How to plan for disasters and personal finance — with social psychology

July 7 14 Comments latest by Rob Cain

There’s a great article in last weekend’s New York Times Magazine on disaster preparedness, which I want to use to highlight the social-psychological reasons for why we behave the way we do.

Photo from e-strategyblog.com

Read the article closely and notice the parallels between preparing for a disaster and preparing for your financial future. They are eerily similar.

Statistics on how few of us are prepared for a disaster, just like few of us are prepared for retirement:

In July and October 2005, the N.Y.U. Center for Catastrophe Preparedness and Response found that 50 percent of survey respondents reported their preparedness level as “about the same” after 9/11 as it was before, while 4 percent said they were either “somewhat less prepared” or “much less prepared.”

A number of things prevent us from preparing for disasters, including self-protective psychological factors that make us not want to think about it. The same protective mechanism works when you have people who are afraid to open their own bills, yet they keep on spending.

What prevents us from preparing for disasters? … Bad advice and false alarms discourage all of us from listening to authorities; the government’s calls for us to build atomic shelters or heed code-orange alerts have done more harm than good [Ramit’s note: Just like Wall Street’s constant drum for new products and BUY/SELL/DO ANYTHING!!! has inured us to taking reasonable steps with investments]. For the poor, scrambling to make it through the small crises of everyday life is far more urgent than planning for a possible emergency, and investing time in preparedness efforts seems relatively unimportant.

A key point: By offering us so many choices about what to prepare for, we do nothing. There is an exact parallel with the number of investment choices in a 401(k): “For every 10 mutual funds made available, the rate of participation in 401(k) investing goes down 2%.” That’s from The Paradox of Choice.

For everyone, there are opportunity costs involved in preparing yourself and your family for a catastrophe that’s unlikely to happen.
One major concern I heard was that there are simply too many things to worry about. Participants complained about having to prepare for too many specific disaster possibilities and in turn feeling overwhelmed, if not helpless.

Finally, a comment about how we don’t want to live in a culture of preparedness.

Beyond that, many people simply don’t want to live in a culture of preparedness. The notion is off-putting, and downright scary for some, because it seems to place fear and defensiveness at the center of our public and private lives. Careful planning means dwelling on the uncomfortable topics of our own mortality, the vulnerability of our loved ones and the fragility of our planet, and there’s a psychological price to be paid for that.

Using social psychology to motivate attitudinal and behavioral change
Let’s tackle the last point — that “we don’t want to be prepared” — which I disagree with. It’s a broad, overreaching statement to say that we don’t want to be prepared (and, in fact, that takeaway was taken from anecdotal research the reporter did from talking to some friends). But it’s an important one: Whether with disasters or money, it’s not that we don’t want to be prepared. Rather, the question is, “Under what conditions would we actually prepare?” Once you can identify patterns in people that do prepare, you can experimentally test and generalize.

Psychology experiment: How to get young people to get tetanus shots (or save money)
Rather than making things up, let’s turn to the social psychology literature to understand how this works. Howard Leventhal has been a prolific researcher in this area, and his study of tetanus shots is a seminal one.

First, the difference between attitudes and behavior: We all say we should be exercising more. We all believe we should read more high-quality publications. And if you asked 100 people if they should be saving more, 100 people would say yes. All of those are attitudes.

Yet, Americans spend more than they make, don’t read very much, and are fat, obviously violating their own attitudes with their behavior. Newspaper journalists will bemoan the American public for being “irresponsible” and “short-sighted,” but psychologists recognize that they need to ask the right question: What kind of message will get people to take action? Here, we turn to health psychology for an answer on how to help people do something that they agree is important, but need help making their behavior congruent with their attitudes.

Leventhal and his team decided to investigate how to get students to get tetanus shots. Once again, they varied the fear levels of their message and found that high-fear messages produced “favorable attitudes toward the tetanus shots among the students, and they also increased the students’ stated intentions to get the shots.” However, I believe Warren G. once said, “attitudinal decision-making ain’t shit.” (That is a complete lie.)

Indeed, a month after the experiment, only 3% of participants had gotten a tetanus shot. As we know, saying something is important doesn’t mean we’ll actually do something about it.

