A review of several behavioral economics / behavioral finance concepts and examples of how to apply the dual-self economic model to advising clients in a financial planning context.

1. This is your brain on finances: Advising imperfect humans Associate Professor Russell James, J.D., Ph.D., CFP® Director of Online Graduate Studies in Charitable Financial Planning Texas Tech University

2. A current example of a brain science “work in progress” A neuro-economic model of decision making Strategies for influencing financial decision making

3. Brain science methods Behavioral Cognitive abilities, Mathematic abilities, Choices Neurological Lesion/stroke studies Other signal receiving methods Functional Magnetic Resonance Imaging (fMRI) Positron Emission Tomography (PET)* Single photon emission computed tomography (SPECT)* Electroencephalography (EEG)** Magnetoencephalography (MEG)** *Requires radioactive injections **Great at WHEN activation, weak at WHERE activation

4. Graduate personal financial planning research & theory class

5. In progress study… A sharing game: Player 1 receives $20. Any amount he gives to Player 2 is tripled. Player 2 may return any amount to player 1. The game ends. Players are anonymous and unseen. There is no economic reason for Player 2 to share any money. Measures generosity-attachment-reciprocity.

6. A prior study found that touch (therapeutic massage) combined with receiving a larger share from Player 1 caused Player 2 to be more generous than with either element alone (Morhenn, et al 2008). Significantly, the generosity was driven by changes in oxytocin, a family/in-group bonding hormone.

7. In our fMRI study for touch, a lab assistant takes the subject’s pulse during some blocks of the trials Attempting a practical analogy to a business practice such as a handshake and a small gift.

8. We care about activation in the amygdala, which has been shown to respond to faces of in-group members more than out-group members following a team building exercise

9. Adding touch to a high sharing scenario may increase activation

10. Adding touch to an “unfair” low-sharing scenario may have a negative effect on activation

11. Moving from low sharing to high sharing in a touch scenario may increase activation

12. A framework for thinking about the neurological processes of human decision-making

13. The “dual-self” model as an alternative to simple “utility-maximizing” rational decision-making

15. Each cares only about immediate experience“Our theory proposes that many sorts of decision problems should be viewed as a game between a sequence of short-run impulsive selves and a long-run patient self.” Drew Fudenburg (Harvard U.) and David K. Levine (Washington U.), 2006, A dual-self model of impulse control. American Economic Review, 96(5), 1449-1476.

16. “The planner is concerned with lifetime utility…” R.H. Thaler (Santa Clara) & H. M. Shefrin (Cornell), 1981, An economic theory of self-control, Journal of Political Economy, 89(2), 392-406.

17. “the doer exists only for one period and is completely selfish or myopic.” R.H. Thaler (Santa Clara) & H. M. Shefrin (Cornell), 1981, An economic theory of self-control, Journal of Political Economy, 89(2), 392-406.

18. Examples of dual-self models in behavioral economics Short-term/impulsive Doer Passions Affective/Visceral Hot state Long-term/patient Planner Impartial spectator Deliberative Cold state Fudenberg & Levine Shefrin & Thaler Adam Smith Loewenstein Bernheim & Rangel; Loewenstein

19. Or we could look at neurology “A crucial fact is that the human brain is basically a mammalian brain with a larger cortex. This means human behavior will generally be a compromise between… animal emotions and instincts, and… human deliberation and foresight.” C. Camerer (Cal Tech), G. Loewenstein (Carnegie-Mellon), D. Prelic (MIT), 2004, Neuroeconomics: Why economics needs brains. Scandinavian Journal of Economics, 106(3), 555-579.

20. Can we see two systems in the brain? Areas of the prefrontal cortex are associated with rational, higher cognitive thought. The more central limbic system is the immediate reward system (“dopaminergic”).

21. Watching decision-making happen By making decisions in an fMRI machine, we can see which areas of the brain are activated. BOLD signal indicates blood usage in the area.

22. Limbic system reactions Choices between more $ later, less $ sooner. Earliest option: Today Earliest option: 2 Weeks Earliest option: 1 month S. McClure (Princeton), D. Laibson (Harvard), G. Loewenstein (Carnegie Mellon), J. Cohen (Princeton), 2004, Separate neural systems value immediate and delayed monetary rewards. Science, 306, 503-507.

