Young People Fall for the Sunk Cost Fallacy More Often than Older Adults

I used to play a game with a friend in college where we took turns flipping a coin. Every time the coin landed heads up, my friend had to buy the next round of beer. Every time the coin landed tails up, I would have to buy the round. In the long run, the coin would land heads up about as often as it landed tails up. In the short run of a single Friday night, however, it was entirely possible that the coin would land heads up or tails up three or four times in a row, meaning one of us would end up paying most of the bar tab that evening.

Now, my buddy had a goofy theory about this. He claimed that if the coin landed heads up several times in a row, that would make it more likely for the coin to land tails up on the next throws, in order to "even things out." I argued that each new toss had an equally likely chance of landing heads or tails, irrespective of the history of the coin's tosses. "The coin doesn't have a memory," I argued. "If this coin were to land tails up five times in a row, could I save it and wait until next Friday night, confident that it would be more likely to land heads up because of its need to 'even things out?'"

"Yes!" was his emphatic answer.

I didn't know the term at the time, but my friend was a victim of the "sunk cost fallacy," the tendency to continue to invest time or money in an endeavor just because you've already invested time or money into it. Individuals, and even corporations and governments, fall for the sunk cost fallacy all the time. (UPDATE: In the comments, David Rosen pointed out that this is not an example of the "sunk cost" fallacy, but of the "Monte Carlo fallacy.") They invest money in a poorly performing stock just because they've already lost a lot of money buying shares of it in the past. They keep building expensive jets that lose money just because they sunk a fortune into tooling and manufacturing it. They keep sending soldiers to die in a war they are losing just because they've sent many soldiers to their deaths before them.

Can we avoid the sunk cost trap? Yes, say researchers at West Virginia University. You can avoid it by getting older. Psychologists JoNell Strough, Clare Mehta, Joseph McFall, and Kelly Schuller, whose paper appears the July 2008 issue of Psychological Science, found that young adults who pay $10.95 to watch a movie that seems "pretty bad" after the first five minutes are more likely to continue watching the movie than older adults are. The young people tried to recoup their investment by suffering through a lousy movie in the hope that it would get better, while the older adults decided to cut their losses and move on.

I haven't seen my college buddy since we graduated, but I wonder if the passing of time has made him rethink his position on magical memory coins.

Mark Frauenfelder – Editor-in-chief of MAKE magazine and the founder of the popular Boing Boing weblog, Mark was an editor at Wired from 1993-1998 and is the founding editor of Wired Online.

Why Tightwads Marry Spendthrifts

When a peer-reviewed research paper opens with a quotation from Dante's Inferno, you know you're in for some interesting reading. "Fatal (Fiscal) Attraction: Spendthrifts and Tightwads in Marriage," published in the Social Science Research Network, begins with the following exchange between The Hoarders and The Wasters, who forever argue in the Fourth Circle of Hell:

They strained their chests against enormous weights, and with mad howls rolled them at one another. Then in haste they rolled them back, one party shouting out: “Why do you hoard?” and the other: “Why do you waste?

To some readers, this scene probably gets played out every time they go over their credit card statements with their spouses. Why is it so often the case one spouse in a marriage is a tightwad/hoarder and the other is a spendthrift/waster?

The paper, written by researchers at The Wharton School (University of Pennsylvania) and Northwestern University seeks to answer that question by examining "whether feelings toward spending money predict whom people marry, as well as whether and why husband/wife differences in feelings toward spending money influence marital well-being."

The conclusions are rather dismal. The found that people who aren't married think they'd be happier with a spouse who shares their attitude towards spending. The researchers also found that this belief is generally  true — pairs of spendthrifts and pairs of misers tend to have happier marriages than ones in which one partner is a spendthrift and the other is a miser.

Unfortunately, they found that "people tend to be attracted to mates with opposing emotional reactions toward spending," because spendthrifts usually don't like their own emotional reaction about spending so they seek a mate who is a tightwad, and vice versa. These mixed marriages, say the researchers, "appear to make tightwads and spendthrifts about as happy as the Hoarders and Wasters in Dante’s Inferno."

What can you do about it if you're in a mixed marriage? My advice: Convert to the other side, if you can stomach it. Or at least work with your partner to find a happy medium.

(Via Priceless, by William Poundstone)

Mark Frauenfelder – Editor-in-chief of MAKE magazine and the founder of the popular Boing Boing weblog, Mark was an editor at Wired from 1993-1998 and is the founding editor of Wired Online.

Credit Scoring Models: A Technical Description of the Design Architecture and Really Fun Reading

We rarely do this, but we thought it was super cool so we're posting John's article for Credit.com to the blog too!