Leventhal was no fool. He added a clever twist that produced astounding results. He took the same messages and simply added a campus map, highlighting the location and times for tetanus shots. By removing the passive barrier, compliance soared to 28%.

The key was giving people a fearful message with specific instructions on what to do next.

Note: Please don’t run off screaming “I KNOW HOW TO MAKE PEOPLE DO THINGS BY USING HIGH-FEAR APPEALS!!!” The research is a little more complicated than that.

What’s the point?
The key takeaway is that informational messages alone, with no influence tactics, are the least persuasive of all. For example, if I simply write up a 1-pager on different types of retirement accounts, I can expect 0% compliance with any behavioral change. (Think about that. Most people believe, “If you have the information, you’ll make the right decision. That is entirely incorrect.)

Just adding fear to the message doesn’t change much: It’s generally ineffective at behavioral change on its own, particularly if the action is far off in the future and make me psychologically uncomfortable to think about (disasters, retirement). You must understand who your audience is and what persuades them.

So, how do you change your own behavior and your friends’ behavior? By experimentally testing your message — how it’s communicated, the persuasive elements within, who it comes from — and by adding specific instructions about what next steps to take, we can help people to make better decisions and, more importantly, take action for their own self-interests.

There are ties between disaster planning, personal finance, and social psychology. I hope this post stirs us to think about how we can better influence our friends to think about planning for their own best interests.

* * *

Note: Research was taken from Age of Propaganda, The Paradox of Choice, and The Tipping Point. All highly recommended.

Interested in having me speak at your school/company? Click here for my speaking details.

(23 votes, average: 3.74 out of 5)

 Loading ...

Email Print Share: Digg/Del.icio.us/Permalink

14 Comments latest by Rob Cain

A fantastic book on behavioral psychology: Sway ($1,000 giveaway)

June 27 34 Comments latest by Rob

Note: There is a $1,000 giveaway at the bottom of this post.

Do you think you could tell the difference between a Coke and Pepsi?

Of course you do.

When I was an RA in college, my residents insisted they could, so I bought Cokes, Diet Cokes, Pepsis, Diet Pepsis, and a generic soda to test them. Of those who tested, every one insisted they could tell the difference.

Only 3 out of 47 could.

In fact, most of us can’t even tell the difference between Coke and Pepsi in a blind test — yet when presented with data indicating how we routinely fail to tell the difference, we insist that we’re different.

Today’s book review is about a remarkable book, Sway, that details how we’re irrational, yet we fail to acknowledge it. Ori Brafman, a friend of mine, and his brother Ram Brafman write about how we insist that we behave methodically and purposefully — that we have an idea, and we act on it. Unfortunately, this ignores decades of research and great stories showing that our behavior is influenced by even the slightest of changes to our environment: We eat more because the plate is bigger, we remember things because they were presented in color on a loud commercial, and we invest in things because our friend told us about them.

I got a review copy of this book and thought it was superb even before it became a New York Times and Wall Street Journal bestseller.

As this fascinating article from Harvard Magazine points out, ‘Poor families are often deterred from applying to colleges for financial aid because the forms are too complicated. ‘An economist would say, ‘With $50,000 at stake, the forms can’t be the obstacle,’ he says. “But they can.’” (And there’s data to prove it.)

I love exploring rationality and relating it to personal finance. For example, many of my friends at Stanford graduated with an economics degree, and many of them assumed that because they knew econ, they understood personal finance. In fact, my friend a bulge-bracket investment bank recently told me about an internal study they ran on their highly compensated portfolio managers. It turns out that the portfolio managers’ asset allocations were no better than average — an astonishing finding considering (1) how bad most people are at investments, (2) that these PMs are paid millions of dollars per year to manage professional portfolios, and that (3) asset allocation is responsible for 90%+ of returns.

Sway is a book of fascinating anecdotes about irrationality, psychology, and financial findings. It’s a key book to understanding why we behave the way we do — and to changing our own behavior. I’ll pull out some of the most interesting findings here.

How A Hot Girl Can Cost You $10,000
You’ve seen me write about how credit card companies (and any good company) test their marketing to find the optimal solution. Here, for example, are two mailings that my friend received. Can you spot the differences?