23. Higher cognitive system reactions Choices between more $ later, less $ sooner. Earliest option: Today Earliest option: 2 Weeks Earliest option: 1 month S. McClure (Princeton), D. Laibson (Harvard), G. Loewenstein (Carnegie Mellon), J. Cohen (Princeton), 2004, Separate neural systems value immediate and delayed monetary rewards. Science, 306, 503-507.

24. Hyperbolic discounting Would you rather receive $100 right now or $101 in a week? Most people choose $100 right now. But when the choice is between $100 a year from now and $101 in a year and a week from now, most people choose $101 in a year and a week. This is time inconsistent, as both choices involve delaying by one week for $1. Note also that choosing $100 right now implies an interest rate charge of 1% per week or APR of 52%

25. Dual-self example Read & van Leeuwen (1998). 200 participants. People who were not hungry, chose the unhealthy snack for delivery in one week 26% of the time They chose the unhealthy snack for immediate consumption 70% of the time ←Next Week Right Now -> 26% 70%

26. Let’s use a simple analogy “The image that I came up with … was that I was a rider on the back of an elephant. I’m holding the reins in my hands, and by pulling one way or the other I can tell the elephant to turn, to stop, or to go. I can direct things, but only when the elephant doesn’t have desires of his own. When the elephant really wants to do something, I’m no match for him.” Dr. Jonathan Haidt, (University of Virginia), The Happiness Hypothesis, 2006, p. 4, Basic Books: New York.

27. Elephant in charge If given total control, the “elephant” side makes choices detrimental to future success and happiness. Long-term Patient Planner Impartial spectator Deliberative Cold state Short-term Impulsive Doer Passions Affective/Visceral Hot state

28. How can we change?

29. Alter our time preference (develop future-orientation or patience) 2. Pre-commitment strategies (change our elephant’s future environment)

30. How do we work to develop more future-orientation (patience)? Victim of my insatiable need for instant gratification.

31. Economic Theory Nobel prize winning economist Gary Becker and Casey Mulligan present a model of time preference for imperfect humans. People may be too focused on instant gratification, but they can spend effort to develop patience (future-orientation). G. Becker (Chicago) & C. Mulligan (Chicago), 1997, The endogenous determination of time preference. Quarterly Journal of Economics, 112(3), 729-758

32. Economic theory: People maximize… A time discount factor (because future enjoyment is not the same as current enjoyment) The enjoyment of future consumption The enjoyment of current consumption G. Becker (Chicago) & C. Mulligan (Chicago), 1997, The endogenous determination of time preference. Quarterly Journal of Economics, 112(3), 729-758

33. Becker & Mulligan say we can change it by spending effort (S) to become more future-focused. In standard economics, our time discount preference (β) is pre-set. A time discount factor (because future enjoyment is not the same as current enjoyment) The enjoyment of current consumption The enjoyment of future consumption G. Becker (Chicago) & C. Mulligan (Chicago), 1997, The endogenous determination of time preference. Quarterly Journal of Economics, 112(3), 729-758

34. A consumer can “make future pleasures less remote by spending resources (S) on imagining them” A time discount factor (because future enjoyment is not the same as current enjoyment) The enjoyment of current consumption The enjoyment of future consumption G. Becker (Chicago) & C. Mulligan (Chicago), 1997, The endogenous determination of time preference. Quarterly Journal of Economics, 112(3), 729-758 , p. 734

35. People can maximize utility “partly by spending time and other resources to produce ‘imagination capital’ that helps them better appreciate future utilities.” G. Becker (Chicago), 1996, Accounting for Tastes. Cambridge, Massachusetts: Harvard University Press, p. 11

36. A Nobel prize winning economist using an economic model incorporating Imagination

37. “How can a person improve his capacity to appreciate the future? What exactly is S? First, Sis partially determined by time and effort spent appreciating future pleasures.” G. Becker (Chicago) & C. Mulligan (Chicago), 1997, The endogenous determination of time preference. Quarterly Journal of Economics, 112(3), 729-758 , p. 734

38. “While forming a mental picture of one’s future pleasures may not be incredibly difficult, the process of anticipation is not merely one of image formation but also one of scenario simulation.” G. Becker (Chicago) & C. Mulligan (Chicago), 1997, The endogenous determination of time preference. Quarterly Journal of Economics, 112(3), 729-758 , p. 734

