This may be the last time you trust “reason” in a crowd.

There are many psychological defects that make us do dumb things with money. We chase performance in the stock market and feel pressure from the next house over to buy fancy cars.

If you’ve read any personal finance blog for more than a week, you’ve probably heard some sort of encouragement to “be different” and separate wants from needs, etc., and all that sounds like good advice.

Personally, I’m not so sure it is. Personal finance advice too often focuses on telling you what to do and encouraging you to do it. It sets up the “Do I buy a new Lexus?” scenario as a rational dilemma with a clear answer and path to follow while summarily dismissing wanting to look good in front of the neighbors as the silly purview of broke cattlemen with big hats.

I’m a much bigger fan of avoiding those defects, through using defaults (automatic savings, auto bill pay, auto portfolio re-balancing) rather than trying to counteract the defects will all that positive thinking. This post is meant to show why.

In short, I’m not so sure we can fight the herd.

ABC runs a show called “What Would You Do?” on Fridays. It’s one of those rare shows that’s actually lasted more than a few episodes, but you really only need the plot of one to know how the rest work.

In an episode I saw a few months ago, a few men and women were put through a mock frat or sorority initiation on a public street. The activities were rather extreme with over-the-top physical and verbal abuse. Hidden cameras were rolling to see if anybody would try to stop it or if, instead, people might even join in.

Most people simply ignored the spectacle, one or two joined it, and I can only remember a couple actually trying to stop the abuse. The show, of course, is meant to make all of us think “Of course I would make them stop!” while showing that most people don’t.

To a social psychologist, the show’s probably not surprising one bit. If you put the onlookers alone in a room with the abuse going on, they might speak up, but in a crowd, suddenly all sense of individuality disappears. If the rest of the mob is doing nothing, best to not stand out. If the mob seems OK with an activity, it must be normal to be OK with the activity yourself.

What Would You Do? was a set-up, but there are several infamous examples of the same phenomenon.

You see a murder from your apartment window. What would you do?

In 1964, Kitty Genovese was stalked and stabbed to death in Queens, New York. The murder didn’t happen at once. She was attacked, left to stumble around, and finally killed about an hour later. Neighbors heard screams, might have seen the attacker, but did nothing. A famous New York Times article began with this chilling line: “For more than half an hour 38 respectable, law-abiding citizens in Queens watched a killer stalk and stab a woman in three separate attacks in Kew Gardens.”

Some parts of the story were later discredited, but it’s since been taught in social psychology classes as evidence of the “bystander effect”. A few years after the Genovese murder, John Darley and Bibb Latane attempted to replicate seeming indifference to emergency situations in the lab.

In the Darley/Latane experiment, an undergraduate would be put into a room, alone, with an intercom. He or she was supposed to talk about difficulties of student life with other members of the group (who were supposedly in other rooms, kept private to protect their anonymity). As they took turns talking, one of them would mention that he suffered from seizures. Later in the conversation, the test subject would hear this:

I-er-um-I think I-I need-er-if-if could-er-er-somebody er-er-er-er-er-er-er give me a little-er-give me a little help here because-er-I-er-I’m-er-er-h-h-having a-a-a real problem- er-right now and I-er-if somebody could help me out it would-it would-er-er s-s-sure be-sure be good . . . because-er-there-er-er-a cause I-er-I-uh-I’ve got a-a one of the-er-sei–er-er-things coming on and-and-and I could really-er-use some help so if somebody would-er-give me a little h-help-uh-er-er-er-er-er c-could somebody-er-er-help-er-uh-uh-uh (choking sounds). . . . I’m gonna die-er-er-I’m . . . gonna die-er-help-er-er-seizure- er-[chokes, then quiet].

Seriously. It was in the script.

So guess how long it took the students to, you know, leave the room and tell somebody that someone else on the conference was having a seizure?

First problem: If there were 6 people on the call (subject, victim, and four others), only 31% ever reported it.

Second problem: Even if they did, it took the subject a full 2 minutes and 46 seconds on average after hearing that to go seek help.

If there were fewer people on the conference, the rates and speed of reporting went up. Being in a group of non-doers is was kept people from intervening.

You see someone about to jump off a building. What would you do?

September 2008. A 17-year old, suffering from a bad breakup, threatens to jump from a parking garage. Police negotiators spend three hours trying to talk him down. The crowd acts a bit differently. Here’s a quote from a security guard who was there: “The police did a fantastic job at the incident and were not helped by a baying crowd, some with children, calling for the lad to jump.”

The teenager jumped.

Or how about August 2001. A 26-year old jumped from the Seattle Bridge, after some members of a crowd taunted “Jump bitch jump!” Or February last year, the mob taunted a jumper in San Francisco.

It’d be easy to pass off the cases as meanness or a lack of awareness of how serious the situations were. Part of it, however, is just herd mentality. If someone individually ran across a jumper, he’d probably call the police. Put in a group, that sense of responsibility dissipates. And once one person starts yelling out at the jumper, the rest feel more inclined to do it themselves.

I have the same visceral, disgusted reaction that you probably do. But sometimes I wonder if but for the grace of God, I could have been in that crowd.

(For a great post on the subject, check out You Are Not So Smart.)

And you think you stand a chance in personal finance?

John has a hot stock tip. Everyone at the barbecue nods in agreement.

Mary guilts you into coming to a charity auction. The bidding gets pretty heated.

You hear about money pouring into stocks or gold or whatever. And you wonder if you should come along too.

Or conversely, you feel like too much of your money is at risk in the stock market, but no one else seems to be concerned.

So tell me, what would you do? And are you so sure now that you see even in extremely terrible situations, so many people checked reason at the door and surrendered to the herd?

All the self-motivating, I-can-learn-my-way-out-of-anything things you think are going to bring you to financial fulfillment don’t hold a candle to the deep, deep psychological underpinnings that separate us from the machines.

You’re not going to reason your ways out of these problems. You need to learn why “reason” has nothing to do with them.

Is your default “trust” or “no trust”?

