Which dot is bigger?
Public Domain. Source: Wikipedia
We know the answer: they’re both the same. But knowing the answer doesn’t change our perception that the dot on the right looks bigger. We naturally compare things to one another, and when an item is surrounded by smaller items all around it, the central item seems larger. Knowing the facts about something doesn’t change how we see it.
Illusions are all around us. Marketers place ads and products into settings where they’re likely to make the best impression. But just knowing that Ray-Ban sunglasses paid for a product placement “Top Gun” doesn’t make them look less cool. In fact, when people talk about a product placement, that tends to amplify its effect. And when the movie came out, sales of their Aviator sunglasses rose by over 40% over the next seven months.
In the economy today we see officials working with the “Money Illusion.” This theory claims that people think of their money in nominal terms, rather than real terms. That is, if inflation is running at 2% and you get a 4% raise, you’ll feel much better (and probably spend more) than if prices are flat and you get a 2% raise. This is the thinking behind the Fed’s goal to raise the average inflation rate back to 2%. This is the theory behind the ”wealth effect,” where people increase their current spending when their retirement accounts grow. It’s not rational. After all, spending more today makes it harder to meet our financial goals, offsetting any recent gains. But it’s a lot harder to dial spending back if the market falls.
Which is longer? Source: Wikipedia. CC BY-SA 4.0.
Making rational decisions in the face of illusions and irrational pressures is hard. We may say we want to invest if the market falls 10%, but when this happens we’ll come up with endless reasons excuses why this isn’t a good time to invest – government policy is unsettling, interest rates are uncertain, the economy is changing, technology is disruptive, etc.
The best way to deal with illusions is accountability: having people in your life who can keep you honest. The professional poker player Annie Duke describes how she recruited a team of “decision buddies” to hold her accountable when she was tempted to do something outside of her game plan. She outlines the idea in her book “Thinking in Bets”:
Because of the loss-limit agreement I had made with myself and my group, I ran the conversation in my head that I’d be forced to have when I explained why I kept playing beyond my limit. It gave me a chance to regret the decision before I bought more chips. (Annie Duke, “Thinking in Bets,” p. 187. Penguin.)
Investors can improve their decision-making by being accountable to one another. We can also be accountable to ourselves. Psychologists encourage folks to make a “Ulysses Contract” with themselves, where they agree to make decisions that – in the long term – are in their own best interests.
Ulysses and the Sirens. Source: British Museum. CC BY-NC-SA 4.0.
The idea comes from a story in The Odyssey. In Homer’s epic, Ulysses is about to sail past the island of the Sirens. In the past, sailor passing the island would become drawn to the Sirens’ songs and crashed on the nearby shoals. Ulysses was aware of the danger, so he stops his sailors’ ears with wax to prevent them from hearing the songs. But Ulysses wants to hear the song, so he has his men tie him to the mast. The plan works perfectly: the sailors are unaffected, and Ulysses experiences what had been irresistible before.
By making commitments ahead of time, we can encourage ourselves to invest even when it’s difficult. Regular commitments to the market – through payroll deductions or automatic bank account withdrawals – can be a great way to execute long-term commitments toward our financial goals. Advisors can help clients decide ahead of time when to buy, hold, or sell a position. Emotional decisions in the heat of the moment are rarely in our best interests.
It’s also important to try and look at things from different perspectives. For example, look at this chart of Amazon’s stock price over the past two decades:
Amazon stock price, 2000-2021. Source: Bloomberg.
The shares look like they’ve been on a rocket ship; it looks like the stock simply can’t go any higher. But now look at this chart:
Amazon stock price, 2000-2021. Source: Bloomberg.
It looks a lot different. The share price data are identical, but with a different frame of reference, using a log scale and increasing the price range. Doesn’t look as irrational, does it? Reframing can be helpful when we want to get a little more perspective. It allows us to take a longer view when we zoom out. We can gain new perspectives by looking at prices over a different scale or in different currencies or with different types of charting techniques.
If we want to be successful with our money, it’s critical to get past our illusions about markets, money, and investing. But getting past them isn’t easy and it isn’t simple. Accountability, advance commitments, and seeking out different perspectives can be tools to help us along the path.