The Brafmans have a new wrinkle to add to this.

“In South Africa, a consumer lending bank wanted to push personal loans to 50,000 of its customers. Working together with a team of economists, the bank crafted several variations on the same basic loan offer letter. The different versions were randomly assigned to recipients and mailed off without the recipients ever knowing that the letter they had received was part of an experiment.

The letters included different interest rates (ranging from 3.25% to 7.75% per month); some featured a comparison to a competitor’s rate, others a giveaway…and still others a photo of either a man or a woman’s pleasant, smiling face.

Now, you’d think that the customer would evaluate the offer based purely on interest rate and the specific terms of the loan…The unexpected effect kicked in with the least relevant variation: the inclusion of a picture of the smiling face in the corner. Men who received a picture of one of four smiling women were much more likely to sign up for the loan than the men who received a picture of a smiling man. The magnitude of this effect is ‘about as much as dropping the interest rate 4.5 percentage points.’” (Page 74)

Malcolm Gladwell’s Blink does a great job of highlighting irrelevant information and its effect on our decision-making, but I found several interesting studies in Sway that I hadn’t heard of before.

Why We’re Afraid of Having Anything Taken Away From Us– And Why We Pay Dearly
We’re more motivated by loss than by gain.

“Companies like Avis and Hertz, facing the challenge of selling a product that is both useless and overpriced, have capitalized on this powerful effect. When we rent cars, our credit cards — not to mention our own car insurance — automatically cover us should anything go wrong with the vehicle. But the rental companies push additional coverage that not only is redundant but would cost a whopping $5,000 on an annual basis. But…the sales rep asks whether we’d like to buy the loss damage waiver. When we hear those words, our minds begin to whir: What if I have bad luck and end up in a wreck? What if, for some reason, my credit card won’t cover me after all?”

This simple technique also explains why we pay more for subscriptions that we don’t fully use when it would be cheaper to pay a la carte: Beyond just convenience, we worry about being overcharged a huge amount one month.

The framing of an offer is important. People criticized Coke when they tested raising their vending machine prices during warm weather to test price elasticity. Imagine the reaction had they lowered prices during cold weather. Whenever I write an email, I try not to use negative phrases. Again, the framing matters, whether in politics or personal finance.

Loss Aversion and Commitment — Like Pringles, Once You Pop, You Can’t Stop
I’m sorry, but I had to make the Pringles reference. Anyway, the authors show how loss aversion, combined with commitment, can form a powerful persuasive force. In fact, gangs and cults use this quite effectively: They make it difficult to join the group (using increasingly difficult initiation rites) and, once you’re in, make it difficult to leave (by demanding you tithe all your money or promising physical retribution if you try). In Sway, the Brafmans write about an auction held each year in a Harvard professor’s class, where he auctions off a $20 bill. The only two rules:

“Bids are to be made in $1 increments. The second rule is…the runner-up must still honor his or her bid, while receiving nothing in return.” You would expect that people would bid up to $20 for the bill, and in fact the bidding escalates quickly until about $12 to $16. “Without realizing it, the two students with the highest bids get locked in. ‘One bidder has bid $16 and the other has bid $17,’ Bazerman says. ‘The $16 bidder must either bid $18 or suffer a $16 loss. The students continue bidding, “$21, $22, 23, $50, $100, up to a record $204. The deeper the hole they dig themselves into, the more they continue to dig.” (Page 26)

Once we commit to something, we use adaptive self-serving biases to adaptively construe results to support our decision. For example, in a classic case of post-decision attitudinal adjustment, once you buy a Honda Accord, you’ll be more likely to notice Accords and to seek our confirming evidence that you made the right choice (such as reading positive reviews and talking to other happy owners of Hondas). Not surprisingly, this affects us even in conditions of life and death, as the Brafmans compare LBJ’s commitment in Vietnam to President Bush’s commitment in Iraq.

