Mark Riepe: I’ve got a letter here that was written by a great scientific mind and observer of human behavior. I’m going to read one passage to you.
“Those who believe an argument to be false may much more easily find the fallacies in it than men who consider it to be true and conclusive. Indeed in the latter case it will happen that the more the adherents of an opinion turn over their pages, examine the arguments, repeat the observations, and compare the experiences, the more they will be confirmed in that belief.”
One theme of this podcast is that the factors that drive poor decision making—they’re ingrained in all of us. They’re human frailties that have been around for a long time and they aren’t going away anytime soon in any of us.
The letter I read from is one example. I picked that letter not because it was from a currently active, paradigm-changing psychologist or economist. No, that letter was written by Galileo Galilei. He wrote it in 1615 to the Grand Duchess Christina of Tuscany.1 He’s warning her about the dangers of what we now call confirmation bias.
I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab.
It’s a show where we study the cognitive and emotional biases that can influence your financial decisions. And we offer strategies designed to help you mitigate those biases and improve your financial life.
Financial services is one of the most regulated industries. Because of that Washington matters, and investors should pay attention to the news out of Washington.
In this episode, we’re going to get an insider’s perspective on some of the biases of politicians, as well as how they use the biases that we have when presenting proposals to the voters.
Now, don’t worry. This episode is not going to be another lament about broken politics and a divided country. This episode, like all of our episodes, is ultimately about financial decision making.
And we’ll share some tools that can help you sort through all the chaos in Washington and, ultimately, improve your financial choices.
Interpreting and using the news from Washington is difficult for several reasons.
The first has to do with taxes. A lot of what happens in Washington that matters to individual investors involves taxation. Taxes generate strong emotions—emotions so strong that they can encourage counter-productive behavior.
One study2 demonstrated that some people dislike paying taxes so much that they were willing to incur a cost larger than the tax in order to avoid the tax.
One of the experiments they conducted was to offer subjects a chance to buy a TV at a store 5 minutes away or a TV at a lower price, at a store 30 minutes away.
When the TV at the other store was described as being 9% cheaper, 59% of the people were willing to take the offer. When the TV that required the 30-minute trip was described as being free of sales tax (where the tax rate was 8%), then 76% of the people were willing to take the offer.
Think about that for a moment: More people wanted to save 8% than 9%. The only difference was that the 8% sale was described as being a chance to avoid paying sales tax.
The second reason that Washington news is hard to interpret is the noise factor. We tell investors to “ignore the noise.” In fact, it’s one of Schwab’s seven investing principles. But Washington has a lot of noise. It always has and it always will. Ignoring the noise is easier said than done because it isn’t always clear what’s noise and what’s useful information. Political news makes this difficult because it’s one area where some practitioners of the political arts are in the business of actively creating a lot of noise.
The third reason is loss aversion. It shows up in all sorts of ways in politics, but it’s hard to recognize.
Loss aversion stems from the fact that people don’t like losses. What makes it interesting is that experimental evidence suggests that people, on average, receive an emotional jolt from a loss that is twice as strong as the joy they receive from a gain.3
This can lead to some poor decision making when it comes to investing. Go back to the “What Should I Sell?” episode if you want hear about many different examples.
What makes loss aversion relevant for this episode is that it isn’t always clear what constitutes a loss.
Let’s say I buy a stock for $100, and it goes up in price to $110. I feel pretty good because I have a $10 gain relative to my reference point of $100. Let’s imagine it rapidly goes to $150, and I think about selling it, but at the last minute I decide not to.
If it drops from $150 back to $100, I feel pretty lousy because I know that I could have sold it at $150, and I keep telling myself I should have. What I’ve done is create a new reference point. My feelings about this investment will be driven by where the stock is trading relative to the $150 a share price point.
Politicians of all stripes seem to understand this and frequently frame proposals in a manner designed to highlight the loss impact of a proposal.
What’s even more complicated is that politicians have different constituents and each of them may have very different perceptions of what constitutes the base line or reference point from which gains or losses should be calculated.
The last bias is the most obvious one when it comes to politics. It has to do with the intersection of how choices are framed or presented and the saliency of the imagery that’s used. In other words, spin. Some of the earliest work in behavioral economics was to show that our preferences can be manipulated rather easily just by changing how a decision is framed. The ease is driven by how salient or vivid the consequences of the choice were made to the subjects of the experiments.4
To help make sense of all this I’m joined by Mike Townsend. Mike is vice president for legislative and regulatory affairs at Schwab. He’s our expert in Washington, helping clients figure out the policy and legislation that could impact investors.
