Gails Blog

People are not rational. This isn’t news to me. I’ve been watching people do really stupid things – things against their own best interests – for years. But WHY do they do stupid things? Ah, that’s the question.

Well economists and behavioural scientists are coming together to uncover the source of our irrationality. I’ve blogged before about the latest in economics – called neuroeconomics – that studies how our brains actually respond to things. We’re not guessing how people “feel” anymore. Now we’re using MRIs to take pictures of how we “feel.”

A breakthrough report cited on Economist.com used active MRIs to show that failure to choose an optimal outcome in the Ultimatum Game correlated with an area in the brain said to be involved with reward and punishment decisions.

Here’s the gist of the ultimatum game:


“Take two people and tell them they have the opportunity to split $10. Furthermore, tell one person that, as first mover, they get to make a one time offer, and tell the other person that, as second mover, they get the opportunity to either accept or reject this offer. If the offer is rejected they both go home with zero.”

According to standard economic theory, as long as the first person offers any money at all, the proposal will be accepted because the second person prefers something to nothing. That’s the rational thing to do.

Here’s the interesting part: lots of people would rather have nothing than accept the offer of just one dollar. So much for “A bird in the hand…” We’d turn our back on a dollar because we’d rather have the other person get nothing than make $9 while we walked away with just a buck. Hmmm.

This may be the very reason why people are unwilling to settle for reasonable rates of return on their investments. If they feel they are being bettered, their F-U switch clicks on and they’d rather lose everything than settle for the bird in the hand.

I get a lot of letters from people who want to earn “a better rate of return” on their investments. Better than what? Better than your brother, you boss, your broker? Better is relative. And so is risk. If you’re prepared to lose everything you’ve worked hard for, you can potentially earn a better return than if you stayed with a completely safe investment option. If that scares your pants off, then you should turn off your F-U switch and settle for a return that lets you sleep at night.

For more information on the relationship between risk and return, go and read How Greedy Are You?