The More We Pay For Things, The More We Like Them
The Brafmans define value attribution as “our tendency to someone or something with certain qualities based on perceived value, rather than objective data.” Why do you spend $500 on a Coach bag or $2 more on Jiffy peanut butter? Those are easy examples, but let’s take a few others:

• Why D.C. subway passengers walked past Joshua Bell’s free violin concert, when he normally charges over $1,000/minute to play (page 42). In a beautiful example of social psychology, the Washington Post asked famous violinst Joshua Bell to bring his $3.5+ million Stradivarius to L’Enfant Plaza in Washington D.C. and play like a normal panhandler. We like to think we can recognize quality when we see it, but we’re more influenced by external factors than by how we think we’d behave. Take a look at the video to change your mind (hint: People didn’t just walk by because they were late to work.)
  

• Why Sobe makes you smarter — if you pay more (page 48). When students were given a mental acuity test and told that the drink SoBe would help with their results, they were put in 3 conditions: No SoBe, SoBe that cost $2.89, and SoBe that cost only $0.89. Why did SoBe drinkers who paid more perform much better than SoBe drinkers who paid less?
• If you discount tickets, you’ll get lower attendance (page 50). In a study of Ohio State’s theater department, “the people who paid full price attended significantly more shows than those who received either [a] $2 discount or [a] $7 discount.” In fact, attendance wasn’t linear: If you got a discount, whether it was $2 or $7, you attended less — just by virtue of the fact that you received a discount. If you’re an entrepreneur or consultant wondering what to charge for your services, let this be a lesson to you: In almost every case, don’t cut your prices.

The key takeaway here is that we value what we pay for. We love to believe that we behave in an A–>B model: We have an attitude (”I like charity”) and our behavior follows (”…so I volunteer at a soup kitchen”). We rarely acknowledge that many of our attitudes are formed by our behavior in a B–>A relationship: “I keep volunteering at this soup kitchen (because it’s close by / my girlfriend wants me to / I need school credit / I was asked to), so I must think it’s important. For more on this, read about attribution theory.

Similar Books I’d Recommend
If you’re interested, I’d consider Sway plus these other books, which are some of my favorites when it comes to social and behavioral psychology:

• Moneyball
  

• Judgment in Managerial Decisionmaking (this is a horrible title for an excellent book)
• Influence: The Psychology of Persuasion
• Mindless Eating: Why We Eat More Than We Think

General Thoughts On Sway: I Like It
The book isn’t perfect: Though the stories are fascinating, at times the book rambles and struggles to link back to the chapter’s original point. Also, the authors are a little too fond of clever social-psychology phrases.

Overall, I’m a huge fan. There were dozens of studied cited that I hadn’t heard about, and Sway uses these examples to great effect to point out examples of irrational behavior and help us understand why we act the way we do. It’s also an excellent guide for understanding why others act the way they do, and I’ve found myself thinking back to the examples while in meetings when people are acting in a particular way. It’s now permanently on my bookshelf, under the psychology section.

* * *

Giveaway: Free gas for all of 2008

All right, guys. I checked with Ori and he agreed to do this for iwillteachyoutoberich readers.

If you buy a book and send your receipt to swaygiveaway@gmail.com in the next 3 days, one winner will get free gas for the rest of 2008 (up to $1,000).

So, here are the details (full rules here):

1. Buy a copy of Sway in the next 3 days
2. Send your receipt to swaygiveaway@gmail.com (forward/scan a receipt) by 11:59pm this Monday, June 30th
3. I’ll announce one Grand Prize winner, who will get free gas for the rest of 2008

Get Sway Here.

[Edit, 7/7/08: The winner has been announced.]

(3 votes, average: 4.33 out of 5)

 Loading ...

Email Print Share: Digg/Del.icio.us/Permalink

34 Comments latest by Rob

Why my friend invests in an insanely expensive fund and why I don’t

September 19 45 Comments latest by Spread betting trader

I was working on my asset allocation this weekend — something I haven’t written about in detail yet — and had something interesting happen.

One of my friends works in finance and was hanging out with me. He told me that I should look at look at one of his company’s funds, which was doing really well. I checked it out and saw a 4.5% (!!) expense ratio, which means they charge a ton of fees. I felt ill. By comparison, some of my funds have a .18% expense ratio.

I told my friend that fund was nuts. For individual investors, passive management crushes active management over the long term. (I’ve written about Warren Buffet’s opinions on that here.) And yet my friend responded with something fascinating: “Working in the industry I’m in, you’ll never convince me of that.” To him, it really is about how “smart” the portfolio manager is. I covered “experts” here, here, and here.