After the accounting scandals earlier this decade (think Enron and WorldCom) many economists were puzzled as to why investors didn’t pick up on problems sooner. Why weren’t the accounting firms that supposedly checked up on these guys under more scrutiny? Why were they still not under more scrutiny after Enron blew up and accounting firm after accounting firm was revealed to be pandering to company executives?

Some economists decided that we were just naturally trusting of certain kinds of relationships. That might sound ridiculous until you start to think about it.

When I choose a contractor to renovate my kitchen, my default is “no trust”. I’ve heard enough contractor horror stories that I’m going to want references and a contract that spells out what happens if he misses deadlines.

Do I show the same distrust with my doctor, lawyer, or hypothetical kid’s teacher? For whatever reason—government regulation, certification boards, or whatever—I’m just more naturally inclined to believe the opinions that those types of people give me.

Some of this is changing of course. The performance of doctors and teachers in particular have been under intense scrutiny. But they’re still professions that I just kind of assume are doing their jobs in the right way, in the same way that investors might have been assuming that Enron’s accountants were doing their jobs.

Even though more kitchen contractors might be skeezballs than doctors (no offense, contractors!), when that doctor, lawyer or accountant does abuse that default of trust, the potential consequences are much more dire. You expect that contractor to have surprise expenses and delays. If the other guys rip you off, you might be blindsided.

Now, you just know that some economist, somewhere, had to go out and devise a diabolical “distrust game” to see the impact of trust or distrust in action, right?

The distrust game

In case you’re not familiar with our new game’s predecessor, lets do a quick review of the “trust game”. In a typical version of the trust game, two players, Joe and Brian, get $10. First, Joe decides whether or not to send some or all of their money to Brian, and the money he sends triples. Then, Brian decides whether or not to send some of the money back.

So…say Joe trusts Brian completely and sends $10 over, which turns into $30. Now Brian, who has $40, can reward his trust by sending $20 back and splitting the take, can keep everything for himself, or do something in between.

Anyway, economists at Harvard decided to devise a new experiment where players take money from each other instead of giving it.

Eric starts with $0, and James starts with $40. In stage one, Eric can take up to $30 from James, but his take would actually be what he steals divided by three. So for example, Eric can take $30, leaving James with $10 and himself with $10.

Similar to the regular trust game, in stage two, James decides how much of the remainder to send to Eric. If Eric left him all $40, he could just keep all $40 for himself or reward the trust by splitting the pot.

Get it? Kind of like the trust game in reverse.

The Harvard professors tried out both the trust and distrust games on 134 college students to see if their behavior differed.

Uh, can you please make that understandable?

Sorry the games are hard to follow. I wish I conjure up a little widget so you could play the games yourselves, but the bottom line is this. In the trust game, the default is to not trust someone. You have to choose to give over part of your cash in order to have the possibility of the second player rewarding that trust or screwing you over.

In the distrust game, the default is to trust. You have to consciously decide how much you don’t trust the guy and take money from him before the second stage.

As the experimenters predicted, with the new game, students were more prone to leave money in the hands of the second player. And in return, they actually got screwed over more often. Nice.

People don’t distrust enough.

At least, that’s the conclusion of the Harvard researchers. But more than that, the researcher plays into the ongoing collection of research that shows we’re lazy bums. We’re creatures of inaction and defaults.

Fixing defaults in other areas of our lives is pretty straightforward. You set up automatic deposit on your IRA to take money from your bank each month and don’t have to worry about taking the action to invest 12 times a year.

But how do you fix a problem that involves a default feeling and one that you might not even know is bad? A couple decades ago, doctors were gods. Even now that we have more accurate performance measures and know about countless times doctors have screwed up, it’s never crossed my mind to get a second opinion. In the same way, I’ve just kind of assumed my lawyers had my interests at heart and teachers were telling the truth.

Is that even something we should fix? I’m at a loss. It would be exhausting to have to second-guess everyone who provides a service.

Is a will to succeed enough?

I’ve never started a business. It’s something I’ve thought a lot about, and you could argue that Pop Economics is kind of a small business. Just one with no revenues. But I’ve been fascinated by all the research that’s been done into what makes entrepreneurs succeed or fail. Are you born an entrepreneur or can it be taught to you?

It seems that the question should really be broken down into two parts. Sure, there are certain behavioral factors that might make you more or less successful in a new venture, but more than that, there’s a certain kind of person that it takes to decide to be an entrepreneur in the first place. Without the second factor, you get a bunch of potentially good entrepreneurs who instead whittle the hours away in a 9-to-5 job.

Entrepreneurs don’t seek risk but they accept it.

One oft-repeated assumption is that entrepreneurs like to take risks. Thing is, the researchers who’ve actually tried to discover how much risk entrepreneurs like to take haven’t been able to prove that their bold streak actually exists.

In the mid-70s, a professor from the University of Illinois surveyed entrepreneurs, newly promoted managers, and newly transferred managers on their risk-taking propensity using a highly-regarded psychological test. There didn’t end up being a statistical difference between the groups or between entrepreneurs and the population as a whole.

So much for that theory.

That’s not to say that entrepreneurs are unaware of risk. In fact, successful ones tend to spread it out amongst other founders and investors so that even if a bad event happens, they won’t be the only ones bearing the brunt of the pain.

Entrepreneurs have an innate need to be successful.

Some researchers have theorized that entrepreneurs simply want it more. They want positive feedback, to be recognized for successes, and to stand out from their peers.

Except they don’t. It turns out that while entrepreneurs are, indeed, high achievers, so are successful managers within a larger company. Being a high-achiever doesn’t make you more prone to start a business, it just gives you the ability to do so.

Entrepreneurs believe they can make a difference.

I’m very much a proponent of black swan theory. I believe unpredictable events have inordinate sway over my fate. That doesn’t make me a complete stick in the mud, but it does mean that I sometimes wonder “What’s the point?” when thinking about an entrepreneurial venture. Success or failure seems random to me.

Entrepreneurs, on the other hand, are supposed to feel “in control” and believe that the intensity of their efforts will translate into success or failure.

