[F] Why Your Brain Sabotages Your Money [GREATEST HITS]

0:00Merry Christmas. Happy final day of Hanukkah. Today is Monday, December 22. We are doing something On Wednesday, Christmas Eve, we're going to be playing the second letter I, investing. On Thursday, Christmas Day, we're going to play R for real estate. And on Friday, E for entrepreneurship. Five episodes this week, all from The Greatest Hits Vault and themed around FIIRE. In honor of the letter F for financial psychology, we are playing an interview with the psychologist and behavioral finance expert, Dr. Daniel Crosby, who discusses why we so often pay attention to the wrong things. This interview originally aired on November 16, 2022, and we are pulling it from the Greatest Hits Vault to share with you.

1:09Enjoy.

1:13Hi, Daniel. Paula, hey, great to be here. Daniel, you are trained both as a clinical psychologist and as a behavioral finance expert. At the risk of an obvious question, how have you seen the worlds of psychology and investing overlap? And what is there new to say about it? We all know about cognitive biases. We all know about heuristics and mental models. What is new that is being discovered in this field? I don't think it's an obvious question. I think it's a great question. And I think the growth and the development of behavioral finance has largely mirrored the growth of psychology broadly.

1:51If you look at psychology, you know, it starts, you know, more or less is popularized with Freud. And Freud is, of course, studying what's wrong with you, right? He's studying brokenness, depression, anxiety, all these things. And then it's only in like the 80s and 90s that we begin to get a psychology of wholeness, you know, a psychology of not just what makes people sad, but what makes people happy and what makes people great leaders and great spouses and great teachers. And I think that behavioral finance is trending in that very same direction. It had to break with traditional economics by sort of documenting these departures from full rationality.

2:30You know, the heuristics and the biases that you mentioned, and that was an important break. Like we had to sort of break ties with the old school and that was necessary. But, you know, now I think you're seeing a lot of talk about what makes people financially happy, what makes people well. And that I think is an exciting new direction for the field. Are there any discoveries that you've made as a behavioral finance expert, any conclusions that you've read about or discoveries that you've encountered that are counterintuitive? A lot of what I'm finding is that money is so central to our lives.

3:07I'm 42. The American Psychological Association has studied the stressors in the lives of Americans since about the year I was born. We've been studying what stresses Americans out. And every single year since they've studied it, finance is the number one stressor in the lives of Americans. What you see is that as people start to get their financial lives in order, other parts of their lives come in order too. I do a lot of research around some of the benefits of working with a financial advisor. For instance, we know that people who work with a financial advisor are more prepared for an emergency.

3:43They have greater global peace of mind. I just had Dr. Sonia Luter on my podcast talking about some of her research, and she found that people who worked with a financial advisor had better marital communications. So you start to see money is sort of transcendent. Money touches every part of our lives. And so as we're able to rein in this number one stressor, we see holistic improvement, whether it be with our relationships, our physical wellness. I think there's a real frontier in workplace financial wellness and some of the benefits that employers will start to see as they help the people they employ become better educated around their personal finances.

4:27It's such a problem, I think, for so many people that once you start to tame that problem, it sort of lifts all boats. When it comes to what you're talking about, reaching that state of financial wellness that permeates all areas of your life, there's, of course, a combination of sufficient income as as well as good financial habits and good financial literacy that would need to both be involved in the picture. We've heard the studies of that minimum income threshold, anywhere from$75 ,000 to$200 ,000, that correlates with happiness after which it plateaus. We've heard the studies of old. Are there new developments?

5:07Is there new research around that piece of it? Is there a minimum income threshold after which more subjective forms of wellness play a larger role in the picture? If you think back to your Psych 100 classes and sort of Maslow's hierarchy, as our income elevates, the class of our money problems elevates, but they don't necessarily go away. You're talking about the Princeton study done by Kahneman, and it was years ago, so I'm not sure what the number would be today. But at that time, it was at$75 ,000, it plateaus rather quickly. The benefits of having more money plateau rather quickly. Well, the reason is because money is what we call a hygiene factor in the social sciences, which is just a fancy way of saying, you know, getting it won't make you happy, but not having it will make you miserable.

5:56What we understand from that bottom row of Maslow's hierarchy. But as you ascend and you have more and more wealth and you have some of the basics of your life taken care of, good shelter and food and good education for your kids and all that, you start to see it have different problems. And now money enters into relationships and you start to have conversations about what is enough. And you don't have enough to eat. The function of money is to get you warmth and shelter and food. But once those things are provided for, you start to have these more relational, these existential financial problems about, you know, does money define you as a person?

