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ExposedHow ourFinancial

Misbehaviorsturn into

The Revealing Science of

Behavioral Economics

Exposes Common Financial

Misbehaviors that are

Sabotaging Americans’

Financial Well-being

If you answered YES to any of these questions,you’re not alone! You’re in the majority ofpeople affected by the trials and tribulationsof human nature. Some theorists say that byidentifying the psychological causes that affectfinancial decisions, you can effectively changeyour behavior in ways that will help buildfinancial strength. This is the basis of the newscience called Behavioral Economics.

What is Behavioral Economics?Behavioral Economics is a relatively new field of study that combines the disciplines of psychology and economics to explain how and why people make seemingly irrational or illogical decisions when theyspend, invest, save and borrow money. These unfortunate decisions can lead to money maladies, which are detrimental to our long-term financial wellness.

A Hard HabittoBreak

?Are you often willing to spend

much more for a product boughton credit than with cash?

• • •

Do you intend to set up a retirement plan but never seem to get around to it?

• • •

Do you mentally “wing it” to keep track of your spending?

• • •

When it comes to choosing investments in your employer’s

savings plan, are you more comfortable with keeping the

“status quo?”

Questionable Financial Behaviors

psychology + economics = + improve financial

decision makingfinancialsecurity

Northwestern Mutual has commissioned several studies of the financial behaviors of Americans, and the results indicate that people do, indeed, commonly fall prey to psychologically driven impulses, or misbehaviors, that affect their financial decisions. Some misbehaviors, describedlater, were proven to be common amongAmericans.1

The good news is that people who learn aboutand understand such potential financial “blindspots” are better able to adjust their behavior,improve financial decision-making skills andtruly attain financial security.

Know your financial “blind spots”For most of us, the fact that we are behavingin ways that can hurt our finances has nevercrossed our minds. Unknowingly, we could bemaking decisions that could be costing us hundreds or thousands of dollars every year.That’s a loss no one wants to take.

But knowledge is power. By learning aboutyour own blind spots and misbehaviors,you’re taking the first and most importantstep to correcting them. Talking with a qualified financial professional is anothergood way to understand these misbehaviorsand turn them into positive behaviors.

Do any of the following misbehaviors sound familiar to you?

Mental AccountingPeople tend to think that money is not created equally.

People create “mental accounts” to keep trackof how much they’re spending in a specificcategory – food, clothing, entertainment, etc.The downside of mental accounts is that wewill optimize our savings within an account,but we won’t treat $1 in one account the sameway as $1 in another. For instance, saving $2off our lunch seems like a good deal, but anextra $2/month on our mortgage paymentdoesn’t seem as significant.

........

Imagine that you are planning to go to thetheater. When you arrive, you discover thatyou lost your $150 theater tickets. Assumingyou can afford another set of tickets, will youstill go to the theater?

Now imagine that you’ve arrived at the theater, and you discover that you lost $150in cash. You haven’t purchased the theatertickets yet. Assuming that you can still afforda set of tickets, will you still go to the theater?

What’s going on? In both cases, you’ve lost$150. However, the mental accounting is different. In the first scenario, the $150 hasalready been charged to the “theater account,”and most people will not want to chargeanother $150 from that account. In the second scenario, the cash doesn’t belong to aspecific account, at least yet, so putting a new$150 into the theater account is still acceptable.

Note how the same amount of money spentcan be regarded so differently – all dependingon our mental view of the situation. In reality, all money is created equal and“spends” the same.

CommonFinancial Misbehaviors:

Exposed!

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1 Behavioral Economics Survey, Northwestern Mutual, September 2003

FramingDecisions are made based on how choices are presented.

Framing often depends on your reference pointand determines what is most likely to influenceyou. People are particularly influenced by whetheran outcome is seen as a loss or a gain.

........

Consider the following questions:

1) Could you comfortably save 20% of yourhousehold’s annual income at this point inyour life?

2) Could you comfortably live on 80% ofyour household’s annual income at thispoint in your life?

What’s going on? Now compare your answerswith other Americans: In a NorthwesternMutual survey, nearly half of Americans saidno, they could not save 20% of their salary(Choice 1). Ironically, in Choice 2, 71% saidthey could comfortably live on 80% of theirhousehold income. Each question is essentiallythe same but worded differently2.

The lesson is that depending on the choiceswe’re given, and how they’re positioned ordescribed, people can make very differentdecisions. It’s important to objectively evaluatefinancial decisions, and be aware of how theapparent “positives” and “negatives” mayimpact your decisions.

Loss AversionIt hurts more to lose than it feels good to gain the same amount.

People are simply “loss averse.” The pain we feelfrom losing $100 is much greater than the pleasurewe feel from gaining $100. When combined withthe influence of framing, this can result in differentoptions being chosen depending on whether thesame decision is framed as a “gain” or as a “loss.”It also suggests that people will work harder toavoid a loss than they will work to achieve a gain.

........

Choose between the following two options:

a) Win $100 for certain

b) 50% chance to win $200 and 50% chance to win nothing

Now imagine that you have just been given $200. Choose between the followingtwo options:

a) Lose $100 for certain

b) 50% chance to lose nothing and 50% chance to lose $200

What’s going on? The description of “gains”in the first example makes people choose thecertain gain, but the same exact outcomeframed as “losses” in the second examplemakes people choose the chance to lose nothing. Losses loom larger than gains.