Except they don’t believe that either. Noticing a trend here? Researchers have found that managers believe in their power to change things just as much as entrepreneurs do.

Entrepreneurs can handle ambiguous situations.

And finally, something that does distinguish effective entrepreneurs from Joe schmoes. When faced with uncertain situations, some people become anxious and uncomfortable. Others don’t mind it or even enjoy it. Entrepreneurs, it turns out, can handle ambiguity without freaking out. Finally, something that distinguishes them.

(P.S. A paper from the UVA Darden School of Business helped me boil down the research on these entrepreneurial traits. It’s meant as an intro for students into the study of entrepreneurship. So definitely worth reading if you’re interested in the subject.)

So behavioral traits don’t help. Is it just luck?

Aside from the awareness of and comfortableness with ambiguity, not much seems to distinguish those guys who start multimillion-dollar companies from those guys who get promoted up through the ranks to run multimillion-dollar companies. The ability to be successful in one realm seems to translate nicely into being successful in the other.

A few Harvard professors took a look at start-ups listed by Dow Jones Venture Source to see if serial entrepreneurs—that is, entrepreneurs who started more than one company—were any better than those who just started one company. The idea is that if you performed well more than once, it must be something skill-related or personality-related that made you successful, rather than randomness. They looked at firms listed between 1986 and 2000, and since they were listed in Venture Source, all of them had gotten venture capital financing.

For the purposes of their study, the professors defined “success” as going public by the year 2003. Of course, selling out shouldn’t be viewed as a sole determinant of success for an entrepreneur. I mean, is Facebook unsuccessful because it’s still private? But anyway…

Their findings: Entrepreneurs doing it for the first time had a success rate of 20.8%. Entrepreneurs in their second or later ventures had a success rate of 25.0%. That’s a significant difference and suggests that something other than pure luck must be playing into the success or failure of new companies.

But sadly, the researchers note: “While our paper identifies entrepreneurial skill, it does not distinguish exactly what the critical entrepreneurial skill is.”

It’s not luck. It’s not being a risk-taker or a go-getter or a believer. Maybe it has to do with dealing with ambiguity, but that can’t explain all of it. Sadly, we’re still searching for our answer to the central question: How do I know if I have what it takes to be an entrepreneur?

Stay tuned: Some information on what successful entrepreneurs do have in common comes on Friday.

Not going to lie: I’m not a huge Dave Ramsey fan.

There have been several times he’s spoken on radio or I’ve seen things he’s written in print where I thought he was flat out wrong or misleading on a point. One of my recurring favorites is how he encourages people to take what they save and put it into a “good growth stock mutual fund that earns 12% on average.” Man, if only it were that easy.

Another one of his non-sensical strategies is also one central to the Ramsey philosophy. The “debt snowball” debt payment plan is completely contrary to basic rules of arithmetic. You see, Ramsey says that if you have a bunch of credit card debts, you should line them all up by the size of each debt, and pay the smallest balance ones off first, regardless of their interest rates.

The rational person in us should cringe at this. The size of individual debts shouldn’t be the driving force. If a $20,000 debt has a 15% interest rate and a $3,000 debt only has a 4% interest rate, you’re going to be paying more interest if you pay off the smaller debt first.

But Ramsey has a lot of experience talking and working with us humans and knows that’s not how we think. We derive pleasure from small wins. So “closing out” a little debt feels like more progress than putting a little dent in a big debt.

I don’t think he studied it empirically, but luckily, we have behavioral economists for that…

MBA students like the debt snowball, too.

Duke’s Dan Ariely actually ran a snowball-like experiment himself. He gave a group of testers a set of five, fictitious loans and a fake salary to pay them off. At the end of the experiment, they got to keep whatever money they had left over.

The “solution” to the experiment—that is, the method that made the subjects the most money—was to pay off the highest interest rate loan first, followed by the lower interest-rate loans with no regard to loan size.

Problem is, none of the test subjects did that. According to Ariely not one of more than a thousand people did that, including some testers who were MBA students.

Ariely’s takeaway, in his interview about it anyway, was that things can and should be done to take away the incentive to “close out” a loan. If you didn’t allow someone to close a loan, for example, people became rational and paid the big one first.

My takeaway, and this is similar to what Ramsey says, is that building those little wins has a psychological benefit that outweighs the extra interest the debtor pays on those small loans with high rates.

If that small win means a debtor keeps paying down debt, instead of giving up out of frustration, it’s a “win” even if he makes the irrational choice.

The theory of “Small Wins”

Ok, so let’s say you’re trying to tackle a big problem. No, not patching the hole in your roof. That’s too small. Really big, like patching the hole in the ozone layer. How are you going to go about doing that?

Just makes you want to shut down and continue playing Angry Birds, right? For a while, management and psychology gurus have posited that in the face of big challenges with complicated solutions, we tend to shut down and give up.

In a classic 1984 article, Karl Weick proposed that to tackle big social issues, we ought “to recast larger problems into smaller, less arousing problems, [so] people can identify a series of smaller controllable opportunities of modest size that produce visible results.”

So telling someone to tackle the ozone problem is pointless. Telling someone to reduce their greenhouse gas emissions by 30 pounds of CO2 is a little better. But telling someone to replace their incandescent lightbulbs with fluorescents…now we’ve got something we can wrap our heads around.

The same can be seen in your office or school. A little pat on the back to a new employee— “Hey James, nice work on that report. You really sold the plan well.” —builds confidence and increases James’s engagement with whatever the next project is.

Applying a small wins strategy to your finances

Aside from the debt snowball, I can see a number of places where a small-wins strategy could give you the psychological boost needed to get a big goal accomplished.

1. Always break down big goals into concrete outcomes of moderate importance.

That’s ripped almost straight from Weick’s article. But the point is this: Big goals are worthy, but not doable. It’s the dozens of small goals that lead up to it that our brains can tackle.

The best goals can be accomplished in a couple hours or even a couple of minutes. For a big goal, try building a work-flow chart that leads from the small goals to the big one.

For example, say I want “to apply to law school.” Big goal, lots of steps.

