The experiment seemed simple enough. Each participant had to rank six paintings from their most favorite (1) to their least favorite (6). They were then told they could take home either the painting they ranked 3rd or the painting they ranked 4th. Naturally, most people choose the painting they ranked 3rd and went on their way.
A few weeks later the experimenters had the participants re-rank the six paintings. What they found was that (on average) the painting the participant took home (originally rank 3) moved up in ranking to be 2nd and the painting they left behind (originally rank 4) moved down in ranking to be 5th. You might be thinking:
Oh well that’s because the participants are justifying their selection to themselves. They are trying to make themselves feel better about their choice. It’s like they are saying, “The one I picked is really good and the one I didn’t pick sucks.”
I thought the same thing, but I was wrong.
The real genius of this experiment was when the experimenters asked another group of participants, ones with anterograde amnesia, to do the same thing. Individuals with anterograde amnesia can’t form new memories and, as a result, have a short term memory that lasts only about 30 minutes. Regardless, just like the non-amnesic participants, those with anterograde amnesia ranked the six paintings and had to choose whether to take home the painting they ranked 3rd or the painting they ranked 4th. Just like the control group, the amnesic participants took home the painting they ranked 3rd.
Here is where the experiment gets interesting. Instead of waiting weeks before having the amnesic participants re-rank the paintings, the experimenters merely had to go outside for 30 minutes to “clear” the amnesic participants’ memory. Upon their return they had to re-introduce themselves and ask the participants to re-rank the 6 paintings.
So, what happened when the amnesic participants re-ranked the six paintings? Their rankings changed in the same way as the non-amnesic participants. The painting they picked previously (originally rank 3) moved up in rank to be 2nd and the painting they did not pick (originally rank 4) moved down in rank to be 5th. They did this despite the fact that they don’t remember which painting they had originally picked!
Think about how amazing this result is. It illustrates how once you make a selection, your preferences change to prefer that selection in the future. This is exactly what happened with the amnesic participants who don’t remember ranking the paintings, but, nonetheless, showed a preference for the painting they don’t remember picking. So, you aren’t subconsciously lying to yourself when you say that something you picked is better than something you didn’t pick. You actually believe that.
This idea, which was introduced to me through a Dan Gilbert TED talk, is known as the free choice paradigm and has been demonstrated many times over since the 1950s. This concept is important because it is applicable to many areas of your life, both financial and non-financial.
On the financial side, the free choice paradigm explains the endowment effect, or the condition where you value something more once you own it. By making a choice to own something (i.e. a home, an individual stock, etc.) you are unknowingly increasing its significance and value in your mind. This can create conditions that cost you financially, such as not selling your losing stocks (the disposition effect) or overvaluing personal assets such as your home. As I have stated before:
Assets are not priced based on fundamentals, but by what someone else is willing to pay for them.
I fell victim to this when I tried to sell my $1,000 guitar amp for $500 a few years after owning it. I was 99% confident it would sell at this price, but it actually ended up selling for $250.
On the non-financial side, there are plenty of cases where individuals stick with a choice though any rational outsider can see that the choice is not optimal. Staying in a dead-end job or a bad relationship are just two such telltale signs of the free choice paradigm working against your better judgment.
So how do you counteract the free choice paradigm?
The only way to counteract the effects of the free choice paradigm is to use an outside source to evaluate your situation. A trusted third party can do more to help you see your biases than you could imagine. For example, instead of pricing your home (or any other personal asset), use comparable assets to value them. Instead of holding onto a losing stock, consider whether you would still buy that stock with its current price and fundamentals (note: this is why individual stock selection is so difficult). In the process of using outside information, you can work against the very preferences that are biasing your judgment without your consent.
When Choices Compound
The free choice paradigm is dangerous because all it takes is one small choice to compound into a large problem. This can happen to you without you realizing it, because one choice changes your preferences and then the next choice changes them again and so forth. The free choice paradigm explains how drugs, gambling, and other vices in society progress into addictions. Small choices can continually change your preferences and spiral out of control.
This is why I am a fan of the “not even once” theory when it comes to engaging in particular kinds of behaviors (i.e. gambling, drugs, etc). Don’t get me wrong, most people can do these once without a problem. However, what if doing something once changes your preferences and makes you want to do it again? This is the real risk associated with engaging in a risky behavior. Or as the rapper Immortal Technique once proclaimed:
So when the Devil wants to dance with you, you better say never
Because a dance with the devil might last you forever.
So, be careful what you choose my friends. As always, thank you for choosing Of Dollars And Data and thank you for reading!
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This is post 69. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data
According to new research from Citi Private Bank, contemporary art returned 13.6% per year on average since 1995, compared to 8.9% for the S&P 500. Additionally, their study showed that, over the same period, art had almost no correlation to the stock market (0.01 correlation factor). But unless you have $10,000,000 to buy a Picasso yourself, the barriers to this asset class have been too high...until now.
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