I've been writing credit articles for the good people at Credit.com for almost 4½ years now. I've always tried to write them in such a way that my grandmother would understand them: simple and straightforward. I think that once every 500 articles, however, I should earn the right to really geek out and get technical on you. So here it is; enjoy!

Every credit scoring model, FICO®, VantageScore®  -- you name it – is actually a series of smaller models referred to as scorecards. Scorecards are models that are designed to best evaluate the credit risk of some sort of homogenous subpopulation, like those who have very young credit histories or have filed bankruptcy, for example. The purpose for this multi-scorecard architecture is to yield the most powerful credit-scoring tool regardless of the type of credit report being scored. 

When your credit file is pulled, and before it is scored, the credit-scoring model decides which scorecard it’s going to use to calculate your score. Don’t make this more complicated than it needs to be. Think of a bowling scorecard or a baseball scorecard. You add up points and at the end of the game you have a final score. This is no different, but instead of tallying runs and pins, the model is tallying the number of points you’ve earned for various credit characteristics. Oh, there I go...more technical. What’s a characteristic? 

A characteristic is a component of every scorecard. In fact, there are many characteristics in every scorecard. Think of a scorecard as a question that the model is asking your credit report. For example, “Mr. Credit Report, how many late payments do you have?” Another example could be, “Mr. Credit Report, how many inquiries do you have?” Those are all characteristics, and they each have an answer. The answer is referred to as a variable because the answer can vary from consumer to consumer and from credit report to credit report.

Each variable (answer) to the characteristic (question) is going to have a value or a weight. The weight is simply the number of points you earn for that particular question. Example: Let’s say you have five inquires on your credit report. That “variable” might equal 25 points (weight). To summarize, every credit report is broken down into characteristics, variables and weights. Once all of the weights are calculated, you end up with your final score. 

So there you have it: Credit Scoring Model Design 101. Thank you for allowing me to geek out on you. I promise I won’t do this more often than once every 4½ years!

John Ulzheimer – Credit scoring and credit reporting expert and author, John is the President of Consumer Education for Credit.com. Formerly with Equifax and Fair Isaac, John shares his unique insight of the inner workings of credit scoring models and the credit reporting industry on CreditBloggers.com.

How to Trick Yourself Into Producing the Sense of "Quasi Elation Associated with Pleasurable Experiences"

Love 'em or hate 'em, the synth band Depeche Mode demonstrated an instinctual understanding of human nature with "Everything Counts In Large Amounts," their 1983 hit song about the pleasure of big payouts. Their conclusions have been verified by a recent study at the University of Bonn, where researchers there and at the California Institute of Technology discovered that large amounts count so much with people that they prefer pay raises with inflation over pay cuts with stable prices -- even when the two scenarios are financially identical.

The experiment involved giving simple mental tasks to 24 subjects. While the subjects were being tested, their brains were scanned to learn which areas were the most active. Test subjects who correctly solved the problems were awarded a certain amount of cash. However, subjects could only spend the cash on items offered in a catalog (which included CDs, computer accessories, suntan lotion, etc.). Then, researchers re-ran the test, but this time they awarded cash payments that were 50 percent higher. However, the prices of the catalog items were also 50 percent more expensive.

The result was that the purchasing power of the money in both tests was identical, but the brain activity of the subjects was anything but identical. "In the low-wage scenario there was one particular area of the brain which was always significantly less active than in the high-wage scenario," said Bernd Weber, one of the researchers. "In this case, it was the so-called ventro-medial prefrontal cortex -- the area which produces the sense of quasi elation associated with pleasurable experiences." It's important to note that the test subjects were told in advance that the second test would involve bigger cash payments, with equally bigger price tags. Nevertheless, their pleasure centers burned more brightly during the second test.

The upshot regarding this "money illusion" is that national fiscal policy is at least as much about psychological manipulation as it is about fixing broken financial institutions. If you're lucky enough to get a raise in the coming months, remember that your new "larger amount" might not be as big as your ventro-medial prefrontal cortex is telling you.

Mark Frauenfelder – Editor-in-chief of MAKE magazine and the founder of the popular Boing Boing weblog, Mark was an editor at Wired from 1993-1998 and is the founding editor of Wired Online.

Credit.com Redesign

Just wanted to share some exciting news with our CreditBloggers readers: We've redesigned our homepage over at Credit.com to feature more of the insight and expertise you've come to expect here on the blog, as well as video, forum discussions, news, and the great mix of products, services, and tools we've carefully selected for our customers over the years. 

We rarely "toot our own horn" on the blog, but we're really proud of the work our team completed pulling this together, and we wanted you to know that this is just the beginning of more exciting developments to come!

When NOT to Ask Your Credit Card Company to Lower Your Rate

For years, our advice has been, “If your credit card rate is too high, call your issuer and ask them to lower it. Threaten to take your business elsewhere if they won't budge.”