6:37How can you be philanthropic? How can you try and buy happiness with your money? There's research around all of that, but it elevates the problems, but there's just sort of a new class of problems. Right. And what are some of those problems within this new class of problems? One of the things that we found among people who were better off, these are people who had mean incomes in sort of the mid six figures were working with a financial professional, they were still having some distress around money. We were measuring relational stress, effectively, what are they fighting with their partner about?

7:10I found it broke down along a couple of dimensions. The most powerful dimension was, is money best used to secure tomorrow or to enjoy today? And of course, you know, both of those things are important. You need to kind of live it up and nothing's promised and YOLO and all that. But we also know we need to plan for the future. we also found disagreements around individualistic versus communal concepts of money. And this broke down largely by culture, culture of origin. So people from Western societies were more likely to say, you know, this money is mine, this money is mine and yours. Whereas people outside of the West were more likely to say, no, this money is for me, you and grandpa and the community and my aunt who needs a place to stay and had sort of a more communal take on it.

8:03We also looked at couples who were having differences around their level of anxiety around money, which is no shocker, but also the level of importance. We found there were about half of people who found money was sort of no big deal. Having wealth was not very defining of who they were, but for other folks, it was highly wrapped up with their sense of self and their personality. All these folks had their basics covered, but they were still experiencing some form of sort of relational turmoil around money around some of these thorny problems. What's interesting to me is that we started the conversation with a focus on how the field of behavioral research is trending towards looking at wellness and happiness.

8:47And very quickly now we're discussing what those problems are still. The inverse of a problem is happiness, right? And so helping some of these folks find that happy medium, that's where we're headed. If you think about this primary point of differentiation, enjoy today versus secure tomorrow, those are both important. And where we find points of conflict is when people are at the poles, at the extremes of that measure, but trying to get people towards the middle, right, where they can take a portion of their wealth and enjoy the moment and savor a delicious meal that may cost a little more than usual or take a vacation while still not neglecting the future.

9:27I do think that the wellness piece and the happiness piece with a lot of this that I'm talking about is found in sort of that happy medium or that synthesis of these two ideas. One of the observations that you make is that sociologically, neurologically, and physiologically, we are wired not to be very good at any of this. And it's interesting to me that you make a distinction between each of the three. So I'd like to elaborate on each one by one. Let's start with physiologically. That's not a term I'd ever thought to associate with behavioral finance or the psychology of money. The reason that people don't think about it is where I was trying to fill the gap in the literature.

10:08Because if you look at things like we know not to go shopping on an empty stomach, because you're gonna wind up with a basket full of Twinkies and Coca-Cola or whatever. But we also know that there's all these other studies that show hunger or fatigue has a dramatic impact on purchase intent. People aren't just buying more Twinkies when they're hungry, they're buying more of everything. And people tend to not understand how their environment and the way that they take care of their body impacts their broader health and their mental health and indeed their financial behavior. When I was a therapist, when I was doing clinical work, This is something that I would always start with and people really underappreciated it.

10:51I have a very specific memory of a client coming to me every day with anxiety and I found that they were drinking like six cups of coffee a day. And I'm like, well, let's start there. And nobody wants to have that conversation. So there's great research that I cite in the book that looked at Israeli judges, that looked at thousands and thousands of decisions handed down by Israeli judges and looked at how lenient or how punitive these judgments were. And the best predictor of whether or not you were gonna get a harsh sentence or a lenient sentence was how recently the judge had eaten. There's all sorts of things like this in our lives where we move through the world thinking we're making sane, rational decisions based on our preferences and our willpower and our goals when in fact, it could be as simple as did you get enough sleep last night or did you have a snack?

11:47Getting people to take into account something as simple as diet and exercise and nutrition with respect to putting together a financial life is, I think, under-discussed. Other than broadly pursuing good health, other than the standard principles of get sufficient sleep, eat a nutritious diet, exercise multiple times a week, other than the standard health the device that we all know, is there anything specific that has a particular impact on the financial decisions that we make? Those are the big ones. And, you know, there's implications for, of course, caffeine and alcohol, of course, having, you know, substance use and caffeine use in moderation, I think is important.

12:32But there was one, this is not, you know, this was just kind of a funny study I came across. I don't think it's going to change anyone's life, but they found that people who needed to pee, actually, they found something called inhibitory spillover. People who were, say, controlling their bladders, restricting the impulse to need to use the restroom, also found that they were restrictive and sort of risk averse when making financial decisions. Now, is that groundbreaking? Should you walk around always needing to pee to get your budget in order? No. But I think the broader implication is that something as small as that can have a profound impact on how you're making decisions about your wealth.

