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SPECIAL ISSUE: Personal Finance Mind over matter

When it comes to your financial security, research suggests your brain is your biggest liability

Melinda Sherwood, Business Editor
   We know better. By now, we all know we should be saving for retirement, putting away for our children’s college education and investing our money rather than racking up debt on our credit cards.
   But we just can’t seem to help ourselves.
   Today, more Americans are in debt than ever before, putting the frivolous needs of today — be it a state-of-the-art home entertainment system, an expensive Chanel suit or an all-inclusive vacation to Hawaii — ahead of financial security tomorrow.
   No matter how often she reminds her clients that a small sacrifice today can lead to a big pay out down the road, Farida Mistry, a certified public accountant and wealth planner with LPL Financial Services in West Windsor, says her clients — even the most well-educated — almost always choose to spend on impulse.
   "I’m talking about (people with) multiple college degrees, and they still don’t see it. … They’d rather spend it now," she said. "People will go and spend for a latté and not think about it. Then voilá! They are in their 40s and they have to write out a check for $36,000 for their kid’s college education — and I’m not talking Princeton — and they go, ‘Oh my God! How am I going to come up with that?’"
   Our spendthrift ways not only put us farther away from achieving our financial goals, but like an addiction, they can be downright self-destructive.
   "I have a young friend and her goal is to get out of her parents’ house and buy a condo," Ms. Mistry continued. "And instead of that she bought a new pair of $350 boots. And I agree they were breathtaking — but those boots are not going to earn compound interest and help you achieve your goal of buying a condo!"
   So why do we do it? Why do we spend what we don’t have, when it runs contrary to our financial survival? What is this monetary affliction that more and more Americans seem to suffer from, and is there a cure?
   Economists have traditionally been consumed in the task of analyzing the impact of our financial choices, but a new field of academic research called neuroeconomics, which investigates the mental and neural processes that drive economic decision-making, is beginning to shed light on why we make some of the financial choices we do.
   At Princeton University’s Center for the Study of Brain, Mind and Behavior, researchers Jonathan Cohen and Samuel McClure are examining the extent to which emotion factors into our economic decision-making.
   Working with David Laibson, professor of economics at Harvard University, and George Loewenstein, professor of economics and psychology at Carnegie Mellon University, the researchers took images of people’s brains as they made choices between small but immediate rewards, and larger awards that they would receive later. The results of the study, which appeared in the Oct. 15 issue of Science, suggests that two areas of the brain compete for control over behavior when a person attempts to balance near-term rewards with long-term goals.
   "The broad statement of it is that we’re not one person — we’re many people," said Dr. Cohen. "What I think this work shows or begins to show is that when we make the simplest decisions, there are at least a couple or more parts of us that are evaluating the decision and the potential outcomes are competing or cooperating depending on the circumstances to arrive at some decision."
   The researchers studied 14 Princeton University students who were asked to consider a problem while undergoing functional magnetic resonance imaging, which shows what parts of the brain are active at all times.
   The students were offered the choice between Amazon.com gift certificates ranging from $5 to $40 in value, and larger amounts that could be obtained only by waiting a period ranging from two to six weeks. The study showed that decisions involving the possibility of immediate reward activated parts of the brain influenced heavily by neural systems associated with emotion. In contrast, all the decisions the students made — whether short- or long-term — activated brain systems that are associated with abstract reasoning.
   Most importantly, when students had the choice of an immediate reward but chose the delayed option, the calculating regions of their brains were more strongly activated than their emotion systems, but when they chose the immediate reward, the activity of the two areas was comparable, with a slight trend toward more activity in the emotion system.
   The researchers concluded that impulsive choices or preferences for short-term rewards result from the emotion-related parts of the brain winning out over the abstract-reasoning parts.
   That emotion may dictate some of our financial decisions may come as no surprise to most of us, but the researchers’ conclusions actually run counter to the prevailing view among economists that pure reasoning drives people’s decisions.
   "Historically, economists have argued, primarily for simplicity’s sake so they can develop formal theory, that people act as rational agents," said Professor Cohen.
   But, as another experiment showed, people actually act less rationally than expected.
   The researchers also examined a much-studied economic dilemma in which consumers behave impatiently today, but prefer or plan to act patiently in the future. The researchers found that people who are offered the choice of $10 today or $11 tomorrow are likely to choose to receive the lesser amount immediately. But if given a choice between $10 in one year or $11 in a year and a day, people often choose the higher, delayed amount.
