When Firefighters Don’t Fight
Recently, a flaming trashcan ignited a house in Tennessee. Local authorities were notified and a crew of firefighters rushed to the scene to put out the fire just in time.
Wait a minute. That’s not at all what happened. In Obion County, firefighters are not on-call to the community at large. Instead, the right to a fireman is only guaranteed to those who pay an annual $75 fire protection fee before their property lights up. When this house (belonging to homeowners who had not paid the fee) caught fire, firefighters refused to come to the rescue. They ignored the family’s begging, only arriving at the scene when the fire jumped to a neighbor’s house (who had, in fact, paid for protection). Still, not a drop of water was wasted on the first house. Firefighters merely stood and watched as the house dissolved into ash.
This problem is related to the question of bailing out people with bad mortgages. Should we help those who took o mortgages that they could not afford? Would it encourage them in the future to keep on being reckless?
Or we can ask a more general question — should we actually let people decide whether they’d like to pay the advance protection fee, or is there something ultimately flawed about letting people decide for themselves? Very few of us think that we will be the ones in need of fire protection, and because we don’t foresee the consequences of not paying, we might not be sufficiently prepared for a potential disaster. And maybe we shouldn’t have to make that difficult decision ourselves.
Taxes and fun?
April: That time of year when the weather is perfect and the mosquitoes have yet to emerge full swarm. When you can start to think about lying by the pool without fully having to come to terms with wearing a bathing suit in public….
…And yet it’s that time of year when the majority of the country will be gripped by stress as that fateful day moves ever closer – April 15th, tax day.
No one likes cutting a check to Uncle Sam, and the fact that the process of filling out the tax forms resembles a nightmarish (Choose-Your-Own-Adventure) story does nothing to improve matters. But as is often the case, the anticipation is arguably the worst part, and typically one dedicated night (in addition to a more substantial amount of time taken to organize) is sufficient to finish the paperwork. It’s just a matter of convincing yourself to sit down and do it.
But what if it wasn’t such a dreadful experience? Imagine how the tax experience would change if you had a way to alleviate the stress and maybe even enjoy some of the aspects of the task at hand…
Let’s say that your 1040 came with a little extra stuff: maybe a container with an alcohol content, or perchance something of the chocolate persuasion. What if your tax forms arrived in a gift box with some financial documents on the side? What if the instructions for filling out the form told you to type in your personal information and take a bite of chocolate, type in your W-2 information and drink some of the alcohol, add your deductions and try some of the nuts etc? What if we could live in a world where you actually looked forward filling out these forms?
What do you think? Would you be interested in doing something like this on this tax season?
If you don’t mind, click this link and let me know what you think about this idea.
Irrationally yours
Dan
Want People to Save? Force Them
In Chile last June, I had the opportunity to spend some time with Felipe Kast, the new government’s minister of planning, and a few of his compadres. (We also went dancing, but that is another story.) One of the topics we talked about was the Chilean retirement saving plan.
By law, 11% of every employee’s salary is automatically transferred into a retirement account. Employees select their preferred level of risk, with the following restrictions: They may not choose either 100% equities or 100% bonds, and the percentage of equity that they can select diminishes as they age. When employees reach retirement, their savings are converted into annuities. The government auctions off the rights to annuitize retirees in groups of 250,000.
This brilliantly conceived approach solves thorny behavioral and institutional challenges. Behaviorally, it recognizes that people are not good at two aspects of financial planning for retirement—deciding to save and eliminating risk in later years—and it forces them to act in a better way. At the same time, the system acknowledges that people who enroll in retirement plans are reasonably good at managing their own risk. So investment choices are left to the individual, with limits on too-risky behavior, especially as a person ages, when bad choices can do irrecoverable damage.
Institutionally, Chile has cracked an age-old problem with annuities. It’s risky business to predict how long people will live, so insurance companies charge a high premium to cover that risk, which makes for an inefficient market. Annuities also suffer from an adverse selection problem, further increasing risk. (The classic example of adverse selection is health insurance: The healthiest people are the least likely to opt in, which increases the pool’s riskiness, making health care less appealing for insurance companies and policies more expensive for the people who want them.) By pooling the risk, the Chilean government makes annuities an attractive business with more competition and better prices. And since everyone is forced to annuitize, the adverse selection problem simply disappears.
I was impressed with this system and wondered how it would fly in the United States, where our own mandated savings program—Social Security—undergoes sporadic efforts to privatize it.
I suspect Americans would consider the Chilean system heavy-handed and limiting—a flagrant example of nanny-state control. You can force me to save money when you pry it from my cold, dead hands. Paradoxically, we happily accept deeply controlling (and expensive) regulation on our behavior in other areas with little thought or protest. Consider the strictures we allow on driving. Wear a seat belt. Drive this speed. Bear the cost of air bags. Pollute only this much. Don’t text while driving.