He’s also the host of Schwab’s newest podcast, WashingtonWise. Thanks for being here, Mike.
Mike Townsend: Great to be with you, Mark.
Mark: Let’s start out by talking about loss aversion. We know that people abhor losses. And my sense is that politicians know this, and they’ll frame policy proposals to show that they can help their constituents avoid a loss of some sort. Have you seen this in action?
Mike: Well, everyone in Washington knows that it’s much easier to kill a piece of legislation than it is to actually get a bill passed. So politicians often frame their messages to constituents in terms of what they prevented from happening, rather than what they accomplished.
Mark: So if I’m an incumbent I might say, “You should re-elect me because without me you would have lost this program, or this benefit, which really matters to the district.” Is that the idea?
Mike: Yeah, think of a typical campaign TV advertisement for a member of Congress. The candidate will often highlight how many times he or she voted against something, like a tax increase. Or they will point out how often their opponent voted for a tax increase. The candidate is reminding voters that he or she stopped something “bad” from happening. And there’s no question that has proven to be an effective campaign technique time and time again.
Another way we have seen this in recent years is through regulation. Some politicians tend to frame regulations as a burden on businesses that will result in that business spending more money to comply with the regulation and then passing that cost on to you, the consumer, in the form of higher prices. As you noted earlier, financial services is a particularly highly regulated industry.
Banks of all sizes tend to complain that every new regulation will “force” them to increase fees that they charge the consumer, or that they will have to tighten lending standards, and that might hurt the consumers who need those loans the most. So if a politician votes to roll back that regulation, they can say to voters that they prevented something bad from happening. You the consumer didn’t necessarily gain anything—you just didn’t lose.
Mark: That phrase “you just didn’t lose,” that’s really loss aversion in a nutshell right there. Mike, one of our goals on the show is to help listeners make better financial decisions, and we know that many of our clients keenly follow the news from Washington.
Give us some tips on what to listen for when policymakers are making proposals or criticizing the proposals of other people.
Mike: Well, pay attention to the language that’s being used. In Washington, the word “tax” is rarely used unless it is followed by “cut.” “Tax cut”—people react positively to that phrase. “Tax increase”—not so much. Instead, politicians tend to use terms like “revenue raiser” or “pay for” when they are referring to something where someone, somewhere, is going to have to pay more. As a member of Congress, if you propose a change in the law that will result in less revenue coming into the U.S. Treasury, you typically need to offset that loss with another provision that raises revenue for the Treasury—or pays for that first provision. Otherwise, the resulting legislation will increase the budget deficit, because Treasury will be taking in less.
Mark: I want to come back to that issue of increasing the deficit later, but before we leave this point about language, I wondered if you had an example to share that would really illustrate this point.
Mike: Sure. Here’s an example from something that is pending right now in the U.S. Senate. Last spring, the House passed a bill, known as the SECURE Act, which is intended to boost retirement savings. One provision in the bill would increase the age at which an individual must begin taking required minimum distributions from his or her retirement account from 70½ to 72. That provision will result in less money coming in to the Treasury—because people might hold off on withdrawing money from their retirement accounts for another 18 months, and thus won’t pay taxes on that money.
To offset that loss, the bill includes a “revenue raiser”—a change to the current law around inherited IRAs. If you inherit a retirement account today, you can spread out the distribution of those assets over your lifetime. The legislation would require that all those funds be distributed within 10 years. The faster that money is distributed, the more quickly taxes are paid on it— hence, the “revenue raiser.” It’s a much nicer way to say “tax increase.” But if you inherit an IRA under these new rules, you will have to pay taxes more quickly than you would under current law.
Mark: That’s a great example, Mike. The bill is supposed to be roughly revenue neutral. But the way it accomplishes that is by offsetting revenue lost today with revenue gained tomorrow.
Of course, whether the money is raised today or tomorrow, the people paying it, they don’t like it. And I think Congress understands this aversion to taxes. Are there ways for Congress to, I don’t know, try to have it both ways? By that I mean, can they create legislation to generate revenue, but make sure that voters don’t actually have to pay more?
