The Amateur Financier

One of the things that always fascinates me is the human mind and how it works.  We are rather interesting creatures.  Unfortunately, we’re not all that rational; while this is good news for psychoanalysts, it does make it harder for the rest of us to function properly without our minds sabotaging us.

Case in point, the Peltzman effect.  The short version of the Peltzman effect goes like this: people adjust their behavior to new safety regulations in ways that negate the intended effects of the legislation.  As a result, any attempt to legislate safety will be largely inefficient, because people will respond to laws designed to increase their safety by behaving in a more unsafe manner, thus negating the legislation’s intended effects.

For but one example, consider mandatory seat belt use.  In theory, the requirement that everyone use a seat belt while driving should cut down on severe injuries and fatalities from automotive accidents.  In practice, there’s an unfortunate tendency for people to drive more aggressively while wearing seat belts than they would if they were unbuckled.

Not to be too prejudiced against SUV drivers or anything...

Of course, you can probably think of plenty examples of the same think happening without the need for regulators to be involved.  When was the last time you were driving and saw someone driving a huge SUV in an obviously unsafe manner?  It’s not too much of stretch to hypothesize that part of the reason that people take more risks in those situations is because their feelings of safety lead them to behave in ways that decrease their safety, as well as the safety of those around them.  Their own sense of safety leads them to behave in a way that ultimately decreases their safety.

Peltzman and Your Money

As you might have guessed by now, there’s plenty of applications that this sort of psychological effect can have on how you manage your money.  The Peltzman effect, or similar methods by which we ‘trick’ ourselves about where our finances stand and the amount of .  To cite just a few examples:

-Getting a raise, and thinking that you can increase your spending even more as a result.  This type of lifestyle inflation can easily take its toll, not only decreasing the money you save and invest for the future, but also increase your perceived needs for what you need in life.

-Keeping too much of your investment money in riskier investments.  When we have long runs of high investment returns, there’s a bad tendency for many people to keep their money in investments like stocks that offer greater average net returns, but also have a greater risk of losing money.

-Investing without doing proper research, because of an agency rating.  Possibly the most topical example I have, there is an unfortunate tendency for people to invest somewhat blindly, putting money into investments that are highly rated without doing their own research.  *Cough*Credit Default Swaps*Cough*  The existence of outside agencies rating bonds and other investments led to increased confidence in them, leading to increased amounts of money that are put into the investments than is actually important.

Fighting the Peltzman Effect

So, now that you have a better idea of what the Peltzman Effect actually is, and ways that perceptions of safety can make you invest and otherwise handle your money in a less safe manner, you’re probably thinking about how you can fight this psychological effect.  Well, you’re in luck, as I have a few suggestions to help you out.

First, keep a close eye on how you invest and otherwise handle your money.  It’s easy to lose track of where you stand with your investments at times, and when you do, then you can end up letting psychological factors unduly influence your investment choices.  As the old School House Rock videos used to say, ‘Knowledge is Power’!

Second, know the real risk of your money choices. If you followed the first step and know what is going on with your money, you should be able to evaluate the risks that you are taking on.  Do your investment choices have the possibility of dropping much more than you can afford before you need to use the money?  Are you investing too conservatively to achieve the growth that you need?  Is your spending increasing much faster than your income?  Answering yes to any of these questions likely means that the risk you are taking is much higher than what is justified for your situation.

Third, make the necessary changes so that you can get your risk level back in line.  There’s no way to completely eliminate all risk, but you can ensure that you are only taking on the amount of risk you need to achieve your goals.  (If you do want to take on more risk, then you should limit that risk taking to a portion of your portfolio that you can afford to lose.)

Finally, don’t think that you can stop after doing one evaluation.  As with so many money management tasks, you can’t let up on keeping track of where you stand with the risk you take on.  Don’t let undesirable risk sneak into your investments, particularly if you don’t know exactly the level of risk that is involved with your money choices.

There you have it; a few methods to keep the Pultzman Effect (and ways by which your mind adversely influences your investment choices) under control.  Good luck keeping your mind in check; I know that you can do it.

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Every so often, I come across something that makes me pause and think.  I am a somewhat voracious reader and do come across a lot of interesting ideas.  Still, it takes something really out of the ordinary to make me sit up, take notice, and go, “Hunh?”

