behavioral economics

Don’t Let Your Brain Throw Away All of Your Money

Hand Holding Money on Fire
Photo: Michael A. Keller/Corbis

The new book The Index Card: Why Personal Finance Doesn’t Have to Be Complicated has a very simple premise, and it’s explained right there in the title: Everyday investors shouldn’t mess around with “sophisticated” strategies that will only lose them money — even seemingly mainstream ones like stock-picking. Index funds and other safe, reliable options that mitigate risk are a much better bet.

The idea for the book originated back in 2013, during a conversation between Dr. Harold Pollack, a University of Chicago social-science professor (and frequent Science of Us source), and Helaine Olen, a New York Magazine contributor and the author of Pound Foolish: Exposing the Dark Side of the Personal Finance Industry. Pollack mentioned that all the personal-finance advice one really needed could fit on an index card, an internet commenter asked him to actually create that then-hypothetical card, and a very helpful personal-finance meme was born. Eventually, Olen and Pollack teamed up to turn it into a book, and The Index Card was released earlier this month.

Pollack’s day job is researching crime and public health — he’s co-director of the University of Chicago Crime Lab — and as a result he’s well versed in behavioral economics, the science of how humans make decisions and how we can get led astray by irrelevant information, psychological biases, and so on. Since these issues are vital to the question of why people get ripped off by shady financial instruments and why they have so much trouble making less exciting but more reliable decisions, I emailed him some questions about the intersection of his book and behavioral science.

The basic idea of your book is that financial investment actually isn’t that complicated — advice for how to do it properly can fit on an index card! So why are people so drawn to complicated, overblown promises in the first place?
I’m not sure why people are drawn to the complexity, but I have a few ideas. In part, we all hope that we will be the person who bought Apple stock 15 years ago. In part, the proper methodical approaches to saving and investing are really boring. It’s much more fun and diverting to time the market or to stock-pick. Many of us simply don’t have enough money. We hope against hope that by detecting the stock market’s secret logic or rolling the dice on some complex variable annuity, we might come out all right.

Unfortunately, the evidence is overwhelming that ordinary investors are incredibly bad at picking individual stocks. As you suggest, the promise of complex investment products is almost always wildly overblown. I’m particularly impressed and depressed by the research of Brad Barber and Terrance Odean in this area. Individual investors underperform the standard market indexes. We trade way too often. We sell our winning stocks while we are reluctant to sell our losers, the precise opposite of what a sensible tax accountant would recommend. Perhaps most depressing, the stocks we choose to buy appear to systematically underperform the stocks we choose to sell. This literature can get complicated. But it produces an admirably simple conclusion: Experts across the political spectrum hold surprising agreement that ordinary people should concentrate their savings in simple low-fee index funds and avoid most other investment products or actively managed funds.

Unfortunately, these simple and accurate messages are obscured by a huge market failure in the financial media. This market failure is so blindingly obvious that it generally escapes notice. The best advice is simply too boring and repetitive to make good TV. Who would regularly tune in to some cable finance show that said, “Buy index funds,” every week? What advertisers would pay for commercials on a program that tells viewers not to buy overpriced investment products they don’t understand? Financial TV has found much greater commercial success hawking far worse financial advice. These sins are most obviously true of gonzo financial TV shows aimed at day traders. They go back to the 1970s if not before, for example to Louis Rukeyser, whose unwise advice was made more toxic because it was delivered with such urbanity and panache to a huge weekly PBS audience.

Let’s get specific: What are a couple of well-known cognitive biases that specifically impact people’s investment decision-making for the worse?
Many cognitive and behavioral biases have been shown to matter for both individual investors and for large institutions whose incredible failures during the foreclosure crisis were scarcely less profound. My cross-campus colleague Richard Thaler has a wonderful intellectual memoir, Misbehaving, which lists many insights of modern behavioral economics that have become central to many disciplines and to public policy.

Status quo bias and inertia pose some of the most basic challenge. In my first job, I basically contributed nothing to my 401(k) because signing up required me to spend 45 minutes reading boring paperwork; $10,000 invested in the S&P 500 back then would be worth something like $160,000 today. A host of studies, some of the best involving Brigitte Madrian and her colleagues, establish that automatic enrollment programs can dramatically increase employees’ retirement savings.

