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Start Here: “The Ultimate Guide to Personal Finance”

A fantastic book on behavioral psychology: Sway ($1,000 giveaway)

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Note: There is a $1,000 giveaway at the bottom of this post.

Do you think you could tell the difference between a Coke and Pepsi?

Of course you do.

When I was an RA in college, my residents insisted they could, so I bought Cokes, Diet Cokes, Pepsis, Diet Pepsis, and a generic soda to test them. Of those who tested, every one insisted they could tell the difference.

Only 3 out of 47 could.

In fact, most of us can’t even tell the difference between Coke and Pepsi in a blind test — yet when presented with data indicating how we routinely fail to tell the difference, we insist that we’re different.

Today’s book review is about a remarkable book, Sway, that details how we’re irrational, yet we fail to acknowledge it. Ori Brafman, a friend of mine, and his brother Ram Brafman write about how we insist that we behave methodically and purposefully — that we have an idea, and we act on it. Unfortunately, this ignores decades of research and great stories showing that our behavior is influenced by even the slightest of changes to our environment: We eat more because the plate is bigger, we remember things because they were presented in color on a loud commercial, and we invest in things because our friend told us about them.

I got a review copy of this book and thought it was superb even before it became a New York Times and Wall Street Journal bestseller.

sway-small.jpg

As this fascinating article from Harvard Magazine points out, ‘Poor families are often deterred from applying to colleges for financial aid because the forms are too complicated. ‘An economist would say, ‘With $50,000 at stake, the forms can’t be the obstacle,’ he says. “But they can.'” (And there’s data to prove it.)

I love exploring rationality and relating it to personal finance. For example, many of my friends at Stanford graduated with an economics degree, and many of them assumed that because they knew econ, they understood personal finance. In fact, my friend a bulge-bracket investment bank recently told me about an internal study they ran on their highly compensated portfolio managers. It turns out that the portfolio managers’ asset allocations were no better than average — an astonishing finding considering (1) how bad most people are at investments, (2) that these PMs are paid millions of dollars per year to manage professional portfolios, and that (3) asset allocation is responsible for 90%+ of returns.

Sway is a book of fascinating anecdotes about irrationality, psychology, and financial findings. It’s a key book to understanding why we behave the way we do — and to changing our own behavior. I’ll pull out some of the most interesting findings here.

How A Hot Girl Can Cost You $10,000
You’ve seen me write about how credit card companies (and any good company) test their marketing to find the optimal solution. Here, for example, are two mailings that my friend received. Can you spot the differences?

Mastercard offer 2Mastercard offer 1

The Brafmans have a new wrinkle to add to this.

“In South Africa, a consumer lending bank wanted to push personal loans to 50,000 of its customers. Working together with a team of economists, the bank crafted several variations on the same basic loan offer letter. The different versions were randomly assigned to recipients and mailed off without the recipients ever knowing that the letter they had received was part of an experiment.

The letters included different interest rates (ranging from 3.25% to 7.75% per month); some featured a comparison to a competitor’s rate, others a giveaway…and still others a photo of either a man or a woman’s pleasant, smiling face.

Now, you’d think that the customer would evaluate the offer based purely on interest rate and the specific terms of the loan…The unexpected effect kicked in with the least relevant variation: the inclusion of a picture of the smiling face in the corner. Men who received a picture of one of four smiling women were much more likely to sign up for the loan than the men who received a picture of a smiling man. The magnitude of this effect is ‘about as much as dropping the interest rate 4.5 percentage points.'” (Page 74)

Malcolm Gladwell’s Blink does a great job of highlighting irrelevant information and its effect on our decision-making, but I found several interesting studies in Sway that I hadn’t heard of before.

Why We’re Afraid of Having Anything Taken Away From Us– And Why We Pay Dearly
We’re more motivated by loss than by gain.

“Companies like Avis and Hertz, facing the challenge of selling a product that is both useless and overpriced, have capitalized on this powerful effect. When we rent cars, our credit cards — not to mention our own car insurance — automatically cover us should anything go wrong with the vehicle. But the rental companies push additional coverage that not only is redundant but would cost a whopping $5,000 on an annual basis. But…the sales rep asks whether we’d like to buy the loss damage waiver. When we hear those words, our minds begin to whir: What if I have bad luck and end up in a wreck? What if, for some reason, my credit card won’t cover me after all?”

