Can Behavioral Economics Boost Your Retirement Savings?

Thanks to the 2008 crash, your IRA and/or 401(k) is hardly any bigger than it was a decade ago. That is truly discouraging ... but, hey, look at the bright side! Consider that human beings have been around for maybe 200,000 years, but we were pretty much full-time hunter-gatherers for the first 190,000. As sickly as it may be, your 401(k) beats any of those guys' retirements. More to the point, if you break a leg, you aren't likely to die. If you have a nice cooking pot or warm clothes, the next strong guy who happens by is less likely to take them away, and you don't have to spend most of your time scrounging up your next meal.

Heck, back then those guys couldn't catch a break. They invested a lot of effort over a long period of time in getting really good at mastodon hunting which, for a comparatively brief while, meant more common times-of-plenty -- and then the dang mastodons went extinct.

So that's the good news: things aren't as bad as you think they are
But it gets better. There's a new interdisciplinary field of study combining psychology, economics, genetics, and neuroscience that focuses on the state of your 401(k) and how it could be improved.

OK, not your portfolio per se, but more generally on how people make value choices. And there could be some help for us there. Because the latest research indicates that our choices are influenced by built-in value decision mechanisms that have been shaped by those 200,000 years of human experience -- during most of which time, the ability to make superior value choices concerning immediate risks and benefits was much more useful than long-range analysis. This could be helpful because if you decide -- now that we have civilization -- that deliberately accepting some short-term risk for potential long-term gains makes more sense. And if you know your brain is biased against doing that, you can compensate.

Traditional behavioral analysis as applied to value choices (behavioral economics) has noted that humans make a disturbingly high number of "irrational" decisions -- that is, choices that are obviously suboptimal given the available information. The pioneering work of the Nobel-prize-winning Daniel Kahneman and Amos Tversky -- most notably in their 1979 paper, "Prospect Theory" -- laid the basis for this line of analysis. Their conclusion, essentially, is that when you make bad value choices you are failing to behave rationally.

In their 1983 paper, "Extension Versus Intuitive Reasoning: The Conjunction Fallacy in Probability Judgment," Kahneman and Tversky cited a study in which college students had been presented with the following:

Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.

Which is more probable?

  1. Linda is a bank teller.
  2. Linda is a bank teller and is active in the feminist movement.

Overall, 85% of respondents indicated that option 2 was more probable than option 1. This is, of course, illogical. While it is probably more likely Linda is a feminist than a bank teller -- and if she is a bank teller, more likely she is also a feminist than not one -- she is obviously (slightly) more likely to be a bank teller and either a feminist or not one (option 1) than she is to be both a bank teller and a feminist (option 2).

So according to traditional behavioral economists, if you picked option 2 above, you are bad at making rational value choices; no wonder your 401(k) is down!

But the new generation of behavioral economists demur! According to them -- let's call them "BENGs," as in "behavioral economist/next generation" -- it is a mistake to measure the rationality of any behavior irrespective of the context in which that behavior occurs. Given the descriptive information in the example cited by Kahneman and Tversky, it is evident that Linda is highly likely to be a feminist and not particularly likely to be a bank teller. Therefore, given what we know about her, whether she is a bank teller is orthogonal data and not important; but we can say with assurance that it is probable Linda is active in the feminist movement. Therefore, in common sense terms, option 2 is a perfectly rational choice.

It gets even more interesting when the BENGs focus on value choices. CalTech Professor of Economics Antonio Rangel, director of the Neuroeconomics Laboratory and a leading BENG, co-authored the 2010 paper, "MAOA-L carriers are better at making optimal financial decisions under risk," which suggests that there may be a genetic component to the ability to make value choices under pressure. According to study data, genetic factors appear to influence two mechanisms your brain utilizes to process risk-laded options: both the way value is assigned to different options, and the way in which selections among these options are made. The bottom line: Carriers of genes encoded for monoamine oxidase-A (MAOA-L) are able to make better financial decisions under risk and are more likely to select options entailing financial risk.