A smaller goal: To get recommendations from my professors.

The best, smallest, and most accomplishable step: E-mail Professor Thompson to ask for a recommendation letter today.

2. Reward yourself for the small wins.

Ariely proposed taking away the reward from paying off a small debt. If you can’t close the loan, he said, you won’t be misled into paying the small ones off first.

It seems the same thing could be accomplished in a positive way. If you have a big credit card debt, why not break it down into each item the went into it?

For example, within your $5,000 debt, maybe $1,200 was a new computer, $400 was a trip to Macy’s, and $600 was an emergency plane ticket home.

Now, when you pay the debt down by $500, you can cross that Macy’s trip off the list and feel like you accomplished something, even though the larger debt didn’t go down by much.

I have a negative incentive myself to post twice per week. If I don’t write two posts, which builds Pop Economics toward a comprehensive behavioral finance blog, I get charged $100 as a penalty. A positive incentive would no doubt make me happier, but I haven’t found one as immediate or effective as the financial penalty.

3. Don’t let reason get in the way of letting good things happen.

Yes, the debt snowball is irrational. However, it’s not bad. It works. Consider the money you’re losing in higher interest payments to be the fee you pay to actually pay off your debt once and for all, just in the same way it’s cheaper to quit smoking cold turkey but nicotine gum might be the more expensive, but better, option.

A lot of very big things can happen if you take the right small steps.

Hat tip to Karen from MSN Smart Spending for pointing me to the Ariely interview.

Both anecdotes and statistics lie.

Earlier this month, the Wall Street Journal and Sarah Palin had a rare face-off over a pretty trivial remark. In a blog post, a reporter wrote about a speech Palin gave against the Fed’s new quantitative easing efforts, and toward the end, pointed out that one bit of rhetoric she gave—“everyone who ever goes out shopping for groceries knows that prices have risen significantly over the past year or so. Pump priming would push them even higher.”—contrasted with the Bureau of Labor Statistics’ official measures of inflation.

Palin (or a representative) responded on her Facebook page, and the reporter responded to that response, and quickly thousands of commenters were chiming in with their own views on whether or not grocery prices had or hadn’t risen in the last year or so.

Anyway, according to the BLS, inflation has been remarkably low. In October, prices rose 0.2% compared to September (including food and energy), the smallest increase the bureau has ever tracked. When you subtract food and energy prices (which tend to be volatile), prices didn’t change at all and were only 0.6% higher than a year ago.

But here’s a shocker that underscores the WSJ/Palin debate, when you have bills to pay every month, you don’t really care what the Labor Dept. says. You care about whether or not your bills have risen. And you make an assumption about how other people’s bills must have changed based on your own experience.

We believe that what we can remember is common.

It’s called the “availability heuristic”. If you can remember more instances of something happening, you’re more likely to believe that whatever that occurrence demonstrates is common.

Daniel Kahnemann and Amos Tversky demonstrated this tendency in the ’70s, asking test subjects to listen to a list of names and afterwards estimate how many men and women were on the list. Some of the lists contained names of famous women but less-famous men. On other lists, the men named were more famous. The test was hard…in reality there was always either one extra man or one extra woman.

One group was asked to simply recall as many names as they could. On average, the 99 people who took the test recalled 42% of the less-famous names and 65% of the more-famous ones.

The other group was asked to estimate if there were more men or women on the list. Of the 99 test subjects, 80 erroneously picked the gender that had more famous names

So in other words, because the testers could remember more of the famous people than the not-so-famous people, they thought more of them must have been on the list.

We remember the negative better than the positive.

How could that translate to this inflation debate? I don’t know about you, but I remember times when I felt like I got ripped off much better than times when I felt like I scored a deal.

I can distinctly remember the last time I paid $7 for a small carton of strawberries, for example. It made me mad. I mean, it’s just fruit! Are you kidding me? Predictably, it happened when the strawberries were out of season, but for a while, it gave me the erroneous impression that strawberries were always that expensive. It took an entire summer of $4 cartons of strawberries before I realized that I wasn’t just getting lucky by finding them “on sale”.

And lest I fall into my own trap of relying on an anecdote to prove a trend, the ability of negative emotion to enhance memory has been well-studied. Boston College’s Elizabeth Kensinger asked volunteers to view “negative” images next to neutral backgrounds—such as a snake by a river—or “neutral” images against to neutral backgrounds—such as a monkey by a forest—and found that people were more prone to remember the neutral background when the primary images were negative.

So if we remember the bad stuff but let memories of the good stuff slip away, could it be that the Labor Dept. isn’t “lying” about inflation, and that prices really might not have moved up that much?

“Anecdotes” on inflation from Mint.com

Lucky for us, the BLS isn’t the only source of price changes anymore. Mint.com, which allows users to aggregate all of their financial accounts in one place, recently began to offer some of their aggregated data to the general public. So now, for example, you can see what the average receipts were for a Publix in Ft. Lauderdale or a Safeway in Seattle.

It turns out that prices haven’t risen much based on that data either. Check out the following graph of purchases at Safeway in Seattle:

At this particular Safeway, grocery purchases have stayed at about $30 for the last 12 months.

Here’s a Whole Foods in Ann Arbor:

Prices have stayed right around $40 and might have even dipped a tiny bit.

Of course, maybe people are buying less food to keep the prices low, as in the case of the shrinking sizes of products that many people have noticed. So maybe people are making more trips to the grocery store, even though individual trips cost the same.

As I churn through these charts, I’m finding a lot of little anecdotes that seem to support the BLS’s conclusions.

The real debate about the Federal Reserve’s quantitative easing methods right now are about whether they’ll cause inflation in the future, which economists are very divided on. But before you get mad and point out that the inflation is already happening, check your bills! I wonder if you (and me, for that matter) are just remembering the rip-offs without remembering the steals.

You can’t keep a kid from his marshmallow.

Back in the ’60s, it was apparently O.K. to torture little kids. Just kidding, but one study came close.

