Join Amanda Clayman for an in-depth discussion in this video Your brain on money, part of Financial Wellness: Managing Personal Cash Flow.
- Imagine 50,000 years ago. As a hunter scans the horizon, he sees a twitch in the distant grass. Without thinking, his body drops into a crouch, weapon ready, heart hammering in his chest. Moments pass and he determines there is no threat. Heartbeat returning to normal, he straightens and walks on. What does this scenario have to do with modern money management? More than you might guess. Our bodies and brains are specifically wired in ways that promote our survival, making us hypersensitive to to potential threats.
When you see a twitch in the grass, it's better to crouch first and then figure out whether it's a predator or not. Recent research in neuroeconomics confirms that financial losses are actually processed in the same areas of the brain that respond to mortal danger. So it's no wonder that watching a portfolio drop makes even a seasoned investor feel like he spotted a lion in the grass. Some might even prefer the lion. In this video, we'll examine the ways that human brains are designed to avoid risk and seek reward and we'll explore a few of the mental shortcuts and biases that can skew the way our system one perceives the facts of a financial choice.
For example, how much would you pay for a subscription to The Economist? Even assuming this is something of interest to you, there's still a good chance you'd struggle to come up with a good price without a little context. Let's take a look at this ad, which caught the notice of renowned behavioral economist Dan Ariely. You probably noticed something funny right away. How can the magazine subscription and the magazine plus web subscription have exactly the same price? Was it a mistake? Dr. Ariely himself was so curious about this ad's intention, after all, you'd think The Economist would have figured out how to price and advertise their own product, that he turned it into an experiment.
When Dr. Ariely showed this ad to 100 MIT students and asked which offer they would choose, 16% selected TheEconomist.com subscription, zero chose the print subscription, and 84% chose the print and digital combo offer. Sounds reasonable, right? But when the print only option was removed from the list, something very curious happened. Now the percentage of people interested in the digital only subscription jumped from 16 to 68% and the number who selected the combo dropped precipitously from 84 to 32%.
Now, it doesn't take an MIT student to recognize that paying the same price for print only as for the print plus digital subscription was a bad deal. So why did it make such an extraordinary difference in people's preferences even though they didn't choose it? This is called the decoy effect and it happens when we're presented with three options, one of which is similar but not quite as good as one of the other options. It enhances the appeal of the similar and slightly better option. It turns out that human beings are highly susceptible to context cues when we're trying to figure out something's value.
Nowhere is this trait more finely exploited than in the very scientific calibration behind, of all things, restaurant menu design. One of the first fancy restaurants I ever went to was Balthazar in New York City. Take a glance here at their menu. Where does your eye almost immediately go? Clearly it's the upper right corner with the illustration of a platter of oysters and the large font red lettering. While obviously delicious, you might quickly dismiss the idea of a dish that costs upward of $150. However, without your even knowing it, this price has already altered how you will evaluate the prices of the other dishes.
$34 for salmon? Must be a bargain, right? This effect is called anchoring and it's the human tendency to rely too heavily, or to anchor, on the first piece of information we see when making a particular decision. Because this effect is so strong, it commonly drives how different price points are presented. This is why, for example, requests for charitable giving usually lead with the highest level of support listed a the top, because when we're first asked for $200, it's easier to say yes to 50. But our true financial achilles heel has to do with the power of free.
A simple buy-one-get-one-free offer can light up the reward centers of the brain while at the same time neutralizing the sense of risk or loss that usually occurs when we part with money. This high-reward low-risk combo often tempts us to buy things that we didn't even want nearly seconds ago. As an example, look no further than retail giant Amazon.com. Amazon discovered that free shipping, now offered as part of their Amazon prime membership, has a huge effect on driving higher sales. We can trace this back to several years ago when Amazon first started offering free shipping on orders over a certain minimum amount.
Sales around the world took off except in France. Were the French too savvy to fall for such an obvious ploy? No, the difference in France was that when customers met the minimum purchase amount, they got shipping for one franc, about 20 cents. Is one franc so different from free? Maybe not when we consider the actual effect that it would have on our bank balance, but as a motivator, it had zero effect. When the French division changed their offer to match the rest of the world, French people demonstrated that they're just as easily swayed by the power of free as the rest of us.
So the next time you're choosing between feature bundles, scanning a menu, or clicking to add another item to your shopping cart, take a moment to ask yourself, what is it that's telling me that this is the reasonable choice? Am I swayed by the decoy effect, anchoring on a high value, or influenced by the power of free? Our automatic thinking system clearly cuts some corners as it quickly frames and executes decisions. In fact, these are only three of the well over 100 identified cognitive biases.
Luckily, we're not solely reliant on system one. Even by asking ourselves, how do I know what's reasonable here, we can bring conscious attention to the decision. This gives system two a chance to balance out the emotions and mental shortcuts by adding rational deliberation to the process.