Article
Let’s start with a simple question: “A bat and ball cost $1.10 together. The bat costs $1 more than the ball. How much does the ball cost?”
The vast majority of people respond quickly and confidently, insisting the ball costs 10 cents. This answer is both incredibly obvious and utterly wrong. Interestingly enough, education does not seem to help since more than 50% of students at Harvard, Princeton and Massachusetts Institute of Technology routinely give the incorrect answer as well. (Please find the correct answer at the end of the article.)
When people face an uncertain situation, they do not carefully evaluate the information or look up relevant statistics. Instead, their decision depends on mental shortcuts called “heuristics” and flawed biases, which often lead them to make foolish decisions. The shortcuts are not a faster way of doing the math; they are a way of skipping the math altogether.
How do you go about making smart financial decisions when our brains are wired to take shortcuts? We are unable to change the biology and chemical makeup of our brains; however, we are able to recognize and educate ourselves on their potential weaknesses and agree to create safeguards to protect from future faulty intuitive thinking.
People are also plagued by biases that cause them to be overconfident, overoptimistic, susceptible to framing, and desiring to stay with the status quo, regardless of the costs. Do you or someone you know suffer from any of these biases?
Overconfidence:
Investor overconfidence has two main implications. The first is that investors take bad bets because they fail to realize that they are at an informational disadvantage. The second is that they trade more frequently than is prudent, which leads to excessive trading volume.
Overoptimistic:
People judge their chances of a experiencing a good outcome such as obtaining financial security, having healthy children, or having a successful marriage higher than average. But when they contemplate the probability that something bad will take place such as losing a job, divorce, losing money on a house, they estimate their odds to be lower than those of other people.
Frame dependence:
A person answers a question differently based on the way in which it is asked or “framed.” Which prognosis sounds better: A) You are given an 80% chance of a successful surgery, or B) You are given a 20% change of death. An individual who is given the option between two surgeries and told that surgery 1 has an 80% chance of success while surgery 2 has 20% chance of complications or death might select surgery 1 because of the positive way the sentence was framed.
Status quo:
People are biased to keep things the way they are, even if they did not originally choose the position. People are biased to avoid risks generated by change, even when the risks are less than from making no change because changing outcomes requires pursuing action and change.
The importance of healthy decision making in regards to personal finance cannot be overstated. A strong financial adviser may act as a change agent in your life to assist you with strong emotions and impulse control. Of course, this is much easier said than done. Educating yourself about financial biases will not sure you from taking mental shortcuts or making irrational decisions; however, creating an awareness of your potential weaknesses may create dialogue with your spouse or trusted adviser leading to the implementation of a systematic and disciplined approach to making smart financial decisions.
The financial planning process creates sustainable change when clients work with a trusted adviser in a relationship that goes beyond the numbers. If you are willing to take the time to explore how and why you make certain financial decisions, you may be better equipped to “stay the course” on the financial plan you create with your adviser.
Here is the answer to our question.
We are told that the bat cost $1.00 more than the ball. For illustration, review the potential prices of the ball ($ball) and what that would mean for the price of the bat ($bat) and the total cost ($Total)?
From the above, “10c” is clearly the wrong answer, though most people would answer .10 for the cost of the ball. It makes the total cost $1.20, not $1.10. Indeed, any cost higher than 5c for the ball must be wrong, as the total cost will be more than $1.10. Ball prices less than 5c mean that the total is less than $1.10. A price of 5c for the ball and $1.05 is the only scenario in which the bat costs exactly $1 more than the ball, and the total is $1.10.
This article originally appeared February 5, 2015 online at MidlandsBiz.com.
