Making Smarter Financial Decisions

Neuroscience finds there are two players in every decision we make:

  1. Our patient self (in our cortex)
  2. Our immediate gratification self (in our limbic system).

At a Financial Planning Association conference in May, Professor Russell James of Texas Tech University presented his findings from MRI images of people asked to make decisions.  In financial decisions, the cortex shows no difference in reward over different timeframes.  In contrast, the limbic system shows higher reaction to immediate reward, even when it is for less money now, rather than more money later.  This leads to a problem called hyperbolic discounting.

A quiz for you

Would you rather have a) $100 now or b) $101 in a week? How about a) $100 in 52 weeks, or b) $101 in 53 weeks? In an oft-quoted study on hyperbolic discounting, more participants chose b) in the first question than in the second question, even though the return is the same – 1% over a one-week period, or approximately 52% on an annualized basis.

Here’s a Weight Watchers example. Given an unhealthy snack choice now or in one week, 70% chose the unhealthy snack now; 26% chose the unhealthy snack in a week.

The fact that our limbic system overrides our rational thinking is not surprising. But how can we change? Professor James has developed “pre-commitment strategies” that alter our future environment and/or our time preference.

When it comes to our future environment, time and effort spent appreciating future pleasures can evoke enough emotion to satisfy our limbic brain. To entice retirement savings, a financial planner might ask a client to envision a day in the next chapter of their life in great detail – immediate surroundings, who they are with, what they are doing, what they smell, what they feel (i.e. sand between their toes, or hugging a grandchild). Capturing that image as a financial goal can be more powerful for some clients than simply being obliged to save for a nebulous future.

The important conclusion

In a 1998 survey of participants over 50, it was found that the longer the time horizon they were concerned about, the more wealth they had after eight years. This study shows that the “propensity to plan” – the more time you spend visualizing the future state – the more wealth you build.

About the author

Holly P. Thomas, MBA, CFP®

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