There is a relatively new field of social science (i.e. the study of social behavior) called behavioral economics. It has been around for about 10 years formally. And two of the leaders in the field (Daniel Kahneman and Amos Tversky) received a Nobel prize a few years back. As a psychologist, initially I had a bit of a cynical view of the field — largely because the idea of economists telling us about behavior patterns struck me as rather ludicrous (economists aren’t known for being very accurate predictors of anything.) But, ta-da!!, it turns out that most of the leaders in the behavioral economics field are actually trained as psychologists (Kahneman, Tversky, and Ariely).

In the past, I have written on the psychology of investing and also the kinds of errors investors make (for example, pulling out your money after the stock market has dropped, and putting it back in after the stock market has already rebounded significantly — sounds like the fall of 2008 and spring of 2010).

Recently, Dan Ariely, a psychologist and behavioral economist at Duke University has been in the news. He has written a new book, The Upside of Irrationality and it was recently previewed in Forbes.

I have his previous book, Predictably Irrational, and thought I’d share a few of his observations and conclusions which I think are quite applicable in our daily lives.

Just to whet your appetite, here are some of the chapter titles:

The Fallacy of Supply and Demand
The Power of a Free Cookie
The Power of Price
The Cost of Social Norms.

The premise of the book is that people do not make rational decisions — especially with regards to money (spending, buying, saving, investing). And further, that we are predictably irrational — there are patterns that we follow.

Let me share from the section entitled, The Truth about Relativity. The main point is that “humans rarely choose things in absolute terms. . . Rather, we focus on the relative advantage of one thing over another. . . We are always looking at the things around us in relation to others. We can’t help it. . . (w)e not only tend to compare things with one another but also tend to focus on comparing things that are easily comparable — and avoid comparing things that cannot be compared easily. . . We like to make decisions based on comparisons.”

Ariel then cites a series of experiments that show a number of principles:

1. People like to make decisions by means of comparing choices (what clothes washing machine to buy, what job offer to take, who to date).

2. If a person does not have an alternative to compare to, they very likely will “pass” and decide “no”.

3. When there are multiple alternatives, people usually (not always, there are some other factors that can intervene) choose the “middle” option. They don’t want the most expensive and they don’t want the cheapest (items on a restaurant menu, clothing, professional services).

4. The downside to comparing, is that we often feel unsatisfied with what we have when comparing to those around us (feeling others have a better job than we do, a better car, took a better vacation, etc.) So comparing usually leads to dissatisfaction.

So here are some of my observations and applications.

a) Although it is good to differentiate yourself in the marketplace from your competitors, if you are too different, potential customers can’t compare you to the competition and they will not choose to use you.

b) When marketing goods or services, know who your competition is and what their price points are. Try to fall in the middle price range (but offer more value).

c) If you are offering a new or unique product or service, provide at least two options (a more expensive one and the one you really want to sell) so customers have a “choice”. [Ariely actually cited a study that demonstrated this application.]

d) If you want to limit your spending, surround yourself with individuals whose lifestyle is lower than yours — not higher. When you compare yourself to what car they drive, where they buy their clothes, and where they go on vacation, you will feel less pull to “trade up” and spend more.

e) When you are shopping, be aware that marketing departments of stores know about the tendency of people to choose the middle price option — often the lower price is actually a better deal.

Have a great week — and watch that irrational behavior!

I am not an economist (thankfully).  But economists, meteorologists (those who try to predict the weather), and psychologists are somewhat in the same situation — our ’sciences’ are not very “hard” — that is, they often are not solidly grounded in data and they lack power to predict.  For example, last night there was no prediction at all of any precipitation and we had a major rain and hailstorm in our area (up to baseball sized hail!).  Part of the problem for all three of these sciences is that there are numerous inter-related factors (many of which are still unknown) that need to be accounted for in trying to predict what will happen.

The point is — no one really has a good handle on the future of the U.S. (and global) economy.  Just turn on the TV or radio and you will hear numerous opinions on what is happening, and what needs to happen to make our economic situation improve.