Here’s the gist. Stanford economists took four-year olds one at a time and put them in a room with a single marshmallow sitting on a table. The experimenter told them that he had to leave for a short errand, but if they waited without eating the marshmallow, they would get an extra one upon his return.

Seventy percent of the kids caved, on average lasting 3 minutes before eating it. The rest of the kids were visibly frustrated as they tried to wait. Some turned away from the table so they wouldn’t see the marshmallow. Some covered their eyes. Decades later, the researchers asked the kids (now adults) for their SAT scores. The patient kids scored better.

Since then, the study’s been replicated a number of ways. But just a few years ago, scientists took it to a new level. To see exactly what was going on, they scanned testers’ brains while they weighed decisions to see what areas showed the most activity. Researchers from the National Bureau of Economic Research asked 14 participants to choose between receiving money at an earlier or later date. For example, they could take $27.10 today or $31.25 in a month. While they thought about what to take, they were put in an fMRI machine to see which regions of their brains were activated.

When they considered one of the immediate cash payments, their brains’ limbic system, which is generally stimulated in emotional situations, was active. On the other hand, the areas of the brain that control reason showed intense activity when they considered the far off payment.

When the emotional and rational parts of the brain square off, guess which one is liable to win?

Controlling impulses

Luckily, there’s a way to even the score. Earlier this year, scientists in Germany published a paper on a similar test. Similar questions about present or future rewards. Same fMRI machines to see which parts of the brain were being activated.

Except this time, the scientists asked the subjects to think about their future selves as they considered the future rewards. What will you do with the money? Where will you be living? What kind of job will you have? By making the subjects think ahead, their brains showed activity in locations of the brain normally associated with autobiography and emotion (in addition to the expected, rational areas).

What’s more, they became much more likely to choose the far-off, and rationally superior, offer.

Recently, some behavioral economists have floated a related idea to get workers to save more in their retirement accounts. Every time they open the account to see their balances, they see a digitally-altered photo of themselves in retirement. So a 27-year old would see an estimate of what he’d look like as a 65-year-old man. Maybe by making them think forward to that future self they’d be more willing to sacrifice his current wants for the guy in the photo.

And keep that blood sugar high

Another interesting finding: Being hungry makes you likely to opt for instant gratification.

Researchers at the University of South Dakota told 65 college students not to eat the morning of an experiment. After bringing them in, they gave some of the students a sugary soda to drink. The others got a diet soda, with aspartame as a sweetener. The researchers also monitored the subjects’ glucose levels throughout the experiment.

Each of the college students was given a series of questions that weighed instant gratification against a future award. “Would you prefer $120 now or $450 in a month?” To make sure the students took the questions seriously, at the end, they rolled dice and were awarded one of the rewards they had chosen.

Here’s what they found: Before drinking the soda, both groups were just as likely to choose instant gratification. But after drinking the soda, the ones given the sugary stuff were much more likely than the other group to choose the delayed prizes.

The researchers think that the experiment links our desire for money with our primitive desire for food. When our blood sugar is low, our brain sends a signal that the body needs satisfaction now. While we’re most likely never at a loss for food, until it’s satisfied, it’s looking for a substitute.

Sounds like a good reason to make important decisions on a full stomach.

Not that any of them are all that great.

The hot air balloon above is inflating. Get it? Get it?! Sorry. I’m tired.

There are only so many ways our government can eliminate the deficit and eventually pay off its gigantic debt. The least painful—and the one federal officials were desperately hoping for when they enacted the stimulus—is to grow the economy. With the economy growing, they get more tax revenues without having to change any laws.

Two, less optimum solutions are to raise taxes or spend less. Both of those make voters angry. Spending cuts sound good until you realize it means your kid’s classroom goes from 25 students to 30 students. Raising taxes never plays well, even when you purport to target the highest-income households.

That leaves inflation. No politician has to vote for it. It’s hard for rivals to point to interest rates and say, “Congressman Smith did this!” Inflation is simply the easiest way to pay off the deficit without alienating your constituents. Yeah, it’s weak, but when push comes to shove, you’ve got to believe inflation is going to rise before Congress successfully balances the budget.

So where does that leave you? And what can you do to make sure a devaluing dollar doesn’t decimate your portfolio? And for that matter, how can you stop Pop from excessive alliteration?

The myth of stocks as inflation-fighter.

One of the most common arguments in favor of investing in stocks is that they keep your portfolio from being silently eaten away by inflation. For your retirement money to keep its earning power, the yarn goes, you need assets whose returns will outpace inflation. Stocks are one, good answer.

Except they aren’t. In fact, stocks tend to do terrible when inflation is high. Take a look at this chart from Martin Capital Advisors.

In times of rapid inflation (the gray boxes), the S&P 500 (the green line) tended to drop, sometimes by a huge amount.

The point is, while stocks will probably outpace inflation over the long-term, holding stocks as a short-term panacea to what you might think is a coming bout of major inflation doesn’t make sense. Indeed, it seems misleading that the two issues ever got combined. Yes, inflation is an enemy to your portfolio. Yes, stocks—even at a conservative 5% growth rate—outpace the average inflation rate of about 3% over the longterm. But the two aren’t built to counteract each other.

What about commodities?

It would seem that commodities—such as oil, natural gas, and, I don’t know, timber—would be better inflation hedges. After all, if prices go up, the prices on the raw goods we need to make things should go up, too. The problem, of course, is that a ton of things, in addition to inflation expectations, influence commodities prices. Let’s take oil for example. This chart is from Inflation Data:

You’ll notice that the 1979 high for oil (in 2010 dollars) wasn’t topped again until 2008. Of course, inflation didn’t go down over that long time period. Quite the contrary. There were just a few hurricanes and a couple major oil crises that jostled the price of oil around, even as inflation made its inevitable climb upward.

Other commodities face similar circumstances. But even if they didn’t, keep in mind: Commodities reflect inflation expectations. So if you’re thinking about buying some oil ETFs right now in expectation of high inflation, you’re already late to the game. Even if inflation does rise rapidly, if it doesn’t keep up with the lofty inflation expectations the market has set for it, commodity prices could still drop.