13:14While this is all standard recommended stuff, eight hours of sleep and three to five days of exercise and nutritious diet and all this, it's not standard practice. Everyone knows to do it, but I think very few of us do it the way we should. I do think there's still room for improvement there. What about neurologically? Yeah, neurologically, we're just wired about opposite as we ought to be wired if we were to be great investors. You know, we really are wired for survival. And as part of that, we're wired for immediacy, action, we're wired to be on high alarm. You know, when you think back historically, the cost of getting a danger signal and missing it could be your life, but the cost of getting a danger signal and sort of overreacting is maybe you look silly for a minute, but it's not going to cost you your life.

14:12Whereas adapting in financial markets takes patience in an action and long-termism, evolutionarily we're wired for the here and now, we're wired for action, we're wired for alarm. And so getting past these things and understanding how bad our wiring is, I think is the first step to putting appropriate guardrails around yourself in the form of automation, in the form of a coach or an advisor, and in the form of sort of trying to tailor your environment to maximize your probability of success. So in just about every way possible, we're wired the wrong way to be good long-term investors. The fact that we are wired for survival, that indicates why we have such negativity bias, why we have such loss aversion.

15:02There are quite obvious parallels there. You also have talked about how we're wired for short-term impulses. And also, we're wired to be lazy. Can you elaborate on both of those? We're wired to be lazy both physically and cognitively. We'll start to seep into some of the other domains here, but if you'll forgive me. So if you think about your brain, your brain accounts for 2 % to 3 % of your body weight, but it accounts for 20 % to 25 % of your caloric expenditure each day. And so you are always looking for ways to think less. You know, you are always looking for ways to do less, to think less, and to conserve that energy, whether it be physical or cognitive.

15:47And so all of these heuristics, all of these biases that we've mentioned today, these are just cognitive shortcuts to be less taxing on our brain. And, you know, to sort of start to bleed over into the social element and see how they're combined, one of the primary means by which we save this cognitive and physical energy is we just do what other people do, right? We say, okay, nine out of 10 dentists choose crests. Sure, fine. Tom Brady wears this kind of jeans. Cool, me too. We do this with financial news media too. I found when putting together the behavioral investor, a study that looked at the brain activity of people who are watching cable financial news and the parts of their brain associated with critical thinking and decision-making actually go to sleep.

16:41You know, we are wired to defer to other people and to be lazy. Now, the flip side of that is actually, can we use this to our benefit? We can. We know that if we set a process in place whereby we auto withdraw and auto escalate our savings and invest it in a prudent manner, because we're lazy, we tend not to mess with that either. So it's hard to get started because we're lazy, but if we set something good in place, we're unlikely to stop it because we're also lazy. So a lot of the power of behavioral finance is understanding ways to make these quirks work in our favor. Right. How to work with our nature rather than against it, fight against it.

17:30Yeah.

17:57Yeah. Join U.S. Soccer Insiders today. Be part of the journey.

18:13Since we've started talking about how we are also sociologically wired to be pretty bad at this, let's continue down that path. You mentioned that we are prone to groupthink. We're prone to following the crowd. What are the other elements of the way that we socialize that make us bad investors? Well, to understand how deeply ingrained this is in us evolutionarily, I think it's good to look at how we're differentiated from other animals. So when you look at other animals, they all have something that either is great offense or great defense that kind of keeps them alive. A turtle has a shell. Tiger has claws.

18:54They can either protect themselves through violence or through protection. That's how they survive. They're fast. They're tough. They have sharp teeth. They have shells. We are soft. We don't have any of those sort of evolutionary advantages. Literally, the one thing that we have over the rest of the animal kingdom is cooperation. So we can work together. We can form states. We can form companies. We can write constitutions. We can create religions and laws of the lands. And all of these things are sort of commonly agreed upon fictions, right? Like the laws of the state of Georgia, like they didn't get mined from the earth.

19:36Like we just got together and we figured them out and we agreed upon them and we act as though they're real. And the same thing is true of economies and stock markets and everything else. So quite literally, this is the number one thing we have going for us is that we're good at mimicry and we're good at working together. Now, in the stock market, though, we know about hurting and crowding and groupthink. And so you are literally asking people at a time of great enthusiasm or a time of great pessimism to sort of spit in the face of the thing that they do best to say, look, I know that everyone is super enthused about, you know, whatever the investment trend du jour is, but you have to run the other way.

20:25Or I know everyone is panicking right now, but you have to remain stalwart. So value investors, right? Sort of contrarian investors. You look at them, they show evidence of social isolation and pain and depression. Like there is a real physical cost to these things. There's a real emotional cost to these things. You are literally asking people to turn aside from the thing that they were wired to do better than any other animal. The other thing that I found so fascinating about the social piece in putting together the behavioral investor was that social preferences can literally change the way we perceive the world.