But let’s take a look at the basics and this will give us some clues.  Economic activity, at its core, is the exchange of goods, services or information for monetary value.  Going back to some basic cause and effect relationships we can follow the following line of thought:

• People work and receive money for their services.
• When people don’t have jobs, they don’t make (as much) money.
• When people don’t have as much money and don’t see the opportunity for more money come in, they either don’t spend as much, or spend on credit.
• At some point, most people, when their income is reduced over a period of time, reach a limit of what they can buy on credit or realize it is not a wise pattern to continue.
• Eventually, people begin to “cut back” on non-essential spending (eating out, recreational activities) and also tend to slow down the process of replacing existing belongings (new technology, new clothes, furniture, cars).
• The lack of spending means businesses are selling less goods and services, receiving less income, and have to cut back expenses in their business, which includes labor.  Hence, they reduce employees’ hours or lay off employees.
• These people now have less money to spend.
• And thus, the negative spiral of an economic downturn continues.

The key question becomes: how does this negative cycle turn around?  This is where economics becomes largely theoretical, and an individual’s answer is related to their beliefs about economic activity and individuals’ behavior.  President Obama and others believe governmental intervention is necessary. Others believe letting the free market forces drive the process.  And obviously, there are combined approaches.

I believe that this is where understanding the psychology of our culture is important.  In actuality, as in economics, there are actually two fairly diverse sets of beliefs that exist is our culture.  And these belief systems drive different expectations and behaviors.

Cultural Belief System #1:

• I deserve “x”.  I have had “x” before, and I still want it. [Note: “x” can be a lot of things — money, a job, health care, free time, retirement benefits, a nice home, etc.]
• If you have “x” and I don’t, you should share at least some of your “x” with me.
• If I don’t have “x”, somebody should do something so that I can have it.
• The problem (of whatever causes me not to have “x”) lies in a greater system of rules, organizations, factors that I don’t have much control over.

Cultural Belief System #2:

• Life is what it is, including bad (or unfair) circumstances.
• Some of my life’s circumstances are directly related to my choices; some circumstances come from factors outside of my control.
• If I want the circumstances in my life to be different, it is largely up to me to figure out how to make that happen. There may be some larger system issues that may need to be changed, but I can’t depend on that happening.
• Making my life’s circumstances better may require me doing things I would prefer not to — work long hours, do work that I don’t enjoy; relocate; be away from my family for a while; live a simpler lifestyle than I am used to.
• I will do what I can to improve my circumstances, knowing there are no guarantees, and hope for the best.

And here we come to a critical factor that can impact a person’s future:  hope.  Psychologists believe that the loss of hope is a key component of depression.  A person can go through a lot of negative circumstances — and become discouraged, worn out or sad.  But when they lose hope that “things will get better”, that is when more serious depression develops.  They give up.

So here is what I predict, as a psychologist.

1. The economic recovery is going to take longer than what most Americans want.  This is due to the economic reality that the ultimate recovery is related to job creation and the resulting economic activity that occurs, and this appears to be a long-term issue.  And secondly, our culture is very present-oriented with little patience.  We want things “now”, and this is unlikely to occur.
2. There will be two groups of people that experience the economic downturn differently:

a)  There will be people who expect life to be “like it used to be”, and expect someone else to make that happen (largely, the government or maybe ‘big business’ or the wealthy.)  These people will become increasingly impatient, angry, and demanding of others.  Their focus will be on economic relief programs and governmental bailouts.

b) There will be a group of individuals who take steps in their lives to make the best of a bad situation, and who will ultimately (some, not all) find opportunities economically — to provide goods, services or information that others need and are willing to pay for.  Their life circumstances will probably be difficult for a period of time but they will “deal with it” and continue on.   There will be a portion of this group who will find significant economic success as a result of their efforts (there are always people who find ways to make money in difficult economic times.)

I think it may be a good time for each of us to ask ourselves:

• What do I believe about what is happening?
• Which group do I want to be a member of?

