Wednesday, August 05, 2009

Research shows temptation more powerful than individuals realize

Lead me not into temptation? Is the "Lord's Prayer" good for financial advice? Ok, so that is probably taking things too far, but the basic idea is that we tend to give into you temptation more than we think we will.

Research shows temptation more powerful than individuals realize:
"The study, led by Loran Nordgren, senior lecturer of management and organizations at the Kellogg School, examined how an individual's belief in his/her ability to control impulses such as greed, drug craving and sexual arousal influenced responses to temptation. The research found the sample, on average, displayed a 'restraint bias,' causing individuals to miscalculate the amount of temptation they could truly handle, in turn leading to a greater likelihood of indulging impulsive or addictive behavior.

'People are not good at anticipating the power of their urges, and those who are the most confident about their self-control are the most likely to give into temptation,' said Nordgren. 'The key is simply to avoid any situations where vices and other weaknesses thrive and, most importantly, for individuals to keep a humble view of their willpower"

Dan Ariely makes a big point of this in his Predictably Irrational book. Specifically chapter 5 in which he reports on various questionnaires (but not actual behavior) that were filled out under various states of, uh, arousal. (I am not going to go into details, but suffice to say that chapter alone kept me from adopting the book for class, I was not sure what the response from university would be and opted to not get into a battle). I will state that in each case, as the arousal was greater, people swayed further from their what they said they would do when being rational.

How is this tied to finance?

Investors are people. They give into mood swings that lead to impulsive decisions (investing "all in equity", investing in penny stocks and other get-rich quick schemes) none in equity etc), we are tempted to time the market. The excitement of beating the market (and getting to brag about it) leads investors to make decisions that they never would in a more sterile environment.

Solution? Probably best thing we can do make a plan in advance and then come as closely as we can to putting it on auto-pilot: Make investments automatically, have money taken out of your checking account each month so you don't try to time the market. Invest in indexes.

Take the discretion out of investing so you won't be able to take unwise chances or take risks that a rational investor would not.

Or as they say, "Lead me not into temptation."

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