Master decision making in money & life

You can employ the same methodologies for making financial decisions as you do for making other major decisions in life. Learn more.

  • Facebook.
  • Twitter.
  • LinkedIn.
  • Google Plus
  • Print

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.

Systems 1 and 2

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 Rider and the Elephant

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?

Elephant Training

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 investments—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:

  1. Thinking, Fast and Slow – Daniel Kahneman
  2. Nudge – Richard Thaler and Cass Sunstein
  3. Misbehaving – Richard Thaler
  4. Blink – Malcolm Gladwell
  5. Drive – Daniel Pink
  6. Start With Why – Simon Sinek
  7. Switch – Chip and Dan Heath
  8. The Power of Habit – Charles Duhigg
  9. The Happiness Hypothesis – Jonathan Haidt
Topics:
  • Financial Planning
  • Financial Planning
  • Financial Planning
  • Facebook.
  • Twitter.
  • LinkedIn.
  • Google Plus
  • Print
This article was written by Tim Maurer from Forbes and was licensed as an article reprint. Article copyright July 24, 2015 by Forbes.
The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.
This reprint is supplied by Fidelity Brokerage Services LLC, Member NYSE, SIPC.
The third party provider of the reprint permission and Fidelity Investments are independent entities and not legally affiliated.
The images, graphs, tools, and videos are for illustrative purposes only.
Fidelity Brokerage Services Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917
733675.1.0
close
Please enter a valid e-mail address
Please enter a valid e-mail address
Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

Your e-mail has been sent.
close

Your e-mail has been sent.

Here's what we suggest you explore next

Taking your wallet on vacation? Here's how to keep it safe

Tourists are often targeted by pickpockets or thieves. Read here to learn how you can keep your wallet safe on vacation.

Like your checking account, but with some useful extras

All ATM fees reimbursed. No minimum balance. Pay bills. Deposit checks.

You might also like

10 smart things you can do with $1,000 right now

It is easy to blow through a decent chunk of cash when you first get it. Instead of spending it recklessly, this article outlines 10 smart financial decisions you can make with $1,000.

What the stuff in your closet can teach you about personal finance

What you spend your money on and never seem to use can teach you a lot about your personal finances. Learn how assessing your spending habits can help your financial planning in the future.

3 ways to turn your closet into cash

Do you have clothes that you never seem to wear? You can use those forgotten items of your wardrobe to generate spending cash.

Start budgeting: Meet Cinch

Introducing CinchSM from Fidelity, a simple way to track your saving and spending. Just answer a couple of questions to get started.