I have been collecting some articles on psychology and wealth from a variety of journals I receive, and recently there was a group of articles published in the Monitor of Psychology which is published by the American Psychological Association.  I thought I would briefly share some of the information reported.
One article in the January 2009 Monitor entitled “Mind over money” was an interview with Dr. Paul Zak who is the founder of the Center for Neuroeconomics Studies.  He is the author of a recent book, Moral Markets: The Critical Role of Values in the Economy (2008).  In discussing the neurology and brain functioning of certain behaviors, he states: “You need to know that your brain is prone to overreaction. . . When there’s a lot of uncertainty, like there is in the stock market, it turns out that making decisions involving money generates strong activation in the areas of the brain associated with fear. .. Studies have shown that brain areas that process risk are the same ones that process pain, so the brain’s reaction to this fearful, uncertain environment is ‘Get away!’”

Dr. Zak continues, “The same dopamine [a brain chemical] system … also activates when we get any kind of new news.  One thing I suggest .. is not to watch TV, where you’re going to get all this rumor and innuendo. Wait until the next morning and read the papers.”

“Just as we saw an overreaction when the market was trending strongly upward, I think we’re also seeing an overreaction as the bubble is bursting.  The brain has put you into survival mode.”

Another article, entitled “What’s Behind American Con$umeri$m?”, (from the July / August 2008 Monitor on Psychology) attempts to answer the question is:  ‘Why do Americans consistently spend more than they earn?’  For example, since 1982 it is reported Americans’ personal savings rate has dropped from 11 percent to below zero.

Some different ideas postulated to answer the question of reduced spending include:

• When we are under stress (as most Americans are), we are more at risk for spending.
• The availability of credit cards to young adults conditions them to the process of incurring debt at a young age.
• Credit cards also facilitate impulse buying (more than buying with cash or checks.)
• We are bombarded with constant messages to spend through TV, the Internet, catalogs, print media and bathroom stalls, airplane tray tables, even egg shells.

Finally, “The Price of Affluence” discusses recent research which shows that “privileged teens may be more self-centered — and depressed — than ever before.”  Although this is really not ‘new’ news, the theme continues.  One of the authors cited, Dan Kindlon from Harvard, has written an excellent book, Too Much of a Good Thing: Raising Children in an Indulgent Age.

Another psychologist, Madeline Levine, believes that much of the mental distress is created by a fear of failure (both by the teens and by their parents).  In fact, one study indicates that parents who overemphasized accomplishments were more likely to have teens who were depressed, anxious, or used drugs.  Additionally, it is suggested that parents not shield their children from early life disappointments — let them try and fail, and learn from it.

I have written previous entries that may provide some additional information (a few worth looking at are: The Price of Privilege; The Dark Side of Wealth; Contentment - A Counter Cultural Concept ).

Have a good week!

Two weeks ago I shared some thoughts from the very interesting book, Inside the Investor’s Brain, by Dr. Richard Peterson. Here are some more of his insights. Some of the initial parts (e.g. feelings) are fairly self-evident but are necessary foundations for later comments and conclusions. [reminder: page numbers are in parens]

Feelings
Feelings are the result of the comparison of one’s expectations and the actual experience. So when one expects a positive event (gains in one’s investments) and this happens, there is a positive response (elation). When you expect a positive event and the event doesn’t occur, a negative feeling response occurs (e.g. disappointment). If you expect a negative event (losses in your investments), but a positive event occurs instead, you have a positive response (e.g. relief). If you expect a negative event, and it occurs, a negative response occurs (e.g. anxiety).
The intensity of the feelings experienced is the result of three factors:
a) the size of the discrepancy between expectations and reality;
b) one’s experience with similar situations; and
c) any significant associations or memories. (39)

So, obviously, the larger the gain in relation to your expectations, the “higher” you will feel. Or the greater the loss in relation to your desires, the deeper the anguish will be.

Comparisons

I find the process of comparing ourselves to others to be one of the biggest contributors to our state of emotional being. And, as I have emphasized previously, we typically compare ourselves to others whom we pereceive to be “better off” than we are (and often our perceptions are incorrect). Thus, we can become angry, disappointed, or envious. Conversely, if we compare ourselves to less well off than we are, we can be quite thankful for our lives (and sometimes feel guilty, too.)

