It Doesn’t Add Up

This is the third installment in the series of articles on Behavioral Finance. In the previous article, we introduced cognitive biases that the reflexive brain has, that permit it to make quick decisions using limited data. In that article, we discussed heuristics (rules of thumb) and overconfidence. In this article, we will discuss how the reflexive brain uses mental accounting and framing.

Mental accounting. We are not good at valuing things when time is a factor. In Aesop’s fable of the ant and the grasshopper, the ant saved for the winter while the grasshopper lived for today. We have both the reflective ant and the reflexive grasshopper active in our brains, but the reflexive grasshopper tends to win out. We value certainty and short-term gains over waiting for a benefit (which makes it seem less likely) even if the return is greater.

An example of this bias is demonstrated in this simple thought experiment. Which would you rather have, $10 today or $11 tomorrow? The majority of people are willing to take the $10 today and give up the 10% gain by waiting one day. And yet, if we have to wait a year to receive $10 but can receive $11 in a year and a day, the majority is willing to wait an additional day for the $11.

Related to this mental accounting is the tendency to treat money in buckets, as if the financial activity in one category (bucket) has no effect on other categories. Picture this: a woman goes shopping for a particular style of dress. She finds one in the perfect color and size priced at $300. She is willing to pay this much for the dress. When she takes the dress to the sales counter, she finds that it has been reduced 50%. Having saved $150 she buys a $60 purse and $90 pair of shoes. (We are assuming that she already had at home perfectly serviceable shoes and purse that go with the new dress.)

In this case, the woman put $300 into her mental wardrobe bucket. Yet, she was never obligated to pay $300. So, in effect, she over-spent $150. Had she set a budget, setting aside $250 for clothing for instance, she would have known that she had saved $100 that she could allocate in some way.

Even in the case of saving $100 for re-allocating, we have to be careful because our reflexive brain doesn’t do math well, but it approximates. She feels good about saving $100, so she decides to take her niece to the movies, and that cost $25. She’s still happy about saving $100, so she decides to take her boyfriend out for Sunday brunch (she’s a liberated woman and he’s a mooch), and that costs $52. Feeling proud of herself, she pays $6 for a venti caramel macchiato. To celebrate her smart shopping, she buys the girls a round of drinks for $31. Her reflexive brain generated happy feelings as she spends $114 celebrating the $100 she saved.

Framing. Our reflexive brains make judgments in very subjective and changeable ways, depending on the surrounding circumstances, feelings, context, or point of view. This inconsistency is known as framing.

A 4-ounce glass with 2-ounces of water is half ______. Whether we say “full” or “empty” depends on how we feel about ourselves at the time. But, let’s change the context. Case A: If a group is shown a 4-ounce full glass of water that has 2-ounces of water poured out, 69% will say it is now “half empty.”

Case B: If that group is shown an empty 4-ounce glass that has 2-ounces of water added to it, 88% will say that the glass is now “half full.” Our reflective brain will tell us that in both cases we have a 4-ounce glass with 2-ounces of water so we should call it the same, but we don’t.

A theater charges $5 per ticket for movies that start before 6 pm or start after 11 pm. They charge $7.50 per ticket for the two showings that start between 6 and 11. The fact is the theater’s costs and profits are covered by a $5 ticket. The theater lists its early bird discount and red-eye discount, when in fact it could list the 50% primetime surcharge. However, even if all theaters in the area had the same pricing schedule, the theater that listed the primetime surcharge would lose customers.

Pregnant parents are concerned about having healthy babies. Amniocentesis can give an indication if birth defects are present, but it triggers spontaneous abortions 1-2% of the time. Parents who are told that 20% of all births in the U.S. have some birth defect are likely to schedule amniocentesis. However, parents who are told that 80% of all births in the U.S. are healthy and normal are much less likely to have the test.

Likewise, in research 400 doctors were told that they hypothetically had a cancer that could be treated by radiation or by surgery. One-half of the doctors who were told that 10 out of 100 patients die in surgery chose radiation treatment. The doctors who were told that 90 out of 100 patients survive surgery had only 16% who chose radiation.

You are more likely to take a risk if you’re told that the odds are 1 in 6 than if you’re told there is a 16.67% chance of succeeding. However, if you are told that there is an 84% chance of failing, you probably won’t touch it.

There’s a surprisingly big difference between how we react to odds expressed as percentages and how we respond to odds expressed as frequencies. Percentages are abstract. Frequencies represent concrete things. If you hear that 1 in 10 will win, you will picture that one person—and often that person is you.

You can engage your reflective brain to evaluate framing issues by converting and inverting. For example, if you are told that you have a 12.5% chance of loss, how do you feel about losing 1 out of 8 times? Is winning 7 out of 8 times acceptable? How about winning 87.5% of the time?

Framing can also affect you when comparisons are involved. Watch for “just” or “only,” re-word the phrase without it. While our reflective brain knows that $19.95 is effectively $20.00, our reflexive brains see $19 is smaller than $20. Fuel prices can be particularly deceiving. $2.49 9/10 looks closer to $2.52 9/10, than $2.50 looks to $2.53.

In upcoming articles we will discuss representativeness, conservatism, and disposition effect, and we will investigate ways to prevent the reflexive brain hijacking decisions that call for reason rather than intuition.