One such article was in an older issue of Time magazine, covering some new advances in marketing.  It featured discussion of neuromarketing research and one the new field’s pioneers, Martin Lindstrom, and his research into the effects of particular sounds on the human brain.  Oh, and how that research and the discoveries made could be used to force us into making purchases.

Wait, what?

Alright, that last sentence was a bit of an exaggeration.  No one, including Mr. Lindstrom, is saying that neuromarketing research can allow marketers (or politicians, or lobbyists, or anyone else who’d want to sway your opinions) to play a commercial that say, forces you to buy the newest and most expensive car on the lot.  That type of brainwashing, if it’s even possible, is still far beyond our scientific capabilities.  (Although, if YOU were able to force anyone to do whatever you wanted, would you be eager to share that knowledge with the world?  Or would you go the mad scientist route, hoarding it for yourself and using your new abilities to slowly take over the world?  I’m just saying, don’t expect a big press conference when mind control is perfected; there’s a lot to be gained by keeping that to yourself…)

"Looook at the Screeeen...Then Buy a Coke"

No, the sort of control we’re talking about here is more subtle.  Rather than playing a subliminal message that forces you to buy item X, Lindstrom is looking into the connections that we already have to particular sounds, the reactions those sounds illicit in us, and how those reactions can lead to moving product.

Certain sounds are embedded into our cultural consciousness; if you’re an American, hearing the tune to ‘My Country ‘Tis of Thee’ will generally cause you to be filled with patriotic emotions.  (The same is true if you’re a Brit, or a resident of one of the other countries formerly occupied by the British Empire like Australia or Canada; the tune is ‘God Save the Queen’.)  We have similar, culturally shaped reactions to everything from the sound of a phone ringing to the sound of a baby crying.

The concept behind neuromarketing, then, is to use those connections in order to influence customer behavior and sell more products.  Piping the sounds of a baby cooing into the baby food aisle at your local supermarket or the sound of children playing into a sporting goods store could influence how you feel and what you buy; the cooing baby might get you into a maternal mood, while the children playing may make you nostalgic for your youth, eager to recapture those days of playing freely out in the yard.  Retailers hope that these moods translate into actions like buying more baby food or shoes, leading you to spend more than you would otherwise.

How to Protect Yourself

Of course, if you’re trying to live frugally, the last thing you want is for the sound of coffee brewing as you walk through the beverage aisle to increase how much coffee you end up buying (particularly if you don’t even drink coffee).  You’ll need to develop ways of resisting the influence these sounds have over you if stores, advertisements, and other marketers start to make extensive use of them.

One way is start associating them with negative situations or events, to decrease their power to compel you.  The article in Time mentions that the default Nokia ring tone, for example, has become a loathed sound in the UK, primarily because of the poor cell phone etiquette practiced by users, causing other people to be turned off when they heard the sound.  (The same is true of the Microsoft start-up sound, due to the amount of time users spent listening to it after restarting their computers.)  Developing some resistance to the manufactured sounds designed to stoke your buying muscles can pay well in decreased spending.

Alternatively, you can fit cooing with crying; subjecting yourself to a recording of unpleasant sounds, like nails on a chalkboard will not only counteract any neuromarketing that a store attempts to use, but will also serve to make you speed up your shopping and spend less time browsing.  (A somewhat less torturous alternative, playing music as you shop, has possibilities as well; although, if you start associating some of your favorite songs with the shopping experience, they’ll end up making you think of shopping every time you hear them.)

Finally, you can just get used to neuromarketing techniques.  Much as with any type of advertising, the best way to keep it from being too effective may be to simply get used to it and work to keep it from affecting you.  You might not be able to keep the sound of a baby’s giggle from making you feel happy and parental, but you can keep it from making you buy an unneeded toy for you own baby.

Like any marketing method, neuromarketing seeks to increase the sales of a retailer or manufacturer; how successful it is depends on whether you are able to resist their influence.

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I am a big fan of philosophy, as you might well be aware, particularly as it relates to money.  Goodness knows, there are plenty of ways that our mental wiring affects how we use (or more frequently, misuse) money.  From misunderstanding sunk costs to greatly overvaluing current funds to those available in the future (hyperbolic discounting).