Dr. Peterson states:
“Emotions often arise when one compares his or her life circumstances to those of others.” (40) “This comparison phenomenon occurs throughout the business world, where measures of self-esteem and accomplishment are often made tangible. Silicon Valley billionaires may feel jealous of the size of each others’ yachts, leading to a boom in the construction of ultra-luxury vessels as each tries to outdo the others. A non-billionaire sailor may feel happy simply to be in the same marina as such beautiful boats.” (41)
Peterson goes on to propose that “when one measures success by comparing oneself to another, . . . then winning the comparison makes one feel happy, but also deprives one of the motivation to continue working hard. .. Alternatively, when success is measured according to an internal benchmark, … then it remains an enduring motivation and leads to long-term excellence.: (41)

Defense Mechanisms

Sometimes we employ the use of psychological mechanisms to defend ourselves from feeling negative feelings (which we typically don’t like to experience) such as guilt or anxiety. One defense mechanism is rationalization where an individual attempts to provide a rationale (a logical reason) for their choice or behavior which created a negative result.
Peterson cites one type of rationalization investors often use called motivated reasoning. “Motivated reasoning is thinking biased to produce preferred conclusions and support strongly held opinions.” (45) [ASIDE: There seems to be a lot of this type of thinking going on in the political realm, on both sides of the spectrum.]
An important implication is that “people who engage in motivated reasoning perform more poorly on decision-making tasks than those who are less defensive about negative information. . . George Soros indicated that one of the keys to his acumen is the ability to non-judgmentally think about why his investment reasoning process may be wrong (his theory of fallibility).” (46)

Investing and Feelings

“ ‘If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring.’” [George Soros] (91)

The Jackpot Trap. Studies of individuals in casinos, reveal the following thinking patterns of individuals gambling. People tend to focus more on the size of the potential reward (the jackpot), rather than the probability of winning.
There are a number of cognitive misjudgments that occur during games of chance (and which can impact financial investment decisions, as well.) Dr. Peterson cites research that found the following:
“When an outcome is possible but not probable, people tend to overestimate its chance of occurring. This is called the possibility effect. (Frequently seen during huge lottery jackpot payoffs.)
When an outcome is likely, people to tend to underestimate its odds. This bias has been named the certainty effect.
Events of probability less than 40 percent are susceptible to the possibility effect. Outcomes with greater than 40 percent probability are in the realm of certainty effect.” (177)
“For the most part, there is dissociation between intellectual judgments of risk and emotional feelings about risk. Emotions in uncertain or risky situations are more sensitive to the possibility rather than the probability of strong consequences, contributing to the overweighting of very small probabilities. In general, naïve investors think that very low probability but emotionally loaded events (such as potential market crashes) are much more likely than they actually are. High-likelihood, emotionally weighted outcomes, such as bull markets, are assumed to be less likely than they actually are.” [emphasis added] (178)

The Anatomy of a Stock Hype

Some investment opportunities directly appeal to investors’ emotional reactions. One such deal is the “stock hype”, where a promoter attempts to hook investors’ interest and commitment by the style in which the information about the investment is communicated. Unfortunately, I could track point-by-point with him on times when I have succumbed to the pressure of this approach.  Dr. Peterson presents the following characteristics of a stock hype:

1. Novelty. An emphasis on new or overlooked areas of the market, in order to stimulate curiosity.
2. Anticipation of a large gain. Suggestions that investors could expect a “huge payoff”.
3. Information overload. Sales pitches loaded with lots of statistics such as projected revenues, earnings, projected market size. The large amount of information tends to shut down people’s ability to critically analyze the data.
4. Bargain buying. An appeal to the investors’ search for a bargain by using phrases such as “under book value” and “dirt cheap”, implying that one can’t lose by investing.
5. Author as expert. The communicator of the deal presents themselves as an expert in the area of investment, attempting to foster a trust of his recommendation. Using obscure, detailed data in one ploy used.
6. Time pressure. The deal is presented in a manner that makes the potential investor to feel as if they may “miss out” if they don’t act quickly. Individuals need to “act soon” or the offer is going to close soon. (94-95)

There is a lot of other both interesting and practically helpful information in this book. One final point from some research Dr. Peterson summarizes: we tend to make better decisions (both in life, generally, and financially) when we are rested, are eating healthily (limit fat, caffeine and alcohol), get moderate exercise, and are connected relationally to others (306-307). So go live a healthy life and have the wonderful secondary result of making better decisions, as well!