And I’m tempted to skip gold, but what the hell…

Not that some reasonable people aren’t making arguments for gold investments. It’s just I feel like it’s unfair to keep beating up on this one. One last chart, also from Inflation Data:

Similar to the oil chart, you’ll see that even though the price of gold, currently at about $1,200 an ounce, has surged this year, it’s still nowhere close to the $2,251 peak it reached in 1980 in today’s dollars.

If anything, gold is a crisis hedge. If the U.S. government collapsed and the world collectively decided to revert to a medieval trading system in which precious metals of limited industrial use became the currency du jour, then gold might be a good investment. When I write about this, a common counterattack is to say that the dollar itself only has value by fiat (i.e., because the U.S. government says it does).

They’re absolutely correct, but that’s the whole point. The dollar has the fiat, both from the government and (implicitly) from investors who flock to it in the face of danger. Gold has an implicit fiat from a limited number of investors and practically no governments. And…oh forget it. If you’re going to buy gold, at least don’t listen to Glenn Beck and buy coins through Goldline.

TIPS: An imperfect option, but the closest to perfect you’ll get.

Treasury Inflation-Protected Securities are Treasury bonds created by the U.S. government whose principal also adjusts with the Consumer Price Index. As many people point out, CPI is an imperfect measure of inflation. Even putting aside the specious, government-lies-about-everything arguments for a moment, there is no possible way that what you spend money on will track CPI exactly. If you, for example, have to spend a lot of money on healthcare, whose cost is rising several times faster than CPI, your personal inflation rate will be higher.

However, TIPS, and their less-mentioned cousins, I Savings Bonds, will at least track inflation loosely, without the wild, speculative swings that stocks, commodities, and gold fall subject to.

Right now, a 10-year TIPS bond yields 1.09% after that periodic inflation adjustment. Given that regular Treasury bonds of that length yield less than 3% right now, that implies investors think inflation over the next decade will actually be extremely low.

And best of all, TIPS can easily be bought straight from the U.S. government. One word of warning though, if you buy them this way, make sure you hold them until they mature. Selling individual bonds is expensive, and bond prices will move around as interest rates move. If you think you’ll sell before the maturity date, try a TIPS mutual fund or ETF instead, though they won’t track inflation as exactly.

Anyway, I’m sure there are good arguments in favor of some of the traditional inflation “hedges” investors have used over the years, and throwing a few charts out there does not a Ph.D. dissertation make. How would you challenge some of the arguments I’ve laid out here?

Jimmy Stewart is dead.

There’s a great scene in It’s a Wonderful Life when the bank of the protagonist, Jimmy Stewart, suffers a bank run. Fearing that Stewart’s bank might be going under, many of its customers come running, asking to withdraw all their savings, lest they be the ones left holding the bag when the bank doesn’t open. Sure enough, the bank gets down to its last few dollars before closing time arrives, but the bank makes it.

Bank runs were a fact of life toward the beginning of the last century—a problem that was supposed to be solved by FDIC insurance. But just a couple years ago, we were treated to some similar behavior. When IndyMac failed, customers waited hours in the heat to withdraw their deposits. A few of them had deposits in excess of $100,000, which was the FDIC limit at that time. A lot didn’t, but were just as worried.

Every time news of bank stress tests or yet another failing bank come out, I see stories about how to check up on your bank’s stability, as if having an average or below-average rated bank is an awful thing. I’ve seen arguments made on both sides. How much should you care about the stability of the financial institutions you use?

FDIC limits and your liquid accounts

You probably know that the Federal Deposit Insurance Corporation protects up to $250,000-worth of deposits you make with each financial institution. Congress recently made permanent the higher, $250k limit, as up until the financial crisis, the limit was set at $100,000.

Easy message here: Don’t keep more than $250,000 in checking accounts, CDs, and savings accounts with one bank. Honestly, unless you were close to or in retirement and have a great need for really safe savings, I don’t see why you’d have that much at a bank anyway.

But (maybe) a more surprising message, as long as you have less than $250,000 in cash to park, look for unstable banks. They’re the ones that need your money the most and will pay you the best rates to get it. According to a recent search of the best 1-year CD rates at Bankrate.com, nine of the 12 banks with the top offered savings rates came from banks rated three stars or fewer in stability.

Those banks are afraid of going under, but you don’t need to be afraid of those banks. If you have less than $250,000, even the tiniest increase in yield you get from going with a less stable bank is worth it, because with FDIC insurance backing you up, that two-star bank is no less safe than the five-star bank. Obviously, make sure that the bank you put your money is, in fact, covered. And if you’re especially worried, you can use this FDIC tool to make sure you’re not over the limit.

No one should own a money market fund right now.

The chances of your money market fund “breaking the buck” and losing money are very low. But it is a risk, and there have been a couple high-profile cases of money market funds going under in the last couple years. Money market funds are meant to be short-term savings vehicles, that offer a low yield but never lose value. To achieve that, the firm you put the money with is supposed to invest in safe, short-term bonds. The problem, as the funds that did lose value found out, is that humans aren’t always good predictors of what bonds are “safe”.

But let me say it again: I don’t think your money market fund is likely to lose money. But I also think it’s silly to own one right now.

In this regard, I am a hypocrite. I have thousands of dollars in Vanguard’s money market fund, earning 0.12%. Imagine if David Bach tried to sell The Latte Factor using that rate. “If she just skipped her $5 per day latte, in 20 years at 0.12% compound interest, her savings would become more than $28,000!” Not quite as compelling as a million dollars, eh. And just for context, according to Crane Data, the top yield for a money market fund right now is 0.26%.

And yet, because it’s Vanguard and because a mutual fund is an “investment”, I’m for some reason keeping this stash sitting there, when I could get a much better rate at a money market account. How much better? Well, according to Bankrate, I could get a money market account at Sallie Mae with an annual yield of 1.39%, which is more than ten times higher than what I get with Vanguard. What’s more, it would be FDIC-insured. Lower risk, higher return. Sorry, Vanguard, it’s time to transfer those funds.