How things change. You may want to think twice before picking up the phone and calling your card issuer today. Here are three situations to watch out for:

   1. You are maxxed out and your rates are decent. Don’t like that 15.9 percent interest rate? Unless you have plenty of open and available credit lines (and/or a strong credit score) and can really afford to take your business elsewhere, you may want to thank your lucky stars your rate isn't higher. Calling may trigger an account review which could result in a higher rate, or worse.

   2. Threatening to close your account when you don't mean it. In the past, if you paid your bills on time, issuers almost never wanted to lose your business. Now they may not mind. If you won’t lose sleep if your issuer calls your bluff and closes your account, go ahead and try it. Otherwise, realize you may just get what you ask for.

   3. You’ve lost your job. Asking your card issuer to give you a break because you just lost your job might result in them enrolling you in a hardship program where your interest rate drops to as low as zero percent for six months or so. But if they do lower your rate under a hardship program, your account will likely be closed to future activity. Or your issuer may decide instead to raise your rate, lower your credit limit, or even close your account. It’s hard to predict. If you are having trouble paying your bills, I would recommend that you first <a href="https://www.credit.com/ufg/credit.com/dcl">talk to a debt counselor</a>. 

While writing this post, I called up Scott Bilker, the expert on negotiating lower rates with credit card companies. (He wrote a terrific book, How to Talk Your Way out of Credit card Debt. I asked him if cardholders are still having luck negotiating lower rates. He said, "Absolutely. It happens every day."

But he also told me that if you're going to make the call, be sure you have other credit options available. That means holding onto the cards you do have, and keeping them active by using them from time to time.

He also added some perspective: "If your card company raises your rate dramatically, what do you have to lose by making that call?"

Have you called to ask for a lower credit card rate recently? What happened?

Gerri Detweiler – Personal finance author and Credit Advisor for Credit.com, Gerri contributes budgeting, debt recovery and savings information online. She is also the co-author of Reduce Debt, Reduce Stress: Real Life Solutions for Solving Your Credit Crisis.

My Experience with IBR: Almost Too Easy to Believe

In June I wrote about Income-Based Repayment, a federal program that allows college graduates to restructure their student loan payments based on their income and how large their families are.

Although IBR went into effect on July 1, 2009, I did my usual procrastinating and waited until the day before my deferment with the federal Direct Loan program was due to expire before I made inquiries.

The verdict? Success! During a 17-minute conversation with a Direct Loan representative (I asked a lot of questions), I began the process that should shrink my monthly loan payment by 59 percent from what it would have been.

The program is designed for borrowers who have a high debt-to-income ratio, such as those who have been laid off or had their work hours cut back. The basics: Payments are capped at 15 percent of discretionary income, which is your gross income minus the amount equivalent to 150 percent of the federal poverty line (which works out to $16,245). Fifteen percent of that, divided by 12 months, is your new monthly bill. The repayment period is also extended from the usual 10 years to 25 years. For other details, check out the FinAid site and IBRinfo.

With my current 10-year repayment plan, I was on the hook for $488.89 a month starting August 7. The Direct Loan representative Beth was so nice that she asked me if I knew what my new monthly payment amount would be. I had indeed run the numbers, and I pegged it at $198.94. The program requires that you re-apply every year and tell them what your updated income is. If it has gone up, your payments go up.

The first thing Beth told me was to extend my deferment to cover my fast-approaching due date, because the IBR paperwork takes a couple of weeks to process. Following a pleasant interlude in which the Muzak version of Peter Frampton’s “Baby, I Love Your Way” played, Beth extended my deferment over the phone. Once IBR is approved, I can send a letter asking for the deferment to be shortened so I can begin making payments.

Direct Loan uses your tax returns to prove how much you earn, and if your earning situation has changed, or if (like me) you’re a freelancer and get paid (ahem) irregularly, you can supplement the application with a “self-certification letter” that describes how much you bring home and how often.

The feds’ IBR application can be found here. Make sure to compare repayment plans to determine whether IBR or other income-based plans are right for you.

Landon Hall – A freelance writer in Silicon Valley, Landon was a reporter, sports writer and editor at The Associated Press in Portland and New York City from 1997-2006.

Think Being Rich, Good Looking, and Famous Will Make You Happy? Wrong.

If you were to encounter a genie who promised you three wishes, what would you wish for? We already know you'd choose world peace, an end to worldwide poverty, and a reversal of global warming, of course. But admit it, wouldn't you be just a little tempted to pick two out of those three, and save one wish for yourself? Who wouldn't want to be fabulously good looking, exceedingly wealthy, widely respected, or internationally famous? Wouldn't that make you happy?