Mike: You know, there’s a great example that’s playing out right now. When the Affordable Care Act was signed into law in 2010, it included the so-called “Cadillac tax”—a 40% tax on health care plans that exceeded a certain threshold. The new tax wouldn’t kick in for eight years—2018. Now, the tax was deeply unpopular then, but it was included in the bill as a way to generate revenue that offset some of the other costs of the new law.
In 2015, Congress approved a delay in the tax from 2018 to 2020. And in 2018, lawmakers delayed the tax again—from 2020 to 2022. Earlier this summer, the House of Representatives voted 419-6 to repeal the tax entirely. Now the Senate has not yet acted on the proposal, but since more than 60 of the 100 senators have signed on as co-sponsors of the bill, it clearly has enough support to pass.
So in other words, a tax that originally was supposed to affect only a segment of the population, and that was supposed to kick in eight years after the law was passed, has been delayed twice and now seems virtually certain to be repealed entirely—without a single taxpayer ever paying a penny. Just the idea of paying the tax was enough to make three different Congresses take steps to delay it or to make it go away entirely.
Mark: Of course, one consequence of raising spending and never getting around to the revenue side of the equation is a rising deficit. We’ll get back to the federal debt and deficit later, but first I have one more question about taxes, and this pertains to what constitutes a capital gain.
One interpretation of an investment gain or a capital gain is that it occurs when you sell something at a price higher than you paid for it. Another interpretation is that a gain exists only after you’ve accounted for inflation. This can make a big difference to investors, as well as the budget, and has gotten some attention recently. What’s happening on this issue right now?
Mike: Well the White House has been talking about indexing capital gains for a year or more. The president has mentioned it as something he’d like to do, and he asked the Treasury Department to study it. The proposal is to exclude any capital gains that are attributable to inflation from taxation. So today, when you sell a stock, you pay tax on the difference in the value of the stock when you bought it—that’s your basis—and the value when you sold it. What the administration is talking about doing is allowing taxpayers to adjust the basis to account for inflation. That would increase the basis, which would make the stock reflect a smaller gain in value and thus lower the amount of tax paid on that gain.
Mark: So Mike, given the current composition of the Congress, it seems unlikely such a bill would pass. Does this have any chance of happening?
Mike: Well, what the administration is exploring is whether the president could do this via an executive order. By doing so, he would bypass Congress entirely. But of course it’s Congress that’s supposed to make laws or make changes to current laws. So there is a real question of whether indexing capital gains by an executive order is even constitutional. If the administration does this, it would be immediately challenged in the courts. And the administration is internally divided about whether they would win in the courts. Plus, they know that the matter would be tied up in the courts for a long time. So the question is whether the administration wants to take on that battle. And so far, they have declined to do so. But it’s clear that decision is not final, so we will have to continue to keep an eye on it.
Mark: Yeah, that’ll be a great topic for WashingtonWise down the road. Before we move on though, this topic raises some interesting questions about loss aversion. For something to be a loss, it has to be compared to something else. In other words, there needs to be a reference point, and different people, they’re going to use different methods for figuring out that reference point.
One example of this is when politicians characterize a spending reduction as a budget cut when sometimes that cut is really just lowering the rate of increase. What are some other techniques that you see politicians use to set the reference point in a way that will make the proposal look better?
Mike: Well, one of the most common uses of this technique in Washington is when politicians obfuscate the basis for the projections they are making. In Washington, the impact of a piece of legislation on the economy is calculated over the next 10 years—that’s the so-called “budget window.” A proposal for a change in tax law, for example, might be said to “raise $1 billion over 10 years.” That, of course, is a future projection that may or may not come true. It’s important to know what assumptions have gone into it. This is also done when projecting budget deficits or surpluses. So a particular thing to watch out for is when a politician’s numbers are based on what he calls “projected growth.”
Mark: The problem there is actually a product of another bias, which is optimism bias. The outcome rarely turns out the way we expect and often is somewhat worse, and that has implications for the federal debt and deficit. Those are two pretty important numbers for investors, but Mike, as you know, there are also all sorts of other numbers that come out of Washington that pertain to the economy which are, of course, hugely important to investors. But those numbers, they can really be hard to interpret because they’re so large and abstract—frankly, it’s kind of hard to relate to them. How can our listeners become more literate when it comes to thinking about the kind of data that comes out of Washington?