39. “Even image formation may not be cheap because images of future pleasures have to be repeatedly refreshed in one’s mind in order to compete with current pleasures.” G. Becker (Chicago) & C. Mulligan (Chicago), 1997, The endogenous determination of time preference. Quarterly Journal of Economics, 112(3), 729-758 , p. 734

40. http://www.youtube.com/watch?v=wPFA8n7goio 1:13-4:30

41. Only emotional goals work The rider may be compelled by logic or emotion The elephant is purely emotional (visceral) To engage the elephant, the imagery of future goals must evoke emotion

42. Time horizon and wealth building In 1998 about 5,000 people over 50 were asked: “In planning your saving and spending, which of the following time periods is most important to you, the next few months, the next year, the next few years, the next 5-10 years, or longer than 10 years?” Comparing people with the same starting wealth, did those with longer time horizons accumulate more wealth in the following 8 years?

43. Wealth growth and time horizon Comparing with the wealth growth of other people with the same starting wealth:

44. Other research finds:Planning ahead->wealth “Why do similar households end up with very different levels of wealth?” “We … measure each household’s ‘propensity to plan.’ We show that those with a higher such propensity spend more time developing financial plans, and that this shift in planning is associated with increased wealth.” Ameriks, J., Caplin, A. (NYU), Leahy, J. (NYU). 2003. Wealth accumulation and the propensity to plan. Quarterly Journal of Economics, 118(3), 1007-1047.

45. Focusing on long-term goals using imagery and emotion can change your future-orientation.

46. Alter our time preference (develop future-orientation or patience) 2. Pre-commitment strategies (change our elephant’s future environment)

47. Pre-commitment gives the rider control over the elephant’s future environment. Few Temptations Many Temptations

48. Pre-commitment Strategies 1. Change the rewards and penalties 2. Change the number of decision points

49. 1. Change the rewards and penalties The goal is to change the environment as perceived by the elephant. The elephant is Emotional Focused on now Fears loss Long-term Patient Planner Impartial spectator Deliberative Cold state Short-term Impulsive Doer Passions Affective/Visceral Hot state

50. Elephant characteristic Emotional Focused on now Hates loss Approach Change peer group & social rewardsto alter emotional payoffs of future choices Change immediate rewards of future choices Reframe the felt losses of future choices

51. Are professors’ retirement savings affected by their peers’ savings? Duflo, E. (MIT) & Saez, E. (Harvard), 2002, Participation and investment decisions in a retirement plan: the influence of colleagues’ choices. Journal of Public Economics, 85, 121-148.

52. “When participation [in a retirement savings program] increases by 1 percent in the department, one’s participation increases by 0.2 percent.” Duflo, E. (MIT) & Saez, E. (Harvard), 2002, Participation and investment decisions in a retirement plan: the influence of colleagues’ choices. Journal of Public Economics, 85, 121-148.

53. Are professors’ choice of mutual fund company affected by their peers’ choice? Duflo, E. (MIT) & Saez, E. (Harvard), 2002, Participation and investment decisions in a retirement plan: the influence of colleagues’ choices. Journal of Public Economics, 85, 121-148.

54. “When the average share of the contribution invested in one vendor increases by 1 percent, one’s share in this vendor increases by 0.5 percent on average.” Duflo, E. (MIT) & Saez, E. (Harvard), 2002, Participation and investment decisions in a retirement plan: the influence of colleagues’ choices. Journal of Public Economics, 85, 121-148.

55. Financial peer groups – Microfinance http://www.youtube.com/watch?v=nMg_Lc6akos(0:00-1:45)

56. 2. Focused on now Change immediate rewards of future choices 3. Hates loss Reframe the felt losses of future choices Negative Choices Positive Choices Reducing the immediate payoff Adding Felt Losses Increasing the immediate payoff Removing Felt Losses

57. Why losses hurt more Is there a conflict between the core “elephant” side of the brain and the rational pre-frontal cortex “rider”. Why? http://www.youtube.com/watch?v=GGQLO_iXKlU 3:06-end

58. Illiquidity may encourage wealth accumulation by reducing the temptation to consume. “All Illiquid assets provide a form of pre-commitment” D. Laibson (Harvard), 1997, Golden eggs and hyperbolic discounting. Quarterly Journal of Economics, 112, p.444.