Why do we accept so much government intervention in driving but chafe when it comes to a few simple rules that would help us make better financial decisions? It’s probably not because we think we’re smarter about finances than driving. I think the reason has to do with our ability to imagine negative consequences. Car wrecks have a way of vividly communicating our incompetence as drivers and making the benefits of regulation crystal clear. Poor money management can carry similarly devastating consequences, but they are less readily apparent. Even in times of economic crisis, we don’t recognize our own bad judgment because people around us are in the same boat and we compare our fortune with theirs.
But the inability to see our own irrationality shouldn’t be an excuse to let it go unchecked. We need to analyze what people and markets are good at and what they’re not good at, and use those insights to improve our institutions. Chile’s approach to saving shows us that it can be done, and done well.
Behavioral finance lesson – frequent flyer points?
Here is an email that I got last week from a financial planner:
Dear Dan.
My hourly model lets clients use whatever retail custodian they like. For various reasons, I tend to recommend the two best as Vanguard and Fidelity. I go over the pros and the cons for each and, as soon as I mention Fidelity gives 25,000 frequent flyer miles, most clients stop me and choose Fidelity. Some will move tens of millions to Fidelity in order to get frequent flyer miles that might have a $200 economic value (and I may be generous). That would be the equivalent of 0.001% on a $20 million portfolio and .01% on a $2 million portfolio.
Any idea why this seems to have more impact than traditional economics might explain?
Curios.
XXX, CFP®, CPA, MBA (name hidden)
Here is my (short) response
Dear XXX,
This phenomenon is what we call “medium maximization.”
The basic idea is that often people focus on near term concrete goals (such as frequent flyer miles), and while trying to maximize these immediate and clear goals they forget or discount the real reason for their actions — which in your case is maximizing their financial outcome. (For a great paper on medium maximization see this paper by Chris Hsee)
Why do people engage is such medium maximizations? Because it is easy. It gives people a clear direction for behavior — and just having something measurable within reach can redirect our motivation. Another reason for the efficacy of medium maximization is that such immediate and concrete goals by which to measure ourselves against give us a sense of progression ….
I am not sure whether this should make you more or less appreciative of your clients, but hopefully you can now understand them a bit better. Or maybe it means that you should start offering them frequent flyer miles?
Irrationally yours
Dan
Effects of high prices
A Focus on Marketing Research
When businesses want to find answers to questions in marketing, whom do they ask? Do they set up experiments to test their ideas, pitting the approach they think is most effective against alternatives? Do they survey consumers on a large scale? Do they go to experts who have questioned and requestioned their theories? Surprisingly, the answer is no. Most often, businesses rely on small “focus groups” to answer big questions. They rely on the intuition of about 10-12 lay people with no relevant training who ultimately have no idea what they’re talking about.
I wonder how can this be a useful strategy? Why ask those who are lacking any kind of proficiency when, by definition, experts are more knowledgeable on the topic and have experience that could actually be beneficial? And even if experts are more narrowly focused, and tunneled vision, how can this be better than carrying out their own research?
Research in psychology and behavioral economics has shown time after time that people have bad intuitions. We are very good at explaining our behavior (sometimes shocking and irrational), and to do so we create neatly packaged stories – stories that may be amusing or provocative, but often have little to do with the real causes of our behaviors. Our actions are often guided by the inner primitive parts of our brain – parts that we can’t consciously access — and because of that we don’t always know why we behave in the ways we do; still, we can compensate for this lack of information by writing our own versions. Our highly sophisticated prefrontal cortex (only recently developed, by evolutionary standards) takes the reigns and paints a perfect picture to explain what we don’t know. Why did you buy that brand of fabric softener? Of course, because you love the way it makes your clothes smell like a springtime breeze when you pull them out of the warm dryer.
So, why do businesses go to our imagination when we know it’s just a cover for what’s really going on? Indeed, why do businesses go to the imaginations of a group of people to find real answers? I suspect that the story here is linked to another one of our irrationalities: As human beings, we have an insatiable need for a story. We love a vivid picture, a penetrating example, an anecdote that will stay in our memories. Nothing beats the feeling of knowledge we get from a personal story because stories make us feel connected – they help us relate. Just one example of customer satisfaction has a stronger emotional impact than a statistic telling us that 87% of customers prefer product A over product B. A single example feels real, where numbers are cold and sterile. Although statistics about how a large group of people actually behave can tell us so much more than the intuitions of a focus group, the allure of a story is irresistible. Our inherent bias to prefer the story compels us to believe in the worth of small numbers, even when we know we shouldn’t.
This “focus group bias” is not just a waste of money it is also most likely a waste of resources when products are designed according to the “information” gathered from these focus groups. We need to find a way to base our judgments and decisions on real facts and data even if it seems lifeless on its own. Maybe we should try and supplement the numbers with a story to quench our thirst for an anecdote, but what we can’t do is forget about the facts in favor of fairy tales. In the end, the truth lies in empirical research.
