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Thinking is Not Enough

This article was written by in Economics. 7 comments.


This is a guest article by Frank Curmudgeon, author of the Bad Money Advice blog. For updates from Frank, subscribe to the Bad Money Advice RSS feed.

We often see the struggle to get control of our spending as being the conflict between our emotional and logical selves. Emotion wants to go out to that new restaurant tonight, logic says cook at home.

We say to ourselves “If only I could stop and think about all my spending decisions, I’d soon be rich.” That’s not wrong, exactly, but it makes at least one big faulty assumption, that it is easy for us to be logical around money when we want to be. The truth is that just thinking about it is not always enough.

There is an entire field of economics, behavioral economics, which studies the differences between what logic would have people do with their money and what they really do. The academics in this area have collected many such “anomalies.”

Mississippi River

One that illustrates well the illogic of our thinking selves is anchoring, the tendency for people to be influenced by even the most ridiculous estimates of a number. The classic example is that if you ask people if the Mississippi is more than 6000 miles long and then ask them to guess its exact length, they will give much higher guesses than if you had just asked them to estimate its length. (It is 2340 miles long, by the way.)

Dan Ariely, a professor at MIT/Sloan, conducted a striking demonstration of this effect. He asked a group of MBA students to write down the last two digits of their social security number. Then he asked them if they would be willing to pay that amount of dollars for a bottle of fine wine he was holding. Finally he had them submit actual bids for the wine, which he really sold to the winner.

Sure enough, the students tended to bid higher if they had social security numbers that ended in higher digits. So the anchoring effect was there even though the participants were fully aware that the suggested value was completely random, even though they were sophisticated and thoughtful (have I mentioned I got my MBA at Sloan?) and even though it was their own real money at stake. This was not an impulse decision in which consumers let emotion get the better of them. These were would-be shrewd businessmen who undoubtedly assumed that Prof. Ariely was up to something sneaky.

And anchoring explains a few oddities in our everyday lives. It is why houses, cars, and jewelry often have high “asking” or “sticker” prices. The seller does not really expect to get this price and the buyer does not expect to pay it. So why bother? Because by attaching a tag on a watch that reads “$500″ the jeweler can more easily talk you into paying $425, even if you know full well that the $500 price was just for show.

And anchoring also helps explain some stock price movements, specifically the phenomenon called price momentum. That is the tendency for stocks that have been going up over the past few months to continue to do so.

Imagine that there is an exciting growth company that announces some positive news when its stock trades at $50. There is a large group of investors who love this company, are excited by the news, and would, in principle, pay $100 a share. However, because of anchoring, they just cannot bring themselves to pay more than $10 above what the stock was trading at in the past month. It just seems expensive. When the stock goes above that level these buyers back off, temporarily. After a few weeks, the current price does not seem so unreasonable, because they get used to it, and they resume buying. The result is that even though in a more logical environment the stock would have gone to $100 immediately, what actually happens is that it climbs steadily at about $10 per month over five months.

It’s important to understand that anchoring doesn’t happen because you are stupid, or too emotional, or overly influenced by advertising. It happens because you are human. It is the way your brain is wired up. You can’t stop yourself from doing it, although being aware of it is a great help.

The point is that merely resolving to think about how you spend is not enough. Spending logically is harder than it looks.

Photo credit: Don3rdSE

Updated June 4, 2009 and originally published June 2, 2009. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Frank Curmudgeon is an unemployed hedge fund manager living in the Boston area. Frank writes the Bad Money Advice blog, where he criticizes the personal finance advice given in the media and blogosphere and occasionally doles out some of his own. Subscribe to the Bad Money Advice RSS feed. View all articles by .

{ 7 comments… read them below or add one }

avatar Erik

I think the habits of spending and saving require a fine balance, just like everything else in life. You must master the balance of emotions and logic. If you make PF decisions solely on logic, you will make cold decisions that could adversely affect you, your family, and others around you. If you make decisions solely on emotion, you’ll spend too much, save too little, and think irrationally like the example you gave of the students with the bottle of wine.

I believe most people fail at personal finance, because they neglect to train their emotions and thoughts.

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avatar Rob Bennett

I believe that insights mined from the field of Behavioral Finance are the future of personal finance “research.” We need to be careful, though. The “research” that works when studying numbers is not the same as the “research” that works when studying human emotion.

I remember reading a book on behavioral finance that pointed to the phenomenon of risk aversion (most of us are less willing to accept losses than we are excited about enjoying gains). The book argued that this meant that most people went with stock allocations that are lower than what is ideal. Unfortunately, the argument was being made during the years of insanely high stock prices, a time when millions of us were going with stock allocations that were two or three times what the historical stock-return data indicated were reasonable at those price levels. Risk aversion is real. But it is something that we focus on at times when we are trying desperately to rationalize taking on excessive risk.

The good news is that our understanding of the extent to which we permit emotion to influence our spending and saving and investing decisions is so minimal today that the gains we can make by turning our attention to these questions is breathtaking. I believe that learning a little about behavioral finance will permit us all to retire five or ten years sooner than is possible given the state of knowledge of personal finance topics today.

Rob

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avatar ObliviousInvestor

Hi Frank.

Do you have any recommended reading on the topic of behavioral finance?

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avatar Rob Bennett

Mike:

It’s good to see you here. My recommendation is Shiller’s Irrational Exuberance.

Rob

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avatar Frank

I like Irrational Exuberance, but it’s not really on behavioral finance, per se.

Dan Ariely’s book Predictibly Irrational is good. There’s a new edition out. And I’ve heard good things about Terry Burham’s Mean Markets and Lizard Brains, but I must admit I haven’t read it yet.

And a good book on how we’re not nearly as bright as we think we are is Daniel Gilbert’s Stumbling on Happiness.

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avatar ObliviousInvestor

Thanks for the recommendations, guys. Adding them to my “to read” list now…

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avatar skylog ♦368 (Nickel)

i agree. thank you for the suggestions and good post

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