21:06There's this famous experiment called the Ash Experiment where, you know, imagine one line on the left and three lines on the right. And you're supposed to match the lines that are the same length, right? Now, if you ask people to do this as a one-off, everybody gets it right. Like it's the easiest thing in the world. But what they ask people to do though, is to do it in sequence. And so say, Polly, you're the 10th person in a row to do this. And the nine people ahead of you are confederates of the experiment. So they give the wrong answer. You know, let's say the right answer is C, and the nine people ahead of you say B.

21:44We know that three quarters of the time, the person in that number 10 slot, you know, you give the wrong answer. And it's the easiest thing in the world. A kindergartner could do it. And yet three times out of four, they give the wrong answer. We used to think that's because they were succumbing to peer pressure. But what or recent evidence has shown is that peer pressure can literally alter the way they physically see the line so that it actually, this is kind of trippy, but it actually physically alters the way you view the length of the line, these other people's perceptions. And so it really can't be overstated how powerful a force this sort of group cohesion is and how much good it does for us.

22:33And so it's so, so difficult to ask us to turn our backs on it in this one sort of specific domain of our lives. Given that reality, does it benefit value investors and other people who take a contrarian approach to find community with one another? Yes, absolutely it does. I think it speaks to the rise of something like Bogleheads or these value forums and other places where like-minded people gather. My friend, Dan Egan, who heads up behavioral finance at Betterment, he wrote a piece a few years ago now that really spoke to me and I think is really true. And he said investors need a religion, not like a real religion, but they need a framework to believe in.

23:16If the framework is indexing, fine. If the framework is value or momentum or growth or a hundred other things, there's many ways to succeed at investing. but we need a framework and we need a tribe and we need a group that we can kind of point to and say, yep, this is how we do it. Because I think it's only through having that tribe and that larger sort of theoretical framework that you're able to make it through the tough times, which inevitably come to any form of investing, no matter how prudent. Let's talk about the four types of behavioral risk that you've written about. You describe them as ego, conservatism, attention, and emotion.

24:00I'd like to talk about each one distinctively. Let's start with ego. Yeah. One theme you're starting to hear is that things that serve us well, other places in our lives serve us poorly as investors. And this is certainly true of ego. Ego is just basically the various forms of overconfidence. And there are a couple. We know that we think we're better than other people on average, right? We know that something like 85 % of people think they're better than average drivers. That's not how that works. Not everyone doesn't get to be great at this. One study I cited in a previous book showed that 95 % of men thought they were better looking than average.

24:39That's not how this works. The second piece is thinking we know more about the future than we actually do. A third piece is thinking that we're luckier than average. And then the final one is what's called over precision, which is I think one that people don't look at much. It's this belief that we can like nail it, be very precise in our predictions about the future. One study that I thought was funny, it asks people how many books are there in the Old and New Testament of the Bible. Most people don't know that. So you take your guess. And then the second question is, give me a range that you're sure encompasses the number of books there are in the Bible.

25:20So when I did this, the answer to the first question was 25, which, you know, that's wrong, but sure. Okay. Most people don't know that. No expectation there. But the answer to the second question is 20 to 30. Now, a rational answer would be something like one to a billion, right? If you're asked to give a range that you're confident includes the right number of books and the right number is 66, you're going to guess one to a million or one to a billion or something like that. But nobody does that because we think we can predict and know the future and guess things better than we can. All of these are sort of forms of overconfidence.

26:04Right. So overprecision, that extreme certainty in what we have forecasted or what we have guessed. Yeah. We got the inflation numbers this morning and it was hilarious watching people on Twitter. The consensus forecast was 8.7. It ended up being 8.5. And people are like, well, I think it's going to be 8.4 because gas prices are down. And you're like, what? Nobody can. You can't just back of the napkin, you know, the US economy. And yet we think we can. And again, all of this helps us in other places. It makes us brave. It makes us ask the good looking person on a date, it leads us to start a business, it makes us happy.

26:47So there's lots to like about overconfidence in other places, and investing, it gets us in big trouble. How does that work in tandem with, you know, You also mentioned, in addition to over-precision, there's the excess belief in your own skill. Most people think that they are more skilled than average, which mathematically speaking cannot be true. On top of that, there's also excessive optimism or unrealistic optimism. It seems as though with all of those working together in tandem, that leads to a massive ego problem. can just one of those be ratcheted down or do they all need to be ratcheted down or kept in check together?

27:29Yeah, it's a great question. And, you know, to further compound this, I think ego is the sort of the bias that begets all of the other biases because it's because of our ego that we never even recognize these errors in our thinking or sort of take the time to check ourselves, I think some people are more prone to one or the other. And what we find, it's interesting, we find that about 80 % of people, they have overconfidence. Well, the 20 % of people who don't suffer from overconfidence, it's not like they're dead on, they're sort of depressed, they're undershooting the mark, whereas people who are overconfident are overshooting the mark.