While losing is a painful proposition formost people, taking a “loss” may not alwaysbe the worst outcome for every decision.Consider all important decisions from severalangles and see if you would react the same ineach. Recall the example used earlier todescribe “framing:” In asking yourselfwhether you can comfortably save 20% ofyour income, do you get the same answer aswhen you ask yourself whether you can comfortably live off 80% of your income?”Again, objectivity is key.

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2 Behavioral Economics Survey, Northwestern Mutual, September 2003

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Nearly half could not comfortably save20% of household’sannual income at this point in life.

71% said they couldcomfortably live on80% of household’sannual income at this point in life.

Status Quo BiasPeople tend to “follow the herd,” even whenit’s not in their best interest.

In general, it’s easier to leave things as they arethan to make a change, even if that changerequires very little effort. Somehow, changing adecision seems to require more justification (toyourself or others) than leaving it as it is. Forexample, people prone to “following the herd”often invest in “hot” stocks and other popularinvestments, or are more likely to buy when stockprices are rising and sell when they are falling.

........

Ask yourself:If you’re currently enjoying perfectly reliableelectric service and were offered somewhatless reliable service for a discount on yourmonthly bill, would you take it?

Now consider:If you had somewhat unreliable electric serviceand were offered more reliable service for amonthly surcharge (equal to the discountabove), would you take it?

What’s going on? A study conducted bybehavioral economists found that almost noone answers “yes” to these offers3. Why? Even if it doesn’t suit their best interests andeven if they’re provided the option to do otherwise, people can feel more comfortablewith a decision previously made by peoplelike them or in their group. Of course, when adecision is recommended or already made byanother in one’s “group,” it’s still valuable tothink through the decision-making processbased on one’s own individual needs.

Decision ParalysisThe more choices and barriers people face, themore likely they are to do nothing.

As more choices are added, it becomes harder tosort through them and pick the option that we likethe best. For instance, as we look at all the placeswe can invest our money, we can become so overwhelmed that we never move our money outof a basic savings account. Without a deadline for making a decision, the paralysis can continue tothe point that a decision is never made at all.

........

Imagine that you’re considering the purchaseof a compact disc player, but you haven’t yetdecided which one or how much to spend.Walking past an electronics store, you noticethat they’re having a one-day sale on CDplayers. They offer a popular Sony model for$99 and a high-quality Aiwa model for $159.Both of these prices are well-below list price.What would you do?

a) Buy the Sony

b) Buy the Aiwa

c) Wait and find out more about other models

Now imagine the same situation, but only theSony model is on sale. What would you do?

a) Buy the Sony

b) Wait and find out more about other models

What’s going on? Most people will prefer towait in the first scenario, but have no problembuying the Sony in the second scenario. In thefirst scenario, having two good choices leadsto decision paralysis.

A lesson to be learned: when putting off financial decisions, some may miss a goodopportunity or run the risk that the prices willrise. Some of the more costly financial mistakespeople make are the result of inaction when itcomes to choosing among investment optionsor delaying investment or spending decisions.

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3 Data from Hartman, Doanne & Woo (1991)

OverconfidencePeople tend to overestimate their own abilities, knowledge and skills, and are overlyoptimistic about their financial futures.

Studies have shown that most people thinkthey’re above-average when it comes to driving,getting along with others and leadership ability.However, when you consider the prevalence of driving accidents, rising divorce rates and the downfall of some high-profile leaders, weknow that just can’t be true.

........

Ask yourself these questions:

> As you prepare for retirement, are you comfortable with the amount of planningand preparation you’ve done?

> How much have you saved so far?

> Are you saving enough for major financialgoals, such as retirement or a child’s education?

What’s Going On? How do you think youranswers compared with other Americans? A survey conducted by Northwestern Mutualrevealed that 7 out of 10 Americans are comfortable with the amount of planning and preparation they’ve done4. But, in reality,many are under-prepared. The study found that:

> One-third of respondents have not yetbegun to plan or save for retirement.

> One-fourth of respondents didn’t know howmuch they’ve saved.

> One-fourth did not save anything at all on amonthly basis for long-term goals, such asretirement or a child’s education5.

It’s important to realize that we’re often moreoptimistic about our abilities – even financialsituations – than we should be. In fact, thetendency to place too much value in what a

person knows, or what they think they know,can cost them dearly. Researching large purchases and retirement investments – andplanning toward those goals – can help cast amore realistic light on the situation.

Oh, Behaaaave!Our unhealthy financial habits can be difficult to change. Changing our financialmisbehaviors can be like changing our eatinghabits. You can’t just stop cold turkey – youhave to eat some food, just like you have tospend some money. It can be challenging tofind a healthy balance.

Exposing our financial blind spots and misbehaviors is the first step toward correctingthem. Developing and following a good financial plan can also help illuminate areas of opportunity and put goals in perspective.Talking with a financial expert can help, too.According to another Northwestern Mutualsurvey, talking with a professional really doeshelp people’s financial health. The studyfound that of those who have met with anadvisor, most feel more financially secure thanthose who have not.6

For more information about these surveys andfinancial misbehaviors, visit NorthwesternMutual’s Web site, www.moneymaladies.com.

Please call your nearest Northwestern MutualFinancial Network representative who canprovide expert guidance and innovative solutions. They’ll help you work through your financial misbehaviors, putting you onthe road to financial security for a lifetime.

4 Money Maladies Survey, Northwestern Mutual, 2000-20025 Money Maladies Survey, Northwestern Mutual, 2000-2002

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6 Money Maladies Survey, Northwestern Mutual, 2000-2002