60. Adding felt losses – paying with cash “In studies involving genuine transactions of potentially high value we show that willingness-to-pay can be increased when customers are instructed to use a credit card rather than cash. The effect may be large (up to 100%).” D. Prelec (MIT) & D. Simester (MIT), 2001, Always leave home without it: A further investigation of the credit-card effect on willingness to pay. Marketing Letters ,12, 5-12

61. D. Soman (U. of Toronto), 2003, The effect of payment transparency on consumption: Quasi-experiments from the field. Marketing Letters, 14, 173-183.

62. Removing felt losses Pre-paying for the gym The automatic millionaire Save more tomorrow Keep the change Tax refund splitting

63. Removing felt losses:Save more tomorrow People commit in advance to allocating a portion of their future salary increases toward retirement savings. “the average saving rates for [Save More Tomorrow] program participants increased from 3.5 percent to 13.6 percent over the course of 40 months.” R. Thaler (University of Chicago), S. Benartzi (UCLA), 2004, Save more tomorrow: Using behavioral economics to increase employee saving. Journal of Political Economy, 112, S164-S186

64. Removing felt losses:Bank of America’s Keep the Change “each time you buy something with your Bank of America Check Card, we’ll round up your purchase to the nearest dollar amount and transfer the difference from your checking account to your savings account.” http://www.bankofamerica.com/promos/jump/ktc/ downloaded 7 Nov. 2009

65. Removing felt losses: Tax refund splitting Tax refund splitting is a pre-commitment to put a portion of the tax refund into a savings account In a pilot program “those that did participate saved 236% more than they said they would before hearing about the program” A. Chiou, S. Roe, E. Wozniak, advisor E. Luttmer (Harvard), 2005, An evaluation of tax-refund splitting as an asset-building tool for low-to-middle income individuals. http://www.d2dfund.org/system/files/publications/PAE+R2A2+FINAL.pdf

66. The problem of felt losses in investing Investors prefer to realize gains (sell winners) but not losses (hold losers). This lowers returns as compared to “buy and hold” strategies. Among active traders, “Men underperformed their buy-and-hold portfolios by 2.652 percentage points annually; women underperformed their buy-and-hold portfolios by 1.716 percentage points annually.” B. Barber (UC-Davis) and T. Odean (UC-Davis), Nov/Dec. 1999, The courage of misguided convictions. Financial Analysts Journal, 41-55

67. Pre-commitment Strategies NEXT 2. Change the number of decision points

68. Each decision point is an opportunity to change direction Increase decision points required for negative options Decrease decision points required for positive options

69. Increasing decision points required for negative options Decreasing decision points Required for positive options

70. Mental accounts(partitions) In standard economics a dollar is a dollar is a dollar. Money is “fungible” In behavioral economics, people put money into different mental categories and react differently to fluctuations in different categories

75. Financial partitioning device

76. A credit request freeze allows consumers to freeze their credit files. No credit applications without going through the thaw request process.

77. Can you implement your own mandatory cooling off periods? Gold Credit Card 0000 2222 1001 0051 Example:Putting your credit card in a block of ice Other ideas?

78. Increasing decision points required for negative options Decreasing decision points Required for positive options

79. 800,000 eligible employees at 657 companies 401(k) plans ranged from 2 to 60 investment options As choices increased what happened to the likelihood of investing? Decreased b) Increased c) Stayed the same

80. S. Botti (Cornell) & S. S. Iyengar (Columbia), 2006, The dark side of choice: When choice impairs social welfare. Journal of Public Policy and Marketing, 25(1), 24-38.

81. Our decision-making can be thought of as the outcome of a game between the “elephant” and the “rider”. The elephant is (1) emotional, (2) focused on now, (3) fears loss The elephant is stronger, but the rider can alter the elephant’s future environment by Emotional future imaging (2) Changing the elephant’s future rewards and penalties through pre-commitment (3) Changing the number of decision points Long-term Patient Planner Impartial spectator Deliberative Cold state Short-term Impulsive Doer Passions Affective/Visceral Hot state