This simple technique also explains why we pay more for subscriptions that we don’t fully use when it would be cheaper to pay a la carte: Beyond just convenience, we worry about being overcharged a huge amount one month.

The framing of an offer is important. People criticized Coke when they tested raising their vending machine prices during warm weather to test price elasticity. Imagine the reaction had they lowered prices during cold weather. Whenever I write an email, I try not to use negative phrases. Again, the framing matters, whether in politics or personal finance.

Loss Aversion and Commitment — Like Pringles, Once You Pop, You Can’t Stop
I’m sorry, but I had to make the Pringles reference. Anyway, the authors show how loss aversion, combined with commitment, can form a powerful persuasive force. In fact, gangs and cults use this quite effectively: They make it difficult to join the group (using increasingly difficult initiation rites) and, once you’re in, make it difficult to leave (by demanding you tithe all your money or promising physical retribution if you try). In Sway, the Brafmans write about an auction held each year in a Harvard professor’s class, where he auctions off a $20 bill. The only two rules:

“Bids are to be made in $1 increments. The second rule is…the runner-up must still honor his or her bid, while receiving nothing in return.” You would expect that people would bid up to $20 for the bill, and in fact the bidding escalates quickly until about $12 to $16. “Without realizing it, the two students with the highest bids get locked in. ‘One bidder has bid $16 and the other has bid $17,’ Bazerman says. ‘The $16 bidder must either bid $18 or suffer a $16 loss. The students continue bidding, “$21, $22, 23, $50, $100, up to a record $204. The deeper the hole they dig themselves into, the more they continue to dig.” (Page 26)

Once we commit to something, we use adaptive self-serving biases to adaptively construe results to support our decision. For example, in a classic case of post-decision attitudinal adjustment, once you buy a Honda Accord, you’ll be more likely to notice Accords and to seek our confirming evidence that you made the right choice (such as reading positive reviews and talking to other happy owners of Hondas). Not surprisingly, this affects us even in conditions of life and death, as the Brafmans compare LBJ’s commitment in Vietnam to President Bush’s commitment in Iraq.

The More We Pay For Things, The More We Like Them
The Brafmans define value attribution as “our tendency to someone or something with certain qualities based on perceived value, rather than objective data.” Why do you spend $500 on a Coach bag or $2 more on Jiffy peanut butter? Those are easy examples, but let’s take a few others:

  • Why D.C. subway passengers walked past Joshua Bell’s free violin concert, when he normally charges over $1,000/minute to play (page 42). In a beautiful example of social psychology, the Washington Post asked famous violinst Joshua Bell to bring his $3.5+ million Stradivarius to L’Enfant Plaza in Washington D.C. and play like a normal panhandler. We like to think we can recognize quality when we see it, but we’re more influenced by external factors than by how we think we’d behave. Take a look at the video to change your mind (hint: People didn’t just walk by because they were late to work.)

  • Why Sobe makes you smarter — if you pay more (page 48). When students were given a mental acuity test and told that the drink SoBe would help with their results, they were put in 3 conditions: No SoBe, SoBe that cost $2.89, and SoBe that cost only $0.89. Why did SoBe drinkers who paid more perform much better than SoBe drinkers who paid less?
  • If you discount tickets, you’ll get lower attendance (page 50). In a study of Ohio State’s theater department, “the people who paid full price attended significantly more shows than those who received either [a] $2 discount or [a] $7 discount.” In fact, attendance wasn’t linear: If you got a discount, whether it was $2 or $7, you attended less — just by virtue of the fact that you received a discount. If you’re an entrepreneur or consultant wondering what to charge for your services, let this be a lesson to you: In almost every case, don’t cut your prices.

The key takeaway here is that we value what we pay for. We love to believe that we behave in an A–>B model: We have an attitude (“I like charity”) and our behavior follows (“…so I volunteer at a soup kitchen”). We rarely acknowledge that many of our attitudes are formed by our behavior in a B–>A relationship: “I keep volunteering at this soup kitchen (because it’s close by / my girlfriend wants me to / I need school credit / I was asked to), so I must think it’s important. For more on this, read about attribution theory.