—
Why Businesses Don’t Experiment
A few years ago, a marketing team from a major consumer goods company came to my lab eager to test some new pricing mechanisms using principles of behavioral economics. We decided to start by testing the allure of “free,” a subject my students and I had been studying. I was excited: The company would gain insights into its customers’ decision making, and we’d get useful data for our academic work. The team agreed to create multiple websites with different offers and pricing and then observe how each worked out in terms of appeal, orders, and revenue.
Several months later, right before we were due to go live, we had a meeting about the final details of the experiment—this time with a bigger entourage from marketing. One of the new members noted that because we were extending differing offers, some customers might buy a product that was not ideal for them, spend too much money, or get a worse deal overall than others. He was correct, of course. In any experiment, someone gets the short end of the stick. Take clinical medical trials, I said to the team. When testing chemotherapy treatments, some patients suffer more so that, down the road, others might suffer less. I hoped this put it in perspective. Fortunately, I said, price testing household products requires far less suffering than chemo trials.
But I could tell I was losing them. In a sense, I was impressed. It was a beautiful human sentiment they were conveying: We care about all customers and don’t want to treat any one of them unfairly. A debate ensued among the group: Are we willing to sacrifice some customers “just” to learn how the new pricing approaches work?
They hedged. They asked me what I thought the best approach was. I told them that I was willing to share my intuition but that intuition is a remarkably bad thing to rely on. Only an experiment gives you the evidence you need. In the end, it wasn’t enough to convince them, and they called off the project.
This is a typical case, I’ve found. I’ve often tried to help companies do experiments, and usually I fail spectacularly. I remember one company that was having trouble getting its bonuses right. I suggested they do some experiments, or at least a survey. The HR staff said no, it was a miserable time in the company. Everyone was unhappy, and management didn’t want to add to the trouble by messing with people’s bonuses merely for the sake of learning. But the employees are already unhappy, I thought, and the experiments would have provided evidence for how to make them less so in the years to come. How is that a bad idea?
Companies pay amazing amounts of money to get answers from consultants with overdeveloped confidence in their own intuition. Managers rely on focus groups—a dozen people riffing on something they know little about—to set strategies. And yet, companies won’t experiment to find evidence of the right way forward.
I think this irrational behavior stems from two sources. One is the nature of experiments themselves. As the people at the consumer goods firm pointed out, experiments require short-term losses for long-term gains. Companies (and people) are notoriously bad at making those trade-offs. Second, there’s the false sense of security that heeding experts provides. When we pay consultants, we get an answer from them and not a list of experiments to conduct. We tend to value answers over questions because answers allow us to take action, while questions mean that we need to keep thinking. Never mind that asking good questions and gathering evidence usually guides us to better answers.
Despite the fact that it goes against how business works, experimentation is making headway at some companies. Scott Cook, the founder of Intuit, tells me he’s trying to create a culture of experimentation in which failing is perfectly fine. Whatever happens, he tells his staff, you’re doing right because you’ve created evidence, which is better than anyone’s intuition. He says the organization is buzzing with experiments.
And so is that consumer goods company. A group there is studying consumer psychology and behavioral economics and is amassing evidence that’s impressive by any academic standard. Years after our false start, they’re recognizing the dangers of relying on intuition.
Spending money
We have lots of discussions about how to get people to save more, which is clearly important.
But today I want to ask a question about spending money: Assume you had $20,000 to spend (and that you could not save it), what would be the ideal way to spend it? In other words, what would be the way to spend this sum if your goal was to get the most joy and happiness out of this amount?
I am not asking because I have an answer, or even an idea of how to do research on this — I am asking because I really don’t know.
So — any input will be welcomed…
Irrationally yours
Dan
Visual illusions and decision illusions
Consider some of illusion at the bottom of the demo page (click here to see it).
The two middle color patches look as if they are different, but in fact they are exactly the same. What is gong on here? How can it be that we see wrong? How can it be that eve after we are shown that these two patches are identical we still can’t see them accurately?
It is because our brain is wired in a particular ways and this wiring, while very good for some things, is not perfect — and it makes us susceptible to certain errors and mistakes. Moreover, because these mistakes are a part of us, we are fooled by them in predictable and consistent ways over and over.
Now, vision is our best system. We have lots of practice with it (we see many hours in the day and for many years) and more of our brain is dedicated to vision than to any other activities. So consider this — if we make mistakes in vision, what is the chance that we would not make mistakes in other domains? Particularly in domains which are more complex (dealing with insurance, money, etc.), and ones in which we have less practice? Domains such as decision making and economic reasoning?
Not very high I think — and this is why we have lots of decision illusions. The predictable, repeated mistakes we all make in our financial, medical, and other daily decisions.
Irrationally yours
Dan