The confusion over brokerage account insurance

Bernie Madoff was the most high-profile case, but there have been several accounts of brokers running investment scams that resulted in their investors losing billions of dollars.

Of the kinds of accounts I’m going to write about today, this is where I think you need to be the most careful. Yes, brokerage accounts are “insured”. But in these cases, you run the highest risk of having assets beyond the insurance limit.

First, it’s important to note that the Securities Investor Protection Corporation, which covers your brokerage accounts, isn’t a federal agency. It’s a nonprofit, funded by the securities broker-dealers who are its members. Its sole responsibility is to facilitate the transfer of customers’ assets from one broker to another in case the broker goes bankrupt. So if you owned 100 shares of Bank of America at Broker X, which went bankrupt, SIPC would make sure those 100 shares made its way to Broker Z.

SIPC’s insurance limits only come into play when those 100 shares end up missing, which sometimes happens with bad record keeping, but, in this digital age, most often happens when a broker ends up being corrupt. For individuals, SIPC will replace up to $500,000-worth of securities, including up to $250,000-worth of cash. That sounds like a lot, and indeed, it’s above the FDIC limits. But whereas you’re unlikely to have more than $250,000 at a bank, you’re very likely to have more than $500,000 at a brokerage if you’re well into saving for retirement.

Spreading your investments between brokerages is probably not worth the effort. If you handle your investments yourself with a well-known brokerage like Vanguard or Fidelity, I probably wouldn’t even worry about it. But if you have a financial advisor who invests directly for you, run the simple checks listed here to make sure he or she actually buys the securities he says he’s buying.

Or what’s going to feel like a double-dip anyway.

Don’t read too much into that. I’m not making a prediction. But there are plenty of people who are. Nouriel Roubini, that guy who just happened to predict the first financial collapse, says it’s likely we’ll have a double dip, in which GDP drops again after going up for a time, or at least a long, slow recovery.

Plenty of other economists disagree. But as I’ve mentioned before, what’s going to matter to you is not what happens to the economy at large but what happens in your personal economy. If you lose your job, the recession was terrible. If you didn’t, it wasn’t so bad. Yeah, it’s a sad, selfish demarcation line. But I bet it’s the truth.

However, it is becoming clear that even if there’s no double-dip, the unemployment rate is going to be staying very high for a long time. And no one is predicting a strong, sustained rebound in the stock market either. You’re still vulnerable to a crummy economy’s effects even if you’ve made it this far unscathed. Here’s how to prepare for the long slog to recovery.

1. Keep your emergency fund high.

Hopefully, you’ve been socking away cash in a money market account or money market fund, just in case unemployment strikes. When the economy started to add jobs again, it was probably tempting to cut that one-year emergency fund back to six months. Big mistake.

For one, let’s put the job “growth” in perspective. In June, the economy lost 125,000 jobs, not counting seasonal farm workers. The unemployment rate did edge down to 9.5%, but that was due to thousands of workers giving up—not because they were finding jobs. Take a look at this chart, via Ezra Klein and the Brookings Institution. The “job gap” is how many jobs it would take to return to the employment level before the recession started.

In what Brookings calls a “more optimistic” scenario, it takes five years to get back to where we were. In other words, losing a job is going to remain unusually likely and unusually painful for a very long time.

Another thing to be wary of: Congress is suspicious of unemployment benefits. For the last few weeks, the Senate refused to extend benefits, dropping the maximum 99 weeks you could collect down to 26. It looks like they’re going to extend them at least until November. But next time, its passage will be even tougher. So, you would be well advised to keep that emergency fund high or even build it up further if you can.

2. Shed unnecessary contracts and expenses.

Contracts are the enemy of a crisis. Two-year cell phone agreements, DSL and satellite television contracts, adjustable-rate mortgages, you name it. Anything that locks in a monthly payment should be shunned like the plague.

I recently wrote that I could move into a cheaper apartment if I needed to cut my expenses. Well, actually that’s not true. Not for another 12 months at least. In fact, cable TV, which in my case came with no contract, was a relatively innocuous expense. If you do lose your job, you don’t want to be in a situation with high fixed expenses, which can’t be downshifted if you’re in trouble. Flexibility is your friend.

How do you cope if you’re already locked in? Well, don’t sign up again—that’s a given. Rather than giving into the temptation to upgrade your phone and lock in another two-year contract, stick with your old one as long as you can and stay month-to-month. Choose cable TV over satellite—you probably can’t get satellite TV for much cheaper anyway.

And in the case of a lease, check your local tenant laws to see what happens if you have to break it. Some states make it very difficult for a landlord to pursue a tenant who gives notice and leaves. And an understanding landlord would rather have you pay what you can and get out than face a tenant who can’t pay and plans to squat through a long eviction process.

3. Become the most important person at work.

You don’t have to literally be the guy who has all the passwords to have all the power. A knee-jerk reaction to turbulence at work is to put your head down and hope you avoid the axe. What you should really do is be visible. Be the one who offers business-growing suggestions at meetings or in a quick e-mail to the boss.

Exceed your sales targets if your a salesman. Finish the project early if you’re a coder. If your company has to cut costs, they will spare the workers who gave them measurable, revenue-generating achievements, not the ones who simply stayed from 9 to 7 instead of from 9 to 5. Coincidentally, if your company doesn’t fire anybody, measurable achievements that you can bring up at review time are also likely to get you a raise.

4. Network now.

There’s not a worse feeling than losing your job and not knowing where to go. I’ve spoken to dozens of people who hadn’t maintained their professional networks other than with a LinkedIn or Facebook account before getting their walking papers. (I am running out of cliched synonyms for “getting fired.” Sorry.)

It’s a sad fact that making connections and getting a new job are much easier when you already have one. So take advantage of that, um, advantage by attending networking events and setting up lunches or coffees with mentors, both outside your company and within it. I once had a boss whose wife asked him every Friday what he had done that week to prepare for his next job. Awesome wife.