Similar Books I’d Recommend
If you’re interested, I’d consider Sway plus these other books, which are some of my favorites when it comes to social and behavioral psychology:

General Thoughts On Sway: I Like It
The book isn’t perfect: Though the stories are fascinating, at times the book rambles and struggles to link back to the chapter’s original point. Also, the authors are a little too fond of clever social-psychology phrases.

Overall, I’m a huge fan. There were dozens of studied cited that I hadn’t heard about, and Sway uses these examples to great effect to point out examples of irrational behavior and help us understand why we act the way we do. It’s also an excellent guide for understanding why others act the way they do, and I’ve found myself thinking back to the examples while in meetings when people are acting in a particular way. It’s now permanently on my bookshelf, under the psychology section.

sway-cover.jpg

* * *

Giveaway: Free gas for all of 2008

All right, guys. I checked with Ori and he agreed to do this for iwillteachyoutoberich readers.

If you buy a book and send your receipt to swaygiveaway@gmail.com in the next 3 days, one winner will get free gas for the rest of 2008 (up to $1,000).

So, here are the details (full rules here):

1. Buy a copy of Sway in the next 3 days
2. Send your receipt to swaygiveaway@gmail.com (forward/scan a receipt) by 11:59pm this Monday, June 30th
3. I’ll announce one Grand Prize winner, who will get free gas for the rest of 2008

Get Sway Here.

[Edit, 7/7/08: The winner has been announced.]

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36 Comments

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  1. Wouldn’t buying a book for $15 just to get a minuscule chance at $1000 be irrational?

    You could say the book itself is worth $15 as well, and the chance for $1000 is merely a nice benefit, but I would disagree. Instead, I’ll reserve this book at my local library.

  2. nice post.
    however, a book for only $15 can’t be good 😉

  3. 3 out of 47? Surely you’d expect that if people couldn’t tell the difference, they’d be “guessing,” and roughly equal numbers of people would get it right vs. wrong (or equal per choice).

    3 out of 47 is people actively choosing the wrong one. Are you sure you didn’t switch the cups?

  4. free gas giveaway? ZOMG. Give me 8 books.

    Ramit started up the Ironical Machine. Touche, Sir.

  5. Yeah, 3 out of 47 sound a little bit weird…

  6. I like this blog to begin with, but I REALLY like soda…so when I saw that the article began with talk of a “Pepsi Challenge” so to speak…it caught my eye immediately.

    I read a lot of business books, so this will very likely wind up on my reading list. It reminds me a bit of “Blink” by Malcolm Gladwell.

    Ramit, I hope you don’t mind that I talked about your blog on MINE…since I blog about soda! (And I don’t make a nickel doing it, so maybe you SHOULD teach me to be Rich! LOL!)

    Ramit Sethi gets free press from “Soda Is Good” here:
    http://sodaisgood.blogspot.com/2008/06/coke-vs-pepsi-will-teach-you-to-be-rich.html

  7. I’ll pick up the book because it sounds facinating (I liked Freakonomics for similar reasons), but free gas isn’t useful to me: I’m a cyclist. I’d rather have the cash 😉

  8. “Chances of winning are…” …?
    “No purchase necessary…” …?

    “Sway” will arrive at my library system shortly and will be delivered to my local branch for me to pick up and read at my leisure. I’ll be reading it at the same as the Girard Reader, which should make an interesting counterpoint. It’s irrational to purchase a book for a single use, rather than to allow the library to purchase it and lend it out to all the people on the (lengthy) wait-list.

    Lotteries are only rational on the individual level if there is transparent information about one’s chances of winning such that one can take a calculated risk. There’s a chance that nobody will buy Sway for this lottery except a single person who says to themselves, “Gee, $15 to get $1000, that sounds like a winner to me!”. That one person will win and probably conclude that making financial decisions without transparency of information Totally Pays Off. “I won, therefore it was rational!”

    Hilarious.

  9. I bought Sway the day it came out and read it quickly thereafter. I guess I’m out of luck for the lottery?

    It is a very interesting book though.

  10. As I said in my review, if you liked The Tipping Point or Freakonomics then you’ll enjoy this quick, 200+ page read.

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