Emotions shouldn’t be ignored and suppressed, but rather acknowledged and accounted for in building a financial plan. Tim Maurer explores ways we can train our emotional and rational selves to work together when making decisions about money.
The most compelling findings regarding financial decision-making are found not in spreadsheets, but in science. A blend of psychology, biology and economics, much of the research on this topic has been around for years. Its application in mainstream personal finance, however, is barely evident. Perhaps a simple analogy will help you begin employing this wisdom in money and life: The Rider and the Elephant.
First, a little background.
Daniel Kahneman’s tour de force, Thinking, Fast and Slow, leveraged his decades of research with Amos Tversky into practical insight. Most notably, it introduced the broader world to “System 1” and “System 2,” two processors within our brains that send and receive information quite differently.
System 1 is “fast, intuitive, and emotional” while System 2 is “slower, more deliberative, and more logical.” The big punch line is that even though we’d prefer to make important financial decisions with the more rational System 2, System 1 is more often the proverbial decider.
Many other authors have built compelling insights on this scientific foundation. They offer alternative angles and analogies, but I believe the most comprehendible comes from Jonathan Haidt.
The author of The Happiness Hypothesis and a professor at New York University’s Stern School of Business, Haidt describes the two systems in a helpfully visual way:
The mind is divided in many ways, but the division that really matters is between conscious/reasoned processes and automatic/implicit processes. These two parts are like a rider on the back of an elephant. The rider’s inability to control the elephant by force explains many puzzles about our mental life, particularly why we have such trouble with weakness of will. Learning how to train the elephant is the secret of self-improvement.”
Do you see the connection? System 1, in this case, is the Elephant. It’s instinctive, powerful and predictably emotional. System 2 is the Rider. It’s the rational thinker, capable of deconstructing complex problems but incapable of overpowering the Elephant.
How, then, do we, as Haidt suggests, train the Elephant?
First, recognize that the Elephant—emotion—is not the problem. Indeed, it may be part of the solution. Too many in the realm of personal finance have labeled emotion as the enemy. They tell consumers that investing, in particular, is best practiced by ignoring or suppressing emotions. But this is shortsighted.
Let’s say an investor is coached that the market goes up and down, but ultimately, a willingness to stay invested in stocks will net the best long-term returns. Therefore, one’s portfolio would be optimally invested wholly (or mostly) in equities. Well, suppressing one’s emotions regarding the fear of deep market losses might help an investor stick with their financial plan in a mild correction, but in the early 2000s and again in 2008, many an Elephant reared up and sent the rider on a precipitous fall of his or her own.
No, optimal portfolio construction involves inviting the Elephant into the boardroom to have a say. Emotions should not be ignored, but rather acknowledged and accounted for in the creation of an ideal investment portfolio. Practically speaking, this means that many people with equity-heavy investements—at any age—should listen to the Elephant and seriously consider increasing their exposure to a portfolio’s stabilizing force: conservative fixed income. It’s also important to recognize at this point that most households have two Riders and two Elephants, each of which needs to be heard.
The Rider and Elephant work best as a team. While this is readily apparent in most areas of investing, it becomes especially clear in decisions involving the prospect of death or disability. Statistically speaking, when it comes to writing estate planning documents and planning for death or disability with insurance, the collective Elephant has simply run for the hills, ignoring this possibility altogether. But the Rider can coach the Elephant very effectively:
Rider: “We need to talk about our will.”
Elephant: “Death? Ooh, no. I’m not going there.”
Rider: “I understand. It’s not exactly fun to consider, but what scares me even more is what could happen if we don’t consider it at all.”
Elephant: “Yeah, I guess I hadn’t thought about it that way.”
Rider: “Like, wouldn’t we rather decide who would take over our role as parent if we were gone, rather than entrust that important decision to the state?”
Elephant: “Yep, let’s schedule that appointment.”
Every great team has to practice in order to work together effectively, so try imagining the implications of your neuro-duo in any number of circumstances, from budgeting, insurance and allocating your 401(k) plan to even more important stuff, such as career, marriage and child-rearing. Through persistent practice, it’s even possible to transfer the once-complex tasks undertaken by the Rider to newly instinctive responses by the Elephant.
And if you’re interested in further training, consider choosing anything from the following reading list:
This commentary originally appeared July 24 on Forbes.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2015, The BAM ALLIANCE