Today, since I like this subject, we’re going to cover a few more ways that your mind might be messing with you.  There are plenty of common logic mistakes that we all fall into from time to time, and knowing them will hopefully help us to avoid spending or investing money unwisely.  Since we’re on the subject of ways our minds mess us up, let’s consider one of the ones that get most people into trouble…

Failure to Understand Statistics

The Problem: Too many people don’t have a good grasp on statistics.  Particularly when the odds and the rewards start to get very big, there is a tendency to conflate them in your mind; 1 in 200,000,000 odds seem pretty reasonable with a prize of $200,000,000 on the line.  Too few people reason out just how extreme those odds are; fewer still, it seems, actually let the odds guide their actions.

Examples: Pretty much anytime gambling comes up, there will be people misunderstanding statistics.  Also, any situation where people devote more time and money to preventing high-impact, low frequency occurrences (like plane crashes) compared to more common but less ‘news-worthy’ disasters (like car crashes).

The Solution: Well, nation (and possibly world-wide) remedial education in statistics is one option.  On the personal level, gaining an understanding of probabilities and a general sense of how likely various events are to occur will help you to prepare for the ones most likely to affect you in a reasonable manner.  (As for gambling, just remind yourself that all the money needed to make those opulent casinos and employ all those workers (or run those nifty programs, for government sponsored lotteries) comes from people who don’t win; they can offer those huge cash prices AFTER paying all those costs because of all the money they take in.)

This is why the only game I play is Dungeons and Dragons

Blaming the Tool

The Problem: When something doesn’t go according to our plans, we usually try to protect our egos by finding something to take the blame.  That’s why there’s a tendency to blame the tools we use (or quite frequently, don’t use) for our failures.  It’s even an common English expression: ‘Bad Workers Always Blame Their Tools‘.

Examples: Weight loss videos don’t magically make you loss weight.  Books don’t automatically make you smart.  Most relevantly for our purposes, investment news letters and other sources of information don’t cause you to develop good money management skills by osmosis.

The Solution: With any tool, the key is that it has to be used, properly and often repeatedly.  Understand that you need to put effort into using your tools if you want any success.  Hard as it can be to face, your lack of success will more likely be your fault, rather than the fault of the tool.  (Although, this is not to say that every tool you will use is a good, high-quality one; there are some faulty tools out there, of all types.  But if most other people are having success with the tool you’re using, there’s a good chance that the problem is with you, not the tool.)

Faulty Pattern Recognition

The Problem: Not everything falls into neat, organized and predictable patterns.  That said, sometimes, there are patterns in the events that make up our lives, and being able to recognize those patterns and respond to them in a reasonable manner is part of the whole ‘learning’ process.

Examples: Making the same bad investment decisions time after time.  Making bad spending decisions repeatedly.  Basically, every time you fail to learn from the past and continue to do the same actions.

The Solution: There isn’t really too much to say other than to learn from your experiences. Try to reflect on your experiences, both good and bad, to see if there are any lessons you can apply to the situation if you find yourself in it again.  Better yet, try to learn from other people’s experiences; why should you do the same bone-headed thing as dozens of other people if you can possibly avoid it?  In either event, the important thing is to be able to recognize similar situations so you can apply the lessons that you’ve learned.

Over-Application of Occam’s Razor

The Problem: Occam’s Razor is a powerful philosophical tool, stating that the simplest explanation is most often correct.  The problem comes when you take it too far; reducing every situation to its simplest explanation can leave out valuable information.  Not every single situation has the simplest explanation as the one and only cause, and attempting to reduce them leaves out valuable information.

Examples: The simplest explanation for crime is that people are evil.  The simplest explanation for the moon landing is that it was a hoax.  The simplest explanation for most everything is that ‘A Wizard Did It’.

The Solution: Remember that not every simplest explanation is correct; sometimes complexity is needed to explain the world correctly.  Don’t automatically discount every theory that requires a sizable amount of explanation, and try to keep an open mind, to avoid falling into this logical trap.

There you have it, four more ways people tend to be illogical.  Now, all you have to do is potentially change your brain to purge it of these flawed mental processes, and you’ll be fine, although that’s easier said than done, most of the time.

