me, it’s easier to do what I really want to do when I have the money to do otherwise. I’m less concerned about what others think…But when I really had very little money coming in (there were a few years not that long ago when I made $4,000 or less per year) I was more concerned about what people thought.”

Similarly, a recent post on FAIL blog: (via Get Rich Slowly) is about someone who’s looking for a new service: “video rental store but for books.” This would be a great idea, maybe even something for a young entrepreneur to jump on…if not for the fact that we already have something called a library. (Or a used bookstore, perhaps.)

But look past the apparent tragic unawareness on the poster’s part of public services. Why, in fact, do people use Netflix instead of the library? Would people actually use a book-Netflix? I suspect they would, even if they were getting the same service for a little money rather than for free, because “only poor people can’t afford to pay for books.”

How much does your fear of looking poor influence what you do? Do you truly want that new car or shiny watch, or do you just want to look like a well-to-do member of society? If you didn’t care what other people thought, would your spending habits change?

Separating necessities and luxuries

Memorial Day Weekend is almost over. Are you satisfied with however much money you spent for it?

$4 gas prices have significantly affected people’s spending habits in a way that hitting the $3 mark didn’t, Marketwatch says. There are articles all over describing how people have been trying to save money on Memorial Day weekend–though not always by canceling plans. “You can’t make financial decisions based on happiness,” said a man whose family used their economic stimulus refund to fund their family gathering (but decided not to buy steak for it).

Money may not buy happiness per se, but it can buy some things that will make you happy–a plane ticket to see your family, or food for a birthday party, or that painting you’ve been wanting for your bedroom. And, of course, money also supplies the necessities of life–food, clothes, medication–without which we find it harder to be happy.

The problem comes in defining and obeying the line between discretionary spending (luxuries) and autonomous spending (necessities)–particularly if you are used to a certain level of discretionary spending and are finding yourself required to reduce it. (more…)

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