Are Some Brains Wired for Bad Financial Choices?

A region of the midbrain called the ventral striatum may be partly to blame for the fact that millions of Americans fell prey to risky financial gambles, such as adjustable rate mortgages. Since the early 1980's, lenders have lured prospective borrowers with complicated loan agreements boasting low teaser interest rates, which, after staying fixed for a period of time, inflate dramatically, leaving some consumers struggling to come up with their monthly payments and resulting in skyrocketing national foreclosure rates.

A new study appearing this week in the journal Neuron offers some insight to what too many of us were thinking, or not thinking, when we signed on the dotted line. It turns out, in some cases our brains are wired to fall into these kind of financial traps. Study co-author, Duke cognitive neuroscientist Scott Huettel, says that when making risky financial decisions, "We do not consider all of the potential probabilities, benefits and costs." Instead, our brains seek out a way to simplify these complex problems. Oversimplifying, however, "may go against the most rational choice," says Baba Shiv, a marketing professor at Stanford's business school. For instance, we may shop for mortgages based solely on finding the best introductory rate, and then be vulnerable to exorbitant reset rates and other hidden fees down the road.

Huettel and his colleagues identified patterns of brain activation that predict who among us is likely to make these simplifications. Subjects were presented with a lottery offering five outcomes-ranging from winning $80 to losing $80. Two outcomes paid out money, two lost money, and one was neutral. Subjects were given a chance to add $20 to one of the outcomes. Standard economic models argue that people hedge against big losses and the study participants would act to minimize the amount of money they would lose (by adding money to the losing option) and maximize their winnings (by adding money to the highest payout). However, 70 percent of the time, the nearly 200 study participants elected to add $20 to the neutral, middle outcome (no payout or penalty). They chose this simplifying strategy says Huettel, because doing that "altered the overall odds of winning, so that there were now more good outcomes [three] than bad outcomes [only two]."

When the subjects played multiple rounds of this lottery while having their brains scanned with functional magnetic resonance imaging (fMRI), the researchers observed differences between participants who were most likely to approach the problem by upping the odds of winning and those who chose to mitigate monetary loss, as would be more logical if you considered all the options. Those who decided to up the odds of winning rather than mitigating any potential losses, showed more activation in the ventral striatum when they won or lost money as compared to their economically savvier counterparts. This means they were more sensitive in that win/lose region of the brain, but less able to do the complex decision-making that would be required to mitigate the loss.

Who are these less financially savvy decision-makers? According to Stanford's Shiv, prior research shows that people with increased sensitivity in their ventral striatum are often extroverted. "They tend to be more impulsive," he says. "They also tend to be more optimistic." So, when confronted with an adjustable rate mortgage, they simplify the situation and might play down the probability of misfortune in the long term, such as losing their job and not being able to make payments or a tanking housing market that would make it impossible to refinance.

In the past, however, these optimistic simplifiers would have been better off because mortgages and even credit card rules were simpler, says Richard Thaler, a behavioral economist at the University of Chicago and the coauthor of Nudge: Improving Decisions About Health, Wealth, and Happiness. In the late-'70s/early-'80s, when the 30-year, fixed-rate mortgage was pretty much the only loan option, a "rule of thumb" worked well: You looked for one number, the annual percentage rate, decided if you could afford it and then signed on the dotted line (or walked away). "Once mortgages got very, very complicated," Thaler says, "doing the correct analysis required having a Ph.D. in economics"-and simplifying under those circumstances became dangerous.

Even with new consumer protections, financial products remain complex, so how do impulsive consumers protect themselves from falling for the tricks and traps in the lending game? Thaler suggests choosing a simple 30-year mortgage. And he says that the government could help make things easier by requiring lending institutions to offer the 20 or so pages of disclosure in a mortgage agreement available in a "machine-readable form," such as a spreadsheet, so that the terms could be compared easily with other mortgage types. (In fact, the Credit Card Bill of Rights Act of 2009, which President Obama signed into law this month, moves in that direction, forcing credit card companies to place their agreements online.) Such a requirement would allow "a third party Web site to go into the business of giving mortgage advice to consumers," says Thaler. A site called billshrink.com, for example, offers counsel on credit card agreements, as well as advising consumers on which of the increasingly complicated mobile phone plans is best for them.

But, what if you aren't interested in a 30-year, fixed-rate mortgage and can't wait for the government to require that those mortgages be put online for easy analysis? Shiv suggests bringing a friend or partner to the lender's office to play devil's advocate. By questioning your whims, they may just block your midbrain from mortgaging your future.