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It’s the end of the week, and that means the last in the series of mental mistakes we make with our money.  If you’ve been reading all week (good for you if you have!), you’ve probably noticed that many of these mental flaws seem to stem from the same basic problem: your brain is bad at predicting the future.  You save everything in the hope that it will go up in value or make unrealistic assumptions about future odds.  Well, buckle up, because we’ve got one more irrationality to deal with:

Irrational Escalation of Commitment

You escalate your commitment when you continue to devote time and money to a course of action as a result of previous commitments.  If you’ve ever tried to climb a mountain (or attempted to reach some other physical or mental peak) and pushed yourself to go a bit further ‘because I’ve already come all this way’, you’ve escalated your commitment to a goal.  Such escalation becomes irrational when the rewards from completing your goal would come nowhere near to covering the expenses you’ve paid to complete the goal.  A business plan that’s already cost more than it could possibly recuperate but is continued anyway is an example of irrational escalation of commitment.

Escalator, Escalating... Get it?

If all of these sounds rather similar to the sunk cost fallacy, you’re onto something; irrational escalation of commitment frequently results when people (or organizations of people like businesses and governments) refuse to see or acknowledge that the money they’ve spent already is sunk, and the insistence that increased expenditures are needed to justify the initial spending.  It becomes an endless spiral of spending more and more to justify previous, sunken costs.  Speaking of which…

Irrational Escalation of Commitment Examples

-The most commonly cited example of irrational escalation of commitment is the dollar auction. The short version is this: a professor offers to give the highest bidder in the class one dollar.  There’s a catch, though: not only will the highest bidder have to pay out his bid to get the dollar, but the second highest bidder will have to pay his bid as well, without receiving anything.  The bidding starts low, at one cent, and quickly increases, until someone bids one dollar.  That should be the end; after that, people are paying more than the dollar is actually worth with each bid, so the bidding should end.

But, because of the rules of auction, the second highest bidder also has to pay, and so he has the incentive to bid even higher; if he wins with a bid of $1.01 rather than losing with a bid of $0.99, he’ll only have to pay one cent rather than ninety-nine.  The dollar bidder has the same motivation; if she wins the auction, she’ll have to pay less than if she comes in second place.  With this seemingly logical thought behind them, they can (assuming the professor allows them to continue) bid the price of the dollar up to many, many multiples of its actual value, only stopping when one bidder runs out of money to make progressively higher bids or the professor calls the auction off.  With each bid, the bidders were doing what would optimize their financial interest, but the overall process could, assuming the professor forces them to pay up, end up costing each of them far more than the value of the prize they’re seeking.

-As mentioned already, anytime a manager opts to continue a project after spending more money than it could possibly recuperate, it’s an example of irrational escalation of commitment.  It might be done to save face or even the manager’s job, but for the company as a whole the process is wasteful and counterproductive.

-Many forms of ‘Keeping Up with the Jones’ can be considered a type of irrational escalation of commitment; as with the dollar auction, even if you ‘win’ and have a more impressive car, lawn, or house, you have still ended up spending more than you could possibly hope to recuperate by selling (assuming there’s even a market for your improvements; last I checked, there’s not too much demand for used lawn ornaments).

Beating Irrational Escalation of Commitment

Well, if you ever find yourself in an economics class and the professor wants you to bid on a dollar bill, just don’t do it!  For the more real-life examples, always keep the potential goal in mind, and aim to keep your costs well under the potential rewards.  If you’re trying to compete in a costume contest to win a $100 grand prize, the cost of your costume(s) should be less than $90 or so; otherwise, even if you do win, you won’t have much to show for it.

Also, be sure to recognize when your costs are sunk, and have the willingness to walk away.  Yes, maybe devoting just a little bit more money to your so-far failed project will enable it to be a success, but it still won’t bring back the money you’ve already spent.  More likely, any attempts to justify that spending will just lead to increased spending in the future, with no increase in rewards.

The key to stopping irrational escalation of commitment is to attempt to be as rational as possible, and look forward to the potential rewards rather than behind to the (sunk) costs you’ve already paid.  Remember, you can’t change the past, but you can do things differently in the future!

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