   "In classic economic theory, this choice is irrational because people are inconsistent in their treatment of the day-long time delay," said Professor Cohen.
   Until now, the cause of this pattern was unclear. Some argued that the brain has a single decision-making process with a built-in inconsistency, but the authors of the Science paper argued that this pattern results from the competing influence of two brain systems.
   So how can this research help us with our day-to-day financial activity? Can it give us the key to overriding our emotions in favor of our more rational decision-making faculties?
   Maybe, says Professor Cohen. As we come to better understand the precise functions that these cognitive systems serve, he said, we may be able to design better financial mechanisms to "to protect people from impetuosity."
   In fact, financial services representatives in some companies are already beginning to use similar research in the related field of behavioral economics — which combines the disciplines of psychology and economics to explain the vagaries of financial decision-making — to help educate and counsel their clients.
   Northwestern Mutual Financial Network, a Milwaukee, Wisc.-based network of subsidiaries and affiliates that provides annuities, mutual funds, long-term care insurance and disability income insurance, commissioned research to uncover some of the key "blind spots" that handicap financial decision-makers.
   Working with Cornell University psychologist Tom Gilovich, an expert in the field of behavioral economics and author of "Why Smart People Make Big Money Mistakes and How to Correct Them," Northwestern Mutual is using this research to help its financial representatives and their clients avoid some common financial mistakes.
   According to an independent survey of 2,700 individuals with household incomes of $75,000 or more, the major blind spots include loss aversion (it hurts more to lose money than it feels good to gain), framing (how an issue is presented can affect financial decisions) and mental accounting (though all money "spends" the same, people treat money differently).
   In the survey questions related to loss aversion, one group of respondents was asked to choose between a 100 percent chance of gaining $240 versus a 25 percent chance to gain $1,000 coupled with a 75 percent chance to gain nothing. More than three-fourths of the group went for the sure gain. The second group’s choices were a sure loss of $240 versus a 25 percent chance to lose $1,000 coupled with a 75 percent chance to lose nothing. More than two-thirds of this group opted for the latter, the chance to lose nothing.
   "These results are not surprising," said Professor Gilovich. "People of all ages and income levels tend to have different tolerances for risk, depending upon whether they’re contemplating losses or gains."
   In the survey questions related to framing, two different groups of people were asked the same question in two ways. When asked, "Could you comfortably save 20 percent of your household’s income at this point in your life?" roughly 50 percent said they could not, but more than 7 in 10 said they could when asked if they could comfortably live on 80 percent of their income.
   Finally, respondents were asked to judge how they would spend their money in two apparently different retail situations. Would they buy a much-needed alarm clock from a local store for $18, or from a store 20 minutes away selling the same clock for $10? And would they buy a new television from a local store for $250, or from a store 20 minutes away for $242?
   In both instances, driving 20 minutes would save $8. But two-thirds of the respondents answered they would drive 20 minutes to save money on the clock, but almost 75 percent would not drive the same 20 minutes to save the same amount on a new TV set.
   "It appears that no one is immune from these specific ‘blind spots,’" said Harlan Wahrman, who has directed Northwestern Mutual’s research in behavioral economics in a series of studies since 2000. "But, we also know that when people are aware of their ‘blind spots,’ they are much better equipped to build a financially secure future for themselves."
   John Putnam, a certified financial planner with Northwestern Mutual since 1990, says that the research is helping him better understand and help his clients. "It’s a little bit like having the answer key before the test — anything that can help a financial professional have clearer insight into their clients is good," he said.
   Another "blind spot" he encounters when working with clients is decision paralysis. "They have so many choices to make that they don’t do anything," he said. Or, he said, they are quick to take information from less-than-credible sources.
   "People tend to feel comfortable with information from people they know, whether it’s right or wrong," he said. "And people may be wired that way. They could feel very comfortable acting upon inaccurate information from a friend or coworker."
   In order to navigate around these psychological trap, professionals are increasingly forced to balance their role as financial planner with the more delicate role of financial "counselor."
   "I share with clients," said Mr. Putnam. "Twenty percent of the time we’re going to talk about products and solutions. Eighty percent of the time we’re going to talk about you — your family, business and where you see yourself going. It’s really a lifelong relationship."