Mike: Well, you’re right. Politicians tend to be very good at using the size of numbers to win either support or stoke opposition. They might emphasize the smallness of the number. For instance, several candidates for the Democratic nomination for president have floated the idea of a financial transaction tax. When they talk about it, they emphasize its smallness—the tax would be just ½ of 1 percent, maybe even as low 1/10 of 1 percent of the value of a stock trade. If you’re trading $100 worth of stock, that’s just 50 cents, or maybe a dime. That sounds like almost nothing. And politicians know that most people can’t figure what the tax would be on a trade with a value of, say, $6,312.
Another common thing politicians do is frame the cost of something in a way that people can relate to in order to make it seem small—like comparing it to the cost of an everyday item. Maybe you’ve heard a politician say that a proposal could be completely paid for if everyone just went to Starbucks one fewer time per month. That makes people think, yeah, I could probably give up a coffee once a month.
The opposite is true, too. Politicians like to call attention to something expensive in a way that makes a large number seem outrageous—and then offer an alternative way to think about how that money could be used. Maybe it’s a new fighter jet for the Pentagon, and it has a price tag of $85 million. A politician opposed to that might tell his constituents that for $85 million, you could end homelessness in a large city, or feed all the hungry children in his state for a year, or buy a computer for every junior high student, some other comparison like that.
Mark: When we get into these numbers like $85 million, they are really big numbers, but they’re nothing compared to the budget numbers, and many investors are concerned about the debt level, that, hey, it might be too high to be sustainable. How does the sheer size of these numbers influence policy debates?
Mike: Yeah, comprehending really large numbers is tough. I think the most striking example is the national debt, currently at more than $22 trillion. Congress just passed a law suspending the debt ceiling until July 31, 2021. The debt ceiling exists as a way to control government spending by capping the amount of debt the country can accumulate. Now, that debt can grow unfettered for the next two years, at which time it’s projected to be $25 trillion. That’s indisputably outrageous. But it doesn’t generate much complaint from the public.
And I think the reason is that $25 trillion is such a big number that it is meaningless to the ordinary person. Few Americans know what that number means to them, or how it impacts their life. That lack of understanding means a lack of outrage, a lack of outrage means that politicians don’t feel any pressure to do anything about the fact that we continue to accumulate this big national debt.
Mark: Well, one way to humanize it is if we hit 350,000,000 people in the country, let’s say two years from now—if we take that number, divide it into the $25 trillion of debt, I think that works out to be about $75,000 per person.
But let’s switch gears, though. I opened the show with a quote from Galileo about the dangers of confirmation bias. One way to mitigate the bias is to seek out opinions different from your own, and that will help you make more informed and, we think, potentially better financial decisions.
We know that politics affects investing, but confirmation bias with political viewpoints—that can be particularly hard to avoid. Partly because most people who claim some sort of political identity, they tend to socialize with people who share those same political views.5
One example of this is a study of about 10 million Facebook users. And the authors found that people who claimed to be politically liberal, about 20% of their friends, their Facebook friends at least, were identified as political conservatives. Among people who claimed to be political conservatives, about 18% of their friends identified as liberal.
Mike, though, your job actually requires you to avoid partisanship and make sure you’re seeing views from all perspectives. So how do you do it? What’s your secret?
Mike: Well, you’re right, Mark. My whole job at Schwab is to do exactly what you are talking about—cut through all the noise and the nonsense and the diversions and figure out what is really happening, what’s really important to investors.
So first of all, I read. A lot. I read the New York Times, and the Washington Post, and the Wall Street Journal every single day. I subscribe to Washington insider publications like Politico and Bloomberg’s Washington service, both of which are really in the weeds of every subcommittee hearing and bill introduction and political development. I read press releases from Republicans and Democrats. I read transcripts of press conferences. I read speeches given on the Senate floor.
Second, I talk to people all over Washington from across the political spectrum to see what they’re thinking and what they’re hearing. I talk to staffers on Capitol Hill and ask them what their boss is really trying to do with this proposal, that sort of thing.
And then I try to think through what’s happening and think: What are the goals of this Member of Congress or this regulatory chairman or this other Washington figure? What’s the political aim? What’s the practical goal? Is Senator So-and-So trying to just make a statement here, or is she really trying to pass this legislation? And ultimately, how might it impact people’s financial lives, regardless of their possible support or opposition?
Mark: You know, it’s hard to make a good choice if you don’t truly understand your options. So I agree that taking the time to really explore alternative viewpoints is great advice.
