When people make decisions, they rely on the animal part of their brain, the amygdala. Sure, we may think about the decision before we make it, but when it comes down to actually pulling the trigger, it’s our emotions (amygdala) that do most of the work. This part of the brain helped our ancestors survive thousands of years ago.
When our ancestors ran into a tiger in the sahara, they acted. They either ran or fought, hopefully they ran. What they didn’t have to do is think. The amygdala took care of that for them. They were able to make a split second survival decision. If they stopped to think it over with their cerebral cortex, they would have been that tiger’s lunch.
Now fast forward thousands of years. We still have this unrefined, emotional part of the brain but our lives have changed. We don’t fight daily to survive and have the leisure to think more. Think and plan. It’s a great thing how we evolved. But we still make decisions based fear, anger, and other emotions that can hinder us.
We’re not as logical as we think. We’re not all rational creatures that optimize all the choices we have to make like Homo Economicus. No. We’re more like Homo Irrationalist – making decisions based on emotion, not logic – to our own detriment.
This is why I don’t believe in the Efficient Market Hypothesis but do believe in Behavioral Economics.
Behavioral Economics allows us to look at the psychological aspects of human behavior. And a big part of Behavioral Economics has to do with resource allocation.
We all have nearly unlimited wants but limited resources. Putting these resources to good use is something that most economist think we do. But Behavioral Economics doesn’t assume we put resources to the best use possible given our situation. It is more concerned with why we do the things we do with our money. And especially why we do things that might not be the most optimal thing.
Ever buy something, then justify your purchase after the fact with confirmation bias? I’ve done that. It doesn’t just have to be with purchases either. It can be with an idea or process for picking between options.
I understand why people take Social Security early, even if they don’t need it and it would be more beneficial to wait 3, 4, or 5 years. And this is just a thought – no data to back it up. I couldn’t help but think about the marshmallow experiment when thinking of why people take Social Security early.
So you’ve probably heard of this famous experiment. An experimenter invites a four year old into a room with a table and one marshmallow sitting on top of the table. The experimenter simply tells the kid that they’re going to leave and if the marshmallow is still there when he comes back, the experimenter will reward the child with a second marshmallow. If you wait, you get rewarded. One now or two later.
The results? Very few waited the 15 minutes (which translates to what? – like 6 hours for the poor kid).
But those kids who were willing to wait to receive the second marshmallow ended up having higher SAT scores, lower levels of drug abuse, lower chance of obesity, better able to deal with stress, and better social skills as reported by their parents.
(I wonder if the longitudinal marshmallow study has reached retirement age yet. It’d be interesting to see if the kids who delayed gratification and waited also waited to file for Social Security.)
The More You Know
I’m reminded of Dan Ariely’s new book, Payoff, in which he describes how more knowledge doesn’t exactly make us better decision makers.
For example, he questioned Americans as to which city had the higher population, Detroit or Milwaukee. About 60% said Detroit and 40% said Milwaukee.
He then asked Europeans the same question, many of whom had no knowledge of either city and many hadn’t even heard of Milwaukee. More than 80% said Detroit and under 20% said Milwaukee.
Detroit has the higher population.
The Americans with the more knowledge of the cities didn’t get it right as often as the Europeans with lesser knowledge. His point was that even though we may have more knowledge of something, doesn’t always mean we know what’s right.
Recognizing We Need Help
It’s important to recognize before you make financial decisions that you have a tendency to make irrational, emotion-driven decisions.
And it’s okay. We’re all human.
But knowing that we’re likely to make bad decisions is a step in the right direction.
Warren Buffett and Charlie Munger knew this (at least since 1984 when Robert Cialdini came out with Influence).
They’re both keenly aware of human shortcomings, including their own. That’s why they have systems in place and talk to one another before making decisions.
Investing and Social Security
When it comes to Social Security, investing, and most things in life, it helps to have some sort of process so that you take the human element out of the equation. After all, humans are flawed.
It’s better to have a framework, a set of principles, or process to make the best decision.
I have some pointers for when to claim Social Security here. There are different tools and rules of thumb that can help you make a decision intelligently but there’s no substitute for sitting down with a good fee-only financial planner.
Investing is a whole different ball game than Social Security because of multi-dimensional aspect.
With Social Security, your main problem is figuring at the most optimal age to file (there are other issues but this is the main one).
With investing, you have to figure out your risk profile, your required rate of return, your allocation, vehicle, etc., etc. Add to this that everyone tells you different things. Some “financial advisors” tell you to invest annuities or mutual funds. Your mom says only invest in certificates of deposit. Your crazy uncle says to buy mortgage liens on a secondary market.
There’s a lot of noise when it comes to investing.
One of the reasons I started this site is to show you that investing doesn’t have to be difficult.
You’ll need a plan. That plan is based on your risk tolerance and investment objective. You’ll want to avoid fees. You’ll need to make sure you think about the other parts of your financial life like taxes, etc. – the holistic approach. Then when your plan is in place, you want to practice benign neglect.