Well, maybe not, according to a study published in the June issue of the Journal of Research in Personality. In fact, according to the three University of Rochester researchers who conducted the study, being rich, famous, well-respected, or beautiful can actually have the opposite effect, making you less happy.

If you think about it, these researchers may be onto something. A quick flip through the pages of a celebrity magazine like Us Weekly, People, or The Star, will reveal story after story about the lousy lives of celebrities: drug abuse, infidelity, diva tantrums, criminal acts, psychological meltdowns, and other assorted examples of self-destructive behavior. The same misfortunes seem to fall on politicians and billionaires. What's going on here?

The researchers found that achieving "materialistic and image-related" goals, such as wealth and fame, can have negative consequences like "headaches, stomachaches, and loss of energy," while pursuing goals that fulfill "one's basic psychological needs for autonomy, competence, and relatedness" -- such as having new and interesting experiences, spending time relaxing with family and friends, and having hobbies -- can make people happier.

One of the researchers, Edward Deci, a professor of psychology and Gowen Professor in the Social Sciences said, "Even though our culture puts a strong emphasis on attaining wealth and fame, pursuing these goals does not contribute to having a satisfying life. The things that make your life happy are growing as an individual, having loving relationships, and contributing to your community."

Good advice, but will I remember it the next time I encounter a genie?

Mark Frauenfelder – Editor-in-chief of MAKE magazine and the founder of the popular Boing Boing weblog, Mark was an editor at Wired from 1993-1998 and is the founding editor of Wired Online.

Be Thankful Your Finances Aren't as Thorny as Michael Jackson's

Why are we fascinated by stories about Michael Jackson’s estate? Perhaps his finances were a bit like his public persona: enthralling, disturbing, messy, and always of interest.

AP, The Wall Street Journal and The New York Times have written about MJ’s fortune and money woes: he earned more than $700 million as a solo artist and owned half of the Beatles’ catalog (which could be worth up to $500 million), yet he was at least $400 million in debt when he died June 25.

A couple of news organizations have used the occasion of the King of Pop’s passing to educate the public on the controversy related to the estate tax. Only 0.82 percent of estates paid the tax in 2004, according to an AP primer. And the number likely will drop, because this year the amount exempted from the tax was raised from $1.5 million to $3.5 million. Jackson’s camp likely will end up with a substantial bill –– some estimate $80 million –– for estate taxes.

When a person dies, his or her assets are added up to arrive at the “gross estate.” Any property willed to the surviving spouse is deducted, tax-free, along with contributions to charity and funeral expenses. What’s left over is the “taxable estate.” Set aside the $3.5 million exemption, and what’s left after that is taxed at a rate of 45 percent.

The current tax is set to expire Jan. 1, 2010, and won’t return until 2011. But Congress is expected to restore the 2010 tax at its current rate and exemption. A WSJ editorial has called this sensible fix “the largest increase in the death tax in U.S. history.” And a National Review blog post claimed that the “big losers” from eliminating the one-year moratorium “will be average workers who otherwise would have gained from a larger capital stock and entrepreneurs’ greater job creation efforts.”

Every dollar in taxes Michael Jackson’s estate has to pay is a dollar that won’t go to his mother and three children. The final amount remains in question, because evaluating the worth of his assets could take years.

“The government is not going to take a Beatles record as payment,” Roy Kozupsky, a New York estate lawyer told AP. “They want to be paid in cash.”

Landon Hall – A freelance writer in Silicon Valley, Landon was a reporter, sports writer and editor at The Associated Press in Portland and New York City from 1997-2006.

Prosper is Baaacckkkk....

Leading online social lending platform Prosper.com has the green light to facilitate personal lending in most states. In case you're not familiar with Prosper, they were one of the first major players in the growing "social lending" or Person-to-Person (P2P) lending business. Often dubbed the "eBay of personal lending," Prosper funded some $180 million in loans before closing the doors to new loans to meet securities registration requirements. Borrowers post a loan request and lenders bid on the loan. The more bids, the lower the interest rate.

Now that their registration process with the Securities & Exchange Commission (SEC) is complete, Prosper has resumed lending in all states except Iowa, Kansas, Maine, and North Dakota. Lenders may participate if they live in one of fourteen states, with more expected to follow soon.

New Enhancements

A new "floor" on interest rates adds protection for lenders. And with the minimum bid dropped to only $25, lenders will be able to spread their risk around even further.

High-risk borrowers will no longer find Prosper as welcoming. The minimum credit score has risen from 520 to 640.

Prosper's relaunch is welcome news in a time when other lenders are reining in credit offers. Let the bidding begin!

Gerri Detweiler – Personal finance author and Credit Advisor for Credit.com, Gerri contributes budgeting, debt recovery and savings information online. She is also the co-author of Reduce Debt, Reduce Stress: Real Life Solutions for Solving Your Credit Crisis.