Irrational Expectations
Posted by John Draper | Filed under Investing, Thinking Out Loud
People are not rational. This isn’t news to me. I’ve been watching people do really stupid things – things against their own best interests – for years. But WHY do they do stupid things? Ah, that’s the question.
Well economists and behavioural scientists are coming together to uncover the source of our irrationality. I’ve blogged before about the latest in economics – called neuroeconomics – that studies how our brains actually respond to things. We’re not guessing how people “feel” anymore. Now we’re using MRIs to take pictures of how we “feel.”
A breakthrough report cited on Economist.com used active MRIs to show that failure to choose an optimal outcome in the Ultimatum Game correlated with an area in the brain said to be involved with reward and punishment decisions.
Here’s the gist of the ultimatum game 
“Take two people and tell them they have the opportunity to split $10. Furthermore, tell one person that, as first mover, they get to make a one time offer, and tell the other person that, as second mover, they get the opportunity to either accept or reject this offer. If the offer is rejected they both go home with zero.”
According to standard economic theory, as long as the first person offers any money at all, the proposal will be accepted because the second person prefers something to nothing. That’s the rational thing to do.
Here’s the interesting part: lots of people would rather have nothing than accept the offer of just one dollar. So much for “A bird in the hand…” We’d turn our back on a dollar because we’d rather have the other person get nothing than make $9 while we walked away with just a buck. Hmmm.
This may be the very reason why people are unwilling to settle for reasonable rates of return on their investments. If they feel they are being bettered, their F-U switch clicks on and they’d rather lose everything than settle for the bird in the hand.
I get a lot of letters from people who want to earn “a better rate of return” on their investments. Better than what? Better than your brother, you boss, your broker? Better is relative. And so is risk. If you’re prepared to lose everything you’ve worked hard for, you can potentially earn a better return than if you stayed with a completely safe investment option. If that scares your pants off, then you should turn off your F-U switch and settle for a return that lets you sleep at night.
For more information on the relationship between risk and return, go and read How Greedy Are You?
August 15, 2008 at 11:54 am
I read the first bit and thought… “offer $6, no one could so no to that”. Then as I kept reading, I was stunned! $1, that’s silly, stupid and greedy people would say no…. and there are no guarantees that the person sitting across to deal with you is neither stupid nor greedy (even temporarily). So the person orchestrating the deal is out the $9…. when they could have at least kept $4.
As far as asking for BETTER returns, I know I would like my investments to AT LEAST keep up with INFLATION (even that is a hefty request with some options).
August 15, 2008 at 12:47 pm
Hmmm… interesting thought on that Tracy. My initial reaction was to split it $5/$5. Seemed fair and equitable to me since you’ve both done nothing to earn it.
I must be so naive…..
August 15, 2008 at 1:01 pm
Christina, I was with you. Before even reading into the experiment, I assumed people would just choose to split it 50/50. Why not, right?
As for the Dictator Study, there is no incentive to split anything equally for the first person, since they keep it all if the person turns it down. Looks like they got the good investment with that one! Any offer would become risk-free.
August 15, 2008 at 1:43 pm
Interesting post. However I would caution people that (a) more return doesn’t have to equal more risk – ie if you have a high MER on your retirement accounts than you can transfer to a similar account with a lowe MER and get a higher return for identical risk as before and (b) that there IS risk in being too cautious. For instance if you accept a guaranteed rate of return that is fixed at 3% and inflation rises at 3.4%, then you’re losing money. Greed isn’t necessary good, but neither is being overly cautious.
August 15, 2008 at 3:41 pm
I have to agree with the post in general – if the person took 8$ to $10 for themselves, my F/U senses would be tingling and I would reject the offer. If I had to decide, I would split 50/50 and hope for the best. Change the figure to $1,000 and not $10 and my senses tingle more.
Geoff, here is a question for you and others. Where would you suggest one keep their emergency fund? Three to Six months of expenses can be a large amount – but keeping it in cash or cashable GICs you don’t keep up with inflation. After 5 years, you may now only have two to five months of emergency funds. Do you accept it – because emergency funds need to be liquid or to do you add some risk to your emergency fund? Would love to hear your comments – you have provided some interesting feedback to the posts.
August 15, 2008 at 3:51 pm
Geoff, I also enjoy reading your comments. You certainly offer some interesting perspectives. Have you considered creating a blog of your own on day to day topics?
Gail, I’d love to see a post about how you started your career. What made you/how did get into this field? Not a “how to do what I do” blog, but a little about your personal history.
August 15, 2008 at 3:55 pm
Mike:
You need easy access to a good part of your emergency fund (CASHABLE). A mix of high interest savings account and GICs will leave you with low probability that the principal amount is gone compared to selecting a higher risk investment. If the total amount builds up high, mix in a third investment such as a low risk mutual fund (bonds, etc). So you might end up with your emergency money split into three areas. You might be able to split your GICs so they mature at different times of the year so you can renew each individually as situation dictates.
Once the new TFSA is available in January, the higher interest rate accounts should be close to keeping up with inflation.
Consult a financial advisor before investing!
August 15, 2008 at 5:20 pm
Mike, Melanie – thanks for your comments. I try.We have a one year old but as soon as that gets easier I may setup my own blog.