I’m on vacation this week — and when I’m on vacation (after the first few days of brainless activity), I dive in to books I have had in my reading pile for a while.  One of the books I brought, Inside the Investor’s Brain: The Power of Mind over Money by Richard Peterson, (published just this year) is quite interesting.  And I’d like to share some of the thoughts from the book with you all.

First off, Dr. Peterson is an associate editor at the Journal of Behavioral Finance, is a psychiatrist, a former stock trader and did postgraduate research at Stanford University in neuroeconomics (i.e. studying the neurology associated with financial decison-making).  So he is no lightweight.

Secondly, the primary focus of the book is to summarize the research which has been conducted over several decades regarding the psychological processes that underlie and impact investment decision-making, and to tie these factors to the physiological components that accompany them neurologically.  That is, Dr. Peterson looks at various decision-making strategies, the biases that interfere with good judgment, the emotional aspects (e.g. fear, overconfidence) that are intertwined, and what is going on chemically within the brain with these.

Rather than summarize the main points here, I want to just give some semi-random snippets of quotes that I personally have found interesting (page numbers follow the quote in parentheses).

“In investment management, mathematical genius may perform well in the short term, but it is no substitute for emotional intelligence.”  (2)

“The pursuit of profit for its own sake can quickly go awry. . . Pursuing profit as one’s primary goal can be a sign of emotional ill health. . . when money becomes the goal, rather than a by-product of enjoyable work, then emotional stability is apt to suffer.” (290)

“‘Our probability assessments shift based on how others present information to us.’” [Michael Maubossin]  Emotionally, investors have stronger reactions if possible outcomes are more vivid or imaginable. . .Stocks with exciting stories cause people to forecast high stock returns.” (179, 181)

“Because the future is intrinsically uncertain and market dynamics change, the past is a poor guide to the future.” (187)  “‘The fundamental law of investing is the uncertainty of the future.’ [Peter Bernstein] (179)  “‘The future is never clear, . . . Uncertainty is the friend of the buyer of long-term values.’” [Warren Buffet] (180) “‘Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.’” [George Soros] (182)

“But, in general, it is a congruence of characteristics, not any one individual trait, that leads to true excellence.  To achieve greatness in investing, education is the first step. . . . The next step is a self-evaluation. Identify your strengths and weaknesses and inventory your resources.  What is your psychological Achilles’ heel, and how will you protect it? . . . Small positive changes in psychological well-being, mental training and physical health improve the probability of successful decision making.  A slightly increased probability of success, over years of decision making leads to better long-term outcomes.” (289-290)

“‘Self-discipline is the single most important success factor.  Without it, nothing else matters.’ [Howard Fleishman, PhD, performance psychologist]. . . one’s degree of self-discipline correlates with wealth level.  In general, pursuing immediate gratification erodes prosperity. . .Investing ‘rules’ are useless for people who don’t first have discipline.” (295-296)  “‘No one can do your push-ups for you. [Jim Rohn]’” (290) 

“‘[Profitability] comes when the investor realizes that investment success does not come from external control, but from internal control.’” [Van K. Tharp] (301)

Dr. Peterson has a number of chapters on the emotional components of decision-making (intuition, fear & anxiety, excitement and its relationship to greed, overconfidence, the love of risk, and the impact of stress on decision-making).  Additionally, he summarizes a number of perceptual biases that affect making good decisions. (I hope to share those later).

To close, I’ll share from the preface to the book: “to really excel in investing, you’ve got to learn the skills to manage yourself.” (xv)