Such nudges are not the complete policy answer. In the case of retirement, we need larger benefits for people of modest incomes. But these nudges are helpful. We must present people with simpler “choice architectures” in retirement programs, in the design of health-insurance exchanges, that reduce complexity and clutter [and] that provide sensible defaults so that if people don’t pay attention or make any active choice, they will be assigned some reasonable choice.

Loss aversion and related notions matter, too. That helps to explain why investors don’t like to sell their losing stocks. A related concept, known by the fancy name of an “asymmetric loss function,” works in similar ways, but ironically also makes people more reckless once they fall behind after placing unlucky bets: If I leave a casino, I’m pretty much as happy coming out ahead $300 as I am winning $500. That’s pretty much in line with what standard economics predicts. If I lose, though, the results are usually different. I’m much sadder taking a loss of $500 than a loss of $300; similarly, losing $200 is far worse than breaking even. In short, we’re much more sensitive to losses than gains when we are running ahead of the game, but we tend to be less sensitive to the size of the loss when we fall behind. (Among other reasons, I might have to explain to my spouse where and why I lost that money.)

One consequence of this gobbledygook is that people who fall behind on risky financial bets are willing to be pretty reckless if there is some prospect that they can get back to zero. This is scary if one makes the obvious extrapolation to day traders who fall behind, or to securities traders who are having a rough day with other people’s money.

I take it you’re not personally immune from these biases and tendencies?
I can hardly avoid thinking about this stuff, since I fall prey to every every problematic heuristic, bias, and behavioral pathology documented in the behavioral economics literature. Every month, I waste hours standing in line at the airport because I’m too lazy to spend a few annoying hours on a single afternoon to get my TSA PreCheck. I had some stupid $10 monthly charge on my credit card for months because I didn’t want to spend 45 minutes on hold required to cancel some service whose password was long forgotten. 

I do try to manage my self-command failures. I spend more money when I use my credit card than when I pay cash. It’s just too easy to pull that poker chip from my pocket and waive it around to get goods and services. So I’ve made a real effort to spend cash instead. I also have to slow myself down and create habits and automatic defaults that help me make good decisions over time. Making saving automatic is essential for me. If setting money aside for my kids’ college required active decisions, I would procrastinate and not get it done. 

I also try to reduce my exposure to distracting but titillating or emotionally charged information. Once I internalized the lesson that ordinary investors should not buy or sell individual stocks, I tried to stop reading speculation about whether Apple has been too slow to make products for the cloud or what’s going on in the C-suite of Twitter. I haven’t checked my retirement savings during January’s stock-market tumble. Since I shouldn’t do anything with this information, why freak myself out with the salient particulars, when I know in broad outline that my wealth is probably down 10 percent but will come back up long before 2035, when I will really need it?

Let’s say you made a second index card not about investment advice but about psychological advice — the bare minimum people should know about how their own brains work when they’re faced with a tough financial decision. What would be on it?
I would start with a few things:

  • Distrust your instincts. Because you are human, your instincts and immediate impulses are often foolish, unconsciously biased, or misinformed.
  • Remember that you are more influenced by context and by peer pressures than you may realize. If nothing else, these frame your immediate responses, your most obvious available choices, and the information most readily available to you.
  • Be especially wary of chasing after shiny objects. In finance, as in so many other realms, these often disappoint.
  • Slow yourself down when you are deciding something important. Remember to use all the skills you have.
  • Seek out human help and conversation. Another pair of eyes is usually helpful. Even if all that person does is listen as you explain your smart or not-so-smart reasoning.
  • Don’t get cocky when a financial decision or investment goes right. Many decisions turn out well due to good luck. Certainly don’t assume you can do that again with the same result.
  • If a financial decision does go wrong, make sure to forgive yourself, too. Smart decisions may reflect bad luck. Even if the initial decision wasn’t so smart, your mistakes prove that you’re only human like the rest of us. 

Don’t Let Your Brain Throw Away All Your Money