As to your question Mike, I’ve broken it down. Keep in mind it’s just my unprofessional opinion
Where would you suggest one keep their emergency fund?
An emergency fund must be available within 24 – 48 hours notice, and be cashable. Thus a high-interest savings account is best for a small portion of it , but I would put the rest in rotating cashable GICs; IE spread out so that you have a 1 year gic, a 2 year gic, a 3 year gic etc to get the best return and only cash them in as needed. Keep in mind I’m a probability guy – the odds of me needing to withdraw the full 6 months expenses in 24 hours is much lower than the odds of me needing to withdraw 1 months expenses in 24 hours. Then I have a full 30 days to decide if I need to withdraw anymore (and which gic to cash). Please also note that I consider an emergency fund to be literally something to keep the wolves at bay – so a car that needs repairing when I can take the TTC for 3 months to save up doesn’t get my emergency fund money. Paying my mortgage does.
Do you accept risk in order to keep emergency fund available? Risk of losing principal? In this particular case – No. I can’t risk the market having a bad week right when I need it to be good. Risk of losing money due to inflation is personally something I’d rather just accept but only on a relatively small amount (3 -6 months of expenses). My comment earlier was slanted towards retirement account planning.
More importantly, it’s highly likely that after 5 years, the $ amount of your 3-6 month expenses will have changed from what they were 5 years previously. So I would recommend that you periodically review your expenses, compare your actual expenses with the amount in your emergency account, and make sure that there’s a zero difference.
Interestingly, and NOT for people who are debt prone, some people advocate having access to a Line of Credit is sufficient emergency savings (based primarily on the idea of having money sitting around losing power due to inflation). Personally, though I see their point, I feel safer having an emergency fund. Also, in interest of disclosure, my own emergency fund is only at 1 month right now but that was largely due to my wife being off on mat leave and having a baby. Thankfully, we have no debt outside our mortgage and are building our emergency supplies back up as we go. Hope this helps. Mike – read canadiancapitalist.com too btw.
August 15, 2008 at 6:37 pm
Geoff and Marie,
Thanks for the comments. I will consider some of your ideas going forward and make some adjustments.
August 15, 2008 at 7:21 pm
Interesting post, Geoff. I’m just starting my emergency fund (I recently started my first job), and so far I’ve kept it in my savings account. If I keep my 3-month emergency fund in a 3% interest savings account and inflation is in the ballpark of 3%, then I’m willing to accept losing some purchasing power for the security of having that money immediately accessible.
But everyone has their own comfort zones; I figure that staying within my personal comfort zone (and hence sleeping better at night) is more important than the extra interest I could be earning. If braver folks than me are comfortable with keeping part of their emergency fund in GICs, more power to them!
August 15, 2008 at 7:41 pm
geoff- don’t hold your breathe, it doesn’t get easier.
for me, i have my emergency fund ever growing and once it gets bigger i plan on spreading it out. but as for immediately liquid, i don’t think it’s necessary. any big emergency requiring cash can be put on our credit card and paid in full at the end of the month, incurring no interest (emergency fund incurs one more month of interest for me) while i pull the $ out of a better performing fund (that would take a couple weeks to do). like it was said above, if it’s a decrease in income over a few months, then you won’t need it all right away anyways.
for those who have issues with credit cards and loc’s forget it. but if you’re debt free, i wouldn’t worry about getting access to your cash too quickly, but always hold a few thousand back in the high interest chequing for safe keeping. unless you are the sorted type who deals in unmarked bills in a suitcase, then keep it in the mattress
August 16, 2008 at 4:33 am
I really like the point about better than what re rate of return on investments. I know too many people who wanted “better” and lost it all….!
August 17, 2008 at 10:09 pm
I have just finishing reading Predictably Irrational : the hidden forces that shape our decisions by Dan Ariely (borrowed from the library of course!). He discusses many of the irrational descisions people make that we think we are making rationally. Some of his co-authored academic papers on the subject (and on which his book is based) are on his website/blog of the same name. Definitely worth a read if you’re interested in behavioural economics.
August 18, 2008 at 3:10 pm
@ Kristen – good point about credit card but keep in mind that some expenses, ie mortgage, are probably set up as withdrawal from chequing and so if you’re unexpectedly short there (ie didn’t paid for whatever reason) then the only option is to transfer funds from credit card, which would count as a cash withdrawal, and cash withdrawals from your credit card do not have any waiting time and are effective the date withdrawn.
August 18, 2008 at 5:21 pm
On where to keep your emergency fund:
Here’s an idea – most banks offer at least one chequing account that if you keep a minimum monthly balance, your monthly service fee is waived.
One FI offers an account that if you keep $2000 in the account and you don’t drop below that balance during a month, your fee is waived, meaning your transactions become unlimited and you are saving at least $47.40 in service fees over 12 months. This works out to roughly 2.3% return on your money. This might be a good place to put part of your emergency fund so that should you need it, it’s immediately accessable, plus saving you your monthly service fee.
I really like the suggestion to split up your emergency fund. I’ve just recently started mine. I’ve got 2 weeks worth of groceries saved so far – it’s a start! I never considered investing it. At this point I’m just going to try hard to build it up and make decisions from there. I think in the long term, I will choose GICs, and keep some cash readily available.
It’s nice to read different perspectives on where to hold those funds.