How to rewire your brain to make money

A new book argues we are hardwired to fail with money, but that with planning we can prevent finanical self-destruction. Rob Stock reports.

Author and financial planner Sheryl Sutherland asks new clients to write themselves a mission statement for their life, an obituary and a letter they'd hope to be able to send once retired to a friend describing how they were now living.

The exercise puts off a few clients, Sutherland admits, but the author of Money, Money, Money, Ain't it Funny, a guide to how we are all wired to fail with money, says the request isn't flippant at all.

In order to write the three documents, new clients have to envision the life they want to lead, and the kind of person they want to be.

And that provides a starting point for discussions which reveal to Sutherland a lot about the attitudes, biases and assumptions - many inherited from their parents - that they bring to money.

Sutherland's new book, which was published last week by Longacre, is a user's guide to outwitting what behavioural economists call "heuristic biases", the unconscious ways in which our nature - and even the way our brains function - shapes the way we see the world. The function of these mental biases, says Sutherland, appears to be to create a "shortcut" to knowledge, helping us cut through the mass of information coming our way, and enabling us to act instead of freezing under information overload.

The trouble is the shortcuts often lead us to a false knowledge which, when it comes to money, can enrich us, but is more likely be a big handicap, so it is a fool who ignores the study of them.

"Only the powerless live in a money culture and know nothing about money," says Sutherland, quoting behavioural economists Phyllis Chester and Emily Goodwin. And it turns out, because of our personal heuristic biases, most of what we each "know" about money is just plain wrong.

"For most of us, the task of beating the markets is not difficult, but beating our own mindset is a different story," says Sutherland. "In this sense, beating ourselves means controlling our emotions and attempting to think independently. Decisions based on our natural instincts invariably turn out to be the wrong course of action."

Such instincts very often scream "sell" when prices of a share have fallen, and just as loudly scream "buy" when prices have peaked, resulting in buying expensive shares when they have done their dash, and selling cheap ones when they are about to recover.

To stand any chance of outwitting these built-in obstacles to wealth, they need to be identified and strategies developed to compensate, says Sutherland, and that means developing a written financial plan, something 71% of people admit to not having.

There are a number of extremely powerful heuristics that handicap people in their journey for wealth.

Social interaction: Great minds might think alike, but so do the minds of the not-so-great. Like it or not, we are all influenced by those around us, the media included, and that can often lead us to make really poor financial decisions, particularly as marketers have been getting smarter at what they do faster than the population has been getting wise to them. It's little surprise that Provincial Finance, which went bust last year, employed former All Black Colin Meads to provide his stamp of approval to what was a highly risky venture.

Familiarity: Investors living in Georgia, Coca-Cola's home town, own 16% of the company. People are more comfortable investing in something to which they feel a physical, or emotional, closeness. Just look at Enron employees, who not only lost their jobs, but also had a huge portion of their retirement savings voluntarily invested in the company's shares. Familiarity is a shortcut to the illusion of knowledge, and that can be dangerous.

Mental filtering: People filter out voices and information which don't agree with their view, and attach a higher importance to that which does agree. Worse still, our views can be heavily influenced by our past experience of events in a process known as anchoring. Because the memory of a loss is stronger than the memory of an equal gain, this can lead us to take a too pessimistic, or optimistic view of an investment.

"The effect of financial experiences we have had in the past is enormous," says Sutherland. "If we experienced a gain, or profit, we are more willing to take a risk; if not we are averse to risk-taking; and, if already committed, go into 'break-even' mode: 'I'll sell those shares as soon as the value comes back up to the original capital I invested."'

We also have a marked tendency to give a higher value to recent events, such as the performance of the housing market last year, than the lessons learned a decade ago, such as sometimes the market overvalues houses and they subsequently drop in value.

Endowment effect (sometimes called status quo bias): We value more highly that which we have and hold. That's why door-to-door salesmen always want to leave goods with you, telling you that you can return them later, if you don't want them. This can lead people to think the investments they hold are better than they actually are, or, in the case of finance companies, less risky.

Mental accounting: We handle money differently depending on its source. Win $50,000 on the lottery and we're more likely to spend some, or all of it, on luxuries. Save it through careful budgeting and we are likely to be much more protective of it. The sums are the same, but one is effectively worth less to us.

Fear of loss is greater than the lust for gain: Investors are more reluctant to sell a share they have made a loss in, than one they have made a profit on. That, says Sutherland, shows a clear propensity to weigh losses more heavily than gains. It can lead to some very strange behaviours, such as grimly holding on to an investment until it recovers to break-even point, even if it's more sensible to sell it and invest in something with better prospects.

Sutherland gives the example of Rose, a property owner who bought her home in the 1990s just before the housing market declined. A year later she shifted to Australia, but opted to rent until the price of her home in New Zealand recovered. A year later the Aussie market had moved ahead, and the Kiwi market fallen back some more, and she had been paying rent in the meantime.

Biased self-attribution: Many of us have a tendency to overconfidence and when things go well, we will take more of the credit for them than when things go badly. When that happens we appear wired up to look for scapegoats to blame, refusing to believe that the decisions we made were because we made a mistake. That limits our ability to learn from our past mistakes.

An insight into just how badly we over-estimate our abilities: surveys show eight in 10 people rate themselves as above average drivers. Our tendency to self-confidence grows as others agree with us, which can make it dangerous to associate only with those who share our views.

This illusion of knowledge, and ultimately therefore control, is exploited by marketers trying to sell us investments.

Framing: Marketers know the way a statement is "framed" influences how we respond to it. Tell a group of doctors that a treatment kills 7% of patients; this will result in a lower usage of that treatment than telling them 93% of patients live if the treatment is used.

Given such biases, is it possible to outwit your wiring?

"I'm an optimist, so the answer is yes," Sutherland jokes. She says the more people study themselves, and their money lives, and read around the topics (and get professional financial advice), the greater their chances.

A great one for quotes (Sutherland even manages to quote Luke Skywalker in the course of Money, Money, Money), Sutherland quotes Benjamin Franklin: "An investment in knowledge always pays the best interest."

Certainly, even if a complete victory isn't possible, a partial victory is certainly within reach, and that could be worth a lot of money.

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