Let’s all step into the Mad Fientist laboratory for a minute to run a little experiment…
I’m going to give you a couple of scenarios and you just have to quickly choose one option and then move on to the next scenario.
Imagine you are the head of the US Center for Disease Control and a deadly disease breaks out.
There has been been an outbreak on two separate islands and there are two courses of action you can take on each island that will affect how many people survive the outbreak.
On island #1, if program A is adopted, 270 people will die.
If program B is adopted, there is a 40% chance that no one will die and a 60% chance that all 450 people on the island will die.
Programs A and B can’t be implemented on island #2 so you have to instead choose between programs C and D.
If program C is adopted, 180 people will be saved.
If program D is adopted, there is a 2/5 chance all 450 people on the island will be saved and a 3/5 chance that nobody will be saved.
Did you choose programs B and C?
When this experiment is conducted in an actual laboratory, the vast majority of people choose program B over program A and program C over program D.
So what’s the point?
Let’s take a closer look at these scenarios again. The expected values of the programs are actually exactly the same for all four programs. For program A, 180 out of 450 people will be saved. For program B, the expected value is (2/5 * 450) + (3/5 * 0) = 180 saved.
Now if you also take a closer look and compare the two scenarios, you’ll see that programs C and D are exactly the same as programs A and B, respectively. For program A, 270 people will die so 180 people will survive, which is the same as program C. For program B, there is a 2/5 chance everyone will survive and a 3/5 chance everyone will die, just as in program D.
So all programs are equal in terms of effectiveness, programs A and C are exactly the same, and programs B and D are exactly the same.
So why is it most people choose to gamble in the first scenario (program B) but choose the sure thing in the second scenario (program C)?
It’s all about how the outcomes are framed and how we feel about risk and loss.
Framing, Loss-Aversion, and Risk
If the problem is framed as a loss, as it is in the island #1 scenario (focusing on the people who die rather than the people who live), we become risk-seeking. Since 270 people would definitely die if we choose program A, we’d rather risk killing everyone for the chance of saving those 270 people.
If the problem is framed as a gain, however, as it is in the island #2 scenario (focusing on the people that will be saved), we become risk-averse. We want to protect our gains (in this case, the saving of 180 people) so the majority of us would choose program C to avoid the risk of losing those 180 if we instead chose program D.
So simply by framing the same exact outcomes in different ways, we’ve altered the decisions of the majority of the population.
How does this apply to finances?
So why am I making you put islanders lives at risk? To illustrate that your brain often affects your decision-making without you consciously being aware of it.
You may feel that you are smarter than other people and that you are able to make logical decisions when it comes to your finances but these subtle quirks of your mind influence every decision you make.
Let me present to you another study to further reinforce this point.
We’ve all probably heard of Gandhi. If you close your eyes, you can maybe even picture him. Since the image is likely an image of him shortly before his death, you’d most likely do reasonably well guessing how old he was when he died.
If before asking you how old you think Gandhi was when he died, I ask, “Did Gandhi live to be 140”, you’d probably laugh at my stupidity and say, “No, that’s ridiculous.”
If before asking you how old you think Gandhi was when he died, I ask, “Did Gandhi live to be 9”, you’d probably also laugh at my stupidity and say, “Absolutely!”
Neither of the responses to these two ridiculous questions is surprising. What is surprising, however, is how the responses to the “How old was Gandhi when he died” question are affected when you precede the question with one of the two ridiculous questions just mentioned.
When asked, “Did Gandhi live to be 140” before being asked how old he was when he died, participants answered, on average, that he was ~67 when he died.
When participants were instead asked, “Did Gandhi live to be 9” before being asked how old he was when he died, participants answered, on average, that he was ~50 when he died.
In this experiment, the ridiculous scenarios, even though they were far-fetched, served as anchors that ultimately affected the answers to the question about Gandhi’s age at death.
It’s not hard to see how this type of anchoring could affect your financial decision-making. If all the talking heads on CNBC are saying the Dow’s going to go to 18,000 by year’s end, an anchor is set in your mind that could potentially affect your view of the market and subsequently, your interactions with the market.
The bad news doesn’t stop at framing and anchoring, however. There’s also confirmation bias (the idea that we tend to place more weight on opinions that we agree with and discount or disregard information that we don’t agree with), illusory superiority (~80% the population believes they are above-average drivers), and many, many more.
How can you save yourself from yourself?
So what’s the solution?
My advice is to try to take your brain out of the investing equation as much as possible. I know that probably sounds like the worst investing advice ever but let me explain…
Your brain is useful when setting up an investment plan but it’s not useful when you execute that plan (for the reasons mentioned above).
I invest the majority of my portfolio in a total stock market index fund. This simple strategy has allowed me to take my brain out of the “what” question completely when it comes time to invest. I don’t spend hours agonizing over which stock to invest in this month and therefore, I don’t let all of the external factors present in the world unconsciously influence my decisions.
You can also take your brain out of the “when” question as well. To do so, set up an automated investment plan that automatically invests a certain amount of money every month.
Automating your investments will further decrease the possibility of your brain sabotaging your investing plan and will allow you to consistently invest your money as soon as it’s available to invest.
This post was inspired by a course on cognitive psychology and cognitive neuroscience I just completed for my free Ivy League degree.
Learning more about how the brain works has inspired me to further investigate what causes us to make the sub-optimal financial decisions that we do.
I am currently in the process of researching game theory, behavioral game theory, and behavioral finance to better understand decision-making in competitive environments and why so many of us do not make good decisions in these types of situations. Look out for more articles on these topics in the future!