To tell you the truth, the fund is doing great. But so are most funds over the last five years. And a 4.5% expense ratio is insane for the long term. Why don’t I just hand over my money in a God damned wheelbarrow, adding all of my pens on top too as icing on the cake, and have it couriered over to you in exchange for the chance to have my money managed by you? Oh, because I prefer not to hand my most treasured possessions over in exchange for seeming cool and for gains of questionable sustainability.

Interestingly, while my friend may have an understandable reason to believe what he does — he works in finance and works with Very Large Institutions — there’s an additional wrinkle. I asked what kind of funds his 401(k) offers. Surprise, surprise: His company only offers company funds to choose from. That means his funds charge a 4.5% expense ratio to him, too. So while there may be a difference between institutional investors and individual investors, in this case I wanted to see how he’d resolve the dissonance of having to choose an insanely expensive investment. I didn’t find a satisfactory answer because the fund’s been doing so well. But wait a few years until double-digit returns aren’t the norm and I’ll report back.

If everybody thinks something is true…
… chances are they’re right. When you think your performance — or the performance of someone you’re associated with — is likely to be wildly above others, you’re probably wrong. I mean that statistically, not pejoratively. As we know from Psych 101, “the Lake Wobegon effect is the human tendency to overestimate one’s achievements and capabilities in relation to others” — which we do in spades.

I read a site called Overcoming Bias, which recently featured a fascinating story by Kahneman and Lovallo:

In 1976 one of us (Daniel Kahneman) was involved in a project designed to develop a curriculum for the study of judgment and decision making under uncertainty for high schools in Israel. When the team had been in operation for about a year, with some significant achievements already to its credit, the discussion at one of the team meetings turned to the question of how long the project would take. To make the debate more useful, I asked everyone to indicate on a slip of paper their best estimate of the number of months that would be needed to bring the project to a well-defined stage of completion: a complete draft ready for submission to the Ministry of education. The estimates, including my own, ranged from 18 to 30 months.

At this point I had the idea of turning to one of our members, a distinguished expert in curriculum development, asking him a question phrased about as follows:

“We are surely not the only team to have tried to develop a curriculum where none existed before. Please try to recall as many such cases as you can. Think of them as they were in a stage comparable to ours at present. How long did it take them, from that point, to complete their projects?”

After a long silence, something much like the following answer was given, with obvious signs of discomfort: “First, I should say that not all teams that I can think of in a comparable stage ever did complete their task. About 40% of them eventually gave up. Of the remaining, I cannot think of any that was completed in less than seven years, nor of any that took more than ten.”

In response to a further question, he answered: “No, I cannot think of any relevant factor that distinguishes us favorably from the teams I have been thinking about. Indeed, my impression is that we are slightly below average in terms of our resources and potential.”

Facing the facts can be intolerably demoralizing. The participants in the meeting had professional expertise in the logic of forecasting, and none even ventured to question the relevance of the forecast implied by our expert’s statistics: an even chance of failure, and a completion time of seven to ten years in case of success. Neither of these outcomes was an acceptable basis for continuing the project, but no one was willing to draw the embarrassing conclusion that it should be scrapped.

So, the forecast was quietly dropped from active debate, along with any pretense of long-term planning, and the project went on along its predictably unforeseeable path to eventual completion some eight years later.

Brutal honesty is hard. Instead, we choose to ignore the hard facts and keep plowing ahead. It’s sexier to buy high-cost investments backed with a Big Brand Name that cost lots of money and trust that a Very Smart Expert will get you market-beating gains. It’s even more complicated when you get great returns for the past five years. But stop for a second. Did you systematically ignore the fact that most other funds have had a great run? Did you sit down and calculate how much that 4.5% expense ratio is actually costing you? Did you model out how much it will cost you for the next 30 years? If you haven’t done that, then why on earth would you pay such high fees? As always, would you rather be sexy or rich?

(3 votes, average: 5 out of 5)

 Loading ...

Email Print Share: Digg/Del.icio.us/Permalink

45 Comments latest by Spread betting trader