5. Invest with caution.

One of the mantras I used to write, but now cringe at, is this: “Buy more stocks when the market crashes. They’re on sale!” That’s about as much of a truism as it is that your local Lexus dealer put a car “on sale” by slashing its price to $35,000 from $40,000. Still seems pretty overpriced to me.

This isn’t a point about market-timing, just about us, “good” investors’ natural tendency to take contrarianism to an unhealthy extreme. Yeah, stocks are a better deal than they were in 2007, but that doesn’t make them such a good deal that you should make an outsized bet on their performance now. Don’t try to make up for losses by taking extra risk with your retirement money.

But I’m actually more concerned right now with people taking extra risk with their short-term savings. Savings rates are abysmal right now. My Vanguard money market fund is paying 0.11%. Money market accounts are paying better, but not by much. This brings the temptation to “chase yield”—by putting money in higher yield, but higher risk investments.

Truth be told, I would be O.K. with my money market funds and money market accounts paying 0% interest—though that would mean I was lazy about finding a better option. My emergency fund is about liquidity and having the money when I need it, not about what that money earns. Peace of mind is its own form of interest.

So good luck out there. The recession is no doubt over, but your personal economy—or, dare I say, your pop economy—is still at risk.

Be sure to check out this week’s Carnival of Personal Finance at NerdWallet. Your’s truly was an editor’s pick.

Oscar Wilde died broke, why not you?

Ok, bad example. Wilde was an extremely gifted poet and playwright, but he had a lot of personal problems confounding him before his death. This post is about a question that’s a little more clear cut than that: Does being smart make you better with money?

Yeah, it’s wide-ranging, and you think you might know the answer off the top of your head. My automatic answer was, “Yes! Of course.” Smart people are better at math, which would make them see through to the consequences of their decisions more clearly, right?

I dug up an old Yahoo! Answers user who posited the same question. The winning answer had a bunch of mumbo jumbo about common sense versus book smarts and something called a “social IQ.” So the Web 1.0 unscientific survey of anonymous web users named “species456″, “Father Christmas”, and “Ratz” says intelligence and money aren’t correlated at all.

I was hoping to find the definitive economic analysis that would allow Pop to smack Ratz back to the, um, sewer, but (sigh), things are never that clear cut. So without further ado, let’s get to how smarts affect wealth.

Smart people take more risks but show more patience.

I recently tripped upon a paper published last year by several German economists who studied whether someone’s IQ plays a factor in how likely they are to take risks or show patience when presented with financial problems. It turns out that it does, even when you control for things like age, experience, and wealth.

First, the thousand or so participants were asked to take different modules of the Wechsler Adult Intelligence Scale test, one of the most popular tests to measure someone’s intelligence quotient (IQ). They also filled out a separate survey with demographic data: age, income, race, etc.

Next, the economists asked participants to participate in one of two paid experiments designed to measure risk aversion or impatience.

The risk aversion test took the form of a lottery. You could either take a guaranteed, safe payment or choose to participate in a lottery where you had a 50% chance of winning 300 Euros (you won nothing if you lost). The tester would “tempt” the subject with a safe payment of 0 Euros to start (I’d guess everyone would pick the lottery at that point), then with 10 Euros, then 20 Euros, and all the way up until someone could pick a safe payment of 190 Euros rather than take the risk. A completely rational person would take the bet until the safe offer hit 150 Euros (50% of 300).

For the patience test, economists told the subjects that they could either have 100 Euros now or a larger amount of Euros a year later. In a similar fashion to the risk aversion test, they tempted people with increasingly larger amounts until the subject said he’d take the delayed payment.

Anyway, to cut to the chase, here’s the graph of their results:

And in case you have trouble reading that (who wouldn’t?), the gray-enclosed line shows how risk-taking changes with increased intelligence and the white-enclosed line shows how impatience changes as people get smarter. It looks like smart people are both more willing to take risks and more willing to wait for a payout.

Smart people make more money, but aren’t necessarily more wealthy.

If I were to pick a favorite data set amongst all the data that the Bureau of Labor Statistics collects (and everyone does this, right?), it would, without a doubt, be the National Longitudinal Survey of Youth. The BLS has been following about 7,400 Americans who were born between 1957 and 1964 for nearly three decades (they started the surveys in 1979), asking them about their work histories, incomes, life events, and all that other fun stuff economists love to analyze. What makes it unique is its long-term look. They spoke to Joe Smith when he was 17, and caught up with him again each year until 1994. Now they only talk to Joe every couple years, but still, that’s a lot of data on one guy that you can harvest for all sorts of interesting experiments.

Well, a research scientist from Ohio State University named Jay Zagorsky decided to mine the data to see how well intelligence predicted how much money people ended up making and how wealthy they were.

Instead of an I.Q. test, the subjects took the Armed Forces Qualification Test, which the Department of Defense uses to judge the mental acuity of new recruits. Then, Zagorsky surveyed them on their incomes, total wealth and three measures of financial distress: if they had maxed-out credit cards, if they had missed a bill payment in the last five years, and if they’d ever declared bankruptcy.

Result numero uno: Smart people do make more money. In fact a one point increase in their IQ score (it’s still called IQ with this test, apparently), was associated with $202 to $616 more income per year. A normal IQ is around 100 whereas a really smart person has an IQ closer to 130—that’s a $6,000 to $18,500 per year difference in income on average.

But on the other two measures, the results were mixed. For one, smart people don’t report higher wealth than the less intelligent people. They apparently just save less of their larger incomes.

In those other measures of financial difficulty, the results were more strange. People of average intelligence were more likely to max out their credit cards than people of slightly better than average intelligence. But the most intelligent people were worse off than the better-than-average. Zagorsky concluded that it was best to have “slightly better than average intelligence.” I, for one, look forward to a follow-up study that explains the trend a little better.

It was slightly amusing to me that the OSU article on Zagorsky’s research ended with a quote noting that OSU professors don’t drive many Rolls Royces or Porsches. That was supposed to show anecdotally that smart people aren’t necessarily wealthy. I know about a thousand people who would argue that your wealth is inversely proportional to how many Porsches you buy. But that’s just me.