I recently picked up the brilliant book, “Nudge” by Richard H. Thaler and Cass R. Sunstein and read it cover to cover. This is one of my favorite books I’ve read in the past few years. It’s filled with loads of useful insights as it relates to personal finance and human decision making. If you read this article until the end you will be able to answer the 3 questions that will reveal how your brain makes decisions.
I believe the biggest takeaway from Nudge is the classification of people into one of two categories.
My educational background is in Economics. I have a bachelor’s and a master’s degree in economics. It is not hyperbole when I say the first several chapters of this book made me question nearly everything, I have learned during my years of studying economics.
In a way, the entire discipline of economics and economic theory sits on the foundation of one seemingly minor assumption, that humans are “rational actors”.
Economics, and particularly microeconomics assumes that if provided with the correct incentives and information, humans will make the optimal decision. It’s one of those things you are told during your first day of microeconomics 101, you accept it and then you never really give it too much thought.
In the real world, we know that humans do not act rationally
People have known for years that smoking has disastrous health consequences including cancer. Governments have added “incentives” not to smoke through the form of taxes. A rational actor would look at the health consequences, and/or react to the financial incentives put in place and decide not to smoke, and yet, people continue to smoke.
The exact same thing is true of sugar consumption. We know it has health consequences, yet we continue to consume sugar daily.
We all know that we need to save money during our working years to fund our retirement. The government has put in financial tax incentives for contributing to a 401k, yet nearly 33% of all employees eligible for a 401K fail to even enroll in the plan.
I could go on and on about all the ways that most humans are not rational actors, but I think you get the point.
Humans VS. Econs
Most of us are humans, meaning we often act irrationally. As humans, we lack discipline and tend to make decisions with “our gut”.
Some of us are econs. An econ responds to incentives in the way that economists assume we all do.
When it comes to major life decisions that impact a person’s finances or health, econs will make an unbiased decision to optimize their well-being, considering all available data. That is not to say, econs are always correct but they will make a rational decision and respond to incentives.
If you are an econ;
You have maxed out your 401K contributions.
You have eliminated or reduced the amount of sugar in your diet.
You never buy a lottery ticket.
Put simply if you are an econ you more closely match the “rational actor” that economic theory is built on.
Automatic Versus Reflective Thinking
To help us better understand the differences between humans and econs the authors introduce two systems of how our brains work; the automatic system and the reflective system.
The automatic system is associated with the oldest parts of our brain, if you have ever heard the term “lizard brain”, our automatic system taps into our lizard brain. When we use our automatic system to make decisions you can think of it as going with “your gut”.
Decisions made using the automatic system are often fast and effortless. When you decide to pour another cup of coffee or light up a cigarette, you are using your reflective system.
The automatic system is extremely powerful because we aren’t even aware of it. If someone makes a bad first impression, it can be difficult to overcome because the other person’s automatic system has decided that they don’t like this person, even if on an unconscious level.
The reflective system is more deliberate and self-conscious. When you are working out a complex math problem, you are using your reflective system.
The following characteristics are described as part of the reflective system.
Thaler and Sunstein crystalize the difference between the automatic and the reflective system using the example of experiencing turbulence on a plane.
The automatic system will say “we are going to crash and die!”
While the reflective system will say “this is uncomfortable, but plane travel is statistically the safest way to travel”.
When it comes to important life decisions that impact our health or finances econs tend to use more of their reflective system while humans use their automatic system.
Are You a Human or an Econ?
To help you understand if you rely more on your automatic or reflective system the authors implement the famous “Cognitive Reflection Test” created by Shane Frederick.
Give it a go for yourself, grab a pen and paper and answer the following 3 questions. I will post the answers below but no cheating.
This is not an IQ test. Cheating completely undermines the objective of the test. Getting the answers wrong does not make you “dumb”, getting them right does not make you “smart”. It only helps you determine if you rely more on your automatic or reflective thinking.
The 3 Questions
1. A bat and a ball cost $1.10 in total. The bat costs $1.00 more than the ball. How much does the ball cost? _____ cents
2. If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets? _____ minutes
3. In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake? _____ days
The test is designed to reveal if you make an automatic decision or a reflective decision.
If you used your automatic decision making you had the following answers.
These are the incorrect answers to the questions.
If you used your reflective thinking you had the following answers
These are the correct answers.
How did you answer these questions, and do you believe you are a “human” or an “Econ”? Let me know in the comments below.