Rangel's Neuroeconomics Laboratory is also conducting research using fMRI, TMI, and EEG technology to map out what areas of the brain are employed in making value choices.

This research is cutting-edge stuff and there is still a lot to learn. But it seems highly likely that the mechanisms our brains utilize to process value choices have evolved in the light of 200,000 years of human experience -- and for the first 95% of those years, there was virtually no agriculture, a nomadic lifestyle, no laws or police or private property, and relatively short life spans, during which most of the time folks were foraging for food.

In those circumstances, the relative benefits of what we might term long-range investing behavior -- e.g., perfecting an improved method of making knife blades or searching for better hunting grounds -- probably seemed pretty paltry compared with the potential risk consequences of not spending enough time storing food for the winter or sustaining a serious injury while far from your clan's campsite. And just as short-term risk seemed to outweigh long-term benefits, short-term benefits were much easier to grasp than long-term risks.

So here we hapless humans are, fecklessly speculating on overpriced real estate, revenue-challenged dot-coms, and tulip bulbs in hopes of a quick killing while undervaluing genuine long-term investments because our brains are not wired to expect to live that long. And even if we do, expending all that effort evaluating and effecting long-term decisions is futile because as soon as we figure out how to hunt them successfully, we expect the mastodons will go extinct. Traditional behavioral economists evolved, but they were not much help, spending most of their time devising measurements to rate more precisely how "irrational" our bad choices were.

But the BENGs have now arrived, and according to them, our choices are perfectly sensible when considered in the context of the totality of human experience and the way our brains have evolved to cope with it. While this doesn't magically transform bad choices into optimal decisions, it is encouraging because if we can perfect an understanding of how our brains process value choices, being as clever and adaptable as we are, it is more likely we can effectively compensate for the fact that life is no longer nasty, short, and brutish.

It's not all bad news
It's too late to improve the mastodon situation, but there is hope yet for your 401(k) performance ... not to mention other value choice-pertinent situations such as living together and coping with limited resources.

To overcome 190,000 years of experience whereby long-term analysis was of little use, we have to develop the discipline to consciously consider long-term risks and benefits in making our value choices. Exactly how to do that effectively varies from person to person, but a good way to start is to review your long-term financial goals. (Here is one of my favorite little toys to get you in the proper frame of mind.) Once you are satisfied those are both adequate for your needs and realistic, then you need to consider significant financial decisions in the light of their potential effect on achieving your goals.

Then all we have to do is get politicians to think past the next election cycle and CEOs to think past the next quarterly report and everything will be hunky-dory!

If you're interested in learning more about what the BENGs are doing, check out these links:

Brad Hessel is a guest contributor to We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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  • Report this Comment On February 17, 2011, at 2:24 PM, JackHoffman56 wrote:

    Fascinating article Mr. Hessel. I do, however, have a few issues with it:

    1. There are still plenty of places in the world where you are likely to die if you break your leg. The implication that individuals in these places are somehow less evolved or civilized could be regarded by some as offensive.

    2. Several statements in the article imply an endorsement of neuroscientific reductionism. Can something as complex as a financial decision actually be reduced to biological activity? Are the sociocultural and psychological aspects of financial decisions less fundamental than the biological aspects?

    Moreover, if there is such a reduction, does the reduction occur at a 1:1 ratio (e.g., areas x, y, and z determine Type A decisions), or is this reduction much more complex?

    Is it only our brains that have evolved over time? Surely traditions and memes do not always evolve in conjunction with the biological aspects of a being.

    The MAOA-L study demonstrated that one's status as a carrier may account for some of the variance in financial decisions, but not that such genes play a causal role in financial decisions. Individuals with such genes may be more likely to have certain kinds of life experiences (e.g., emotion disorders) or may have simply come from families/a cultural background that values shorter-term gains. This also speaks to another bias within the article: why are longer-term gains considered more valuable than shorter-term gains? Is your happiness from ages 65-75 more valuable than your happiness from ages 18 - 65? In short, it might be helpful to refrain from interpreting a group difference as indicating that one group is "worse."

    3. Particularly concerning is the conclusion that "if we can perfect an understanding of how our brain processes value choices... it is more likely we can effectively compensate for the fact that life is no longer nasty, short, and brutish."

    a) By what criteria are we saying that life is no longer nasty or brutish?

    b) It is highly unlikely that we will ever perfect an understanding of how our brains process things such as 'value' or 'choices.' This is because these latter two things are psychological constructs: there is no universal definition for a psychological construct that is not tautological (e.g., as Wittgenstein famously pointed out, there is not even a perfectly sensitive/specific definition of "game"). In other words, we can never completely reduce a psychological construct to a physical construct such as brain activity.

    c) Even if we were able to do such a thing, or if we admitted that there was a high degree of error within this process (e.g., manifest measures of the latent construct of value), would this biological information be more useful, fundamental, or valuable than social or psychological information? Why must be specifically seek out or wait for biological information or regard it more highly than other types of information? How would this information allow us to compensate for anything?

    d) What are the mechanisms by which this presumably more fundamental biological level controls psychological and social-level phenomena? What of the evidence suggesting that social and psychological events may substantially alter biological substrates?

    4. Are there effective psychological or social interventions that could effectively reduce supposed "problems" like a preference for short-term gains? Wouldn't such interventions be more specific to the (psychological and social) issue at hand than the arguably more removed biological aspects?

    Jack Hoffman, Ph.D.

  • Report this Comment On February 17, 2011, at 4:37 PM, bhessel wrote:

    Dr. Hoffman,

    Thank you for your reflective note. Some comments:

    [4] Most probably, yes; indeed this is the main point of my article. As we (unsuprisingly) have evidently failed to undo 190,000 years of brain wiring in the last 10,000 years, we need such psychological/social interventions to compensate for our wired-in biases. Any suggestions along these lines welcome! :-)

    [3d] This is a cutting-edge question; check out the research being done by the Neuroeconomics Lab and others (see links at end of article).

    [3c] Same answer.

    [3b] This may prove to be correct—as with virtually all research—however, recent studies have identified particular regions of the brain that are active when humans are engaged in making value choices…we clearly know more about the process now than five years ago. Surely you don’t mean to suggest we stop this sort of research because it may eventually fail to address this particular issue; even if that turns out to be so, we may discover other ways to utilize the knowledge we are gaining.

    [3a] Umm…well of course everything is relative…but compared to nomadic hunting and gathering, would culture, criminal justice systems, and increased life span do the trick for you? :-)

    [2] Clearly nature and nurture are intertwined, arguably to the point of conceptually separating them being a false dichotomy. We are not (yet) trying to define on a percentage basis a breakdown of the factors influencing a decision, but rather just to discover what pertinent factors may exist, and gain some appreciation of the mechanisms by which they exert influence. Intuitively, it seems like common sense that if you move in one direction for 190,000 years and then in the opposite direction for 10,000 years, you’re probably not back to where you started yet. Given that it is extremely likely such a bias exists—as indicated by the fact that humans survived those 190,000 years when conditions favored short-term thinking—is not an effort to understand how it operates, potentially enabling us to compensate, a perfectly logical and rational thing to do? And certainly studying the biological components of this bias does not preclude attending to the psychological aspects. Dr. Rangel (head of the Neuroeconomics Lab at CalTech) has a PhD in economics, not biology, and there are psychologists on his team as well.

    As for the relative value of investing versus speculation, this whole website is a testament to the efficacy of long-term investing. Speculation tends to work faster but being necessarily based on inferior intelligence, the down zags tend to zero out the up zigs.

    [1] Dr. Hoffman, please! I said nothing about levels of evolution. My point is simply that in a world with hospitals, a broken leg is less likely to be a catastrophe than in a pre-tech, pre-agricultural world of nomadic existence.

    Brad Hessel

  • Report this Comment On September 26, 2011, at 9:10 AM, bhessel wrote:
  • Report this Comment On November 25, 2011, at 10:49 AM, bhessel wrote:

    Tweet of potential interest:

    AJEnglish Al Jazeera English

    Opinion: The neuroeconomics revolution

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