I want to move on to another bias, and that’s the planning fallacy. This is the tendency to underestimate the difficulties of getting something done—even when you know better and have personal experience with how long it takes to get things done. I’m bringing this up because every time a shiny, new policy proposal comes up that affects investing, we get lots of questions from clients. I’ll see those questions and send you an email that is usually in the form “Hey, Mike. I just read about policy proposal X. Is this going to happen?” You then patiently explain the many hurdles these proposals need to clear in order to become legislation. What advice do you have for listeners about how to react to proposals that come from politicians?
Mike: Well, first of all, be skeptical when a politician touts that he or she “introduced legislation” to do something. There are literally thousands of bills introduced every Congress, the vast majority of which never are considered in any formal way. Introducing a bill is really nothing more than kind of raising your hand and saying, “I’ve got an idea.”
Then, remember that the process of turning an idea into a law is long and arduous—and the bigger the change that’s being considered, the longer and harder that process will be. A bill that’s introduced has to go through one and sometimes multiple committees in the House of Representatives. Then, it will get amended and changed, then get voted on by the full House, then go to the Senate and go through the whole same process over again. If the Senate changes the bill, then it has to go back to the House, and there’s a conference between the House and the Senate to reconcile the differences between the two versions. Once the participants in that conference agree, the House and the Senate have to re-vote and pass the exact same version. Only then can it go to the president for his signature. The point is—there are so many steps along the way where the process can bog down.
My best advice? Find online the Schoolhouse Rock cartoon and song, “I’m Just a Bill.” This was first broadcast in 1975, but it remains the best three-minute guide to how hard it is for a bill to become a law that I know of.
Mark: I am delighted to meet another fan of Schoolhouse Rock. I loved those as a kid growing up in Iowa. The best one, though, is “Conjunction Junction, What’s Your Function?” but I remember the episode you’re talking about, Mike, and it’s fantastic.
Speaking of Iowa, though, one of the nice things about growing up in Iowa was that every four years, you got a chance to see every politician with presidential aspirations.
And that presidential election cycle is in full swing right now. Is there anything that’s especially important for people to be listening to?
Mike: Well, as the 2020 campaign continues to ratchet up, be skeptical when a candidate promises to do something “on the very first day” they are in office, or in their first 100 days, or, really, any specific timeline at all. As I just outlined, Congress moves on a much slower timeline.
Also keep in mind that candidates for elected office, particularly for the presidency, they’re trying to win an election, they’re not necessarily making policy, at least not right now. Most, if not all, of the candidates for the Democratic presidential nomination right now have proposed a number of changes they would like to make to the tax code. Elizabeth Warren, for example, has proposed a wealth tax, a tax on assets above a certain threshold for the wealthiest filers. Bernie Sanders has proposed a financial transaction tax, a tax on every time you trade a stock, bond, mutual fund, ETF or another investment vehicle. But if one were to be elected president, he or she couldn’t wave a wand and make these things immediately happen. Congress makes the laws, Congress takes a really long time to do so, and Congress is filled with people with very different ideas. It’s hard to get major legislation through Congress. It’s supposed to be hard. And it’s really hard when the House is controlled by one party and the Senate is controlled by the other party—which is the situation we have now. So just take with a big grain of salt every candidate’s pronouncements about what policies they would champion if elected.
Mark: Mike, these are great insights, and I appreciate you making the long trip from Washington out here to San Francisco. I want to wrap up by asking you about overconfidence. There are many explanations for it. The ones I’ve found most persuasive suggest that overconfidence is driven by misperceptions of skill or a misperception of the difficulty of a task. However, there’s another explanation that I wanted to run by you. The idea is that people, in fact, are very aware of task difficulty and their level of skill, relative to others. The overconfidence that’s projected is primarily driven by the need to signal strength and to signal competence. I’d love to get your take on that as it applies to political leaders.
Mike: Well, Mark, overconfidence is the hallmark of politics. Every politician, whether he or she is running for president or the local town council, campaigns on a series of promises—the vast majority of which will never come to fruition. I mean, presidential candidates literally write books full of policy proposals. They’ve got websites with pages and pages of detailed plans for every issue you can think of. If elected, they will have time to address only a handful of those issues. And their proposals will change in a million ways as they wind their way through Congress—if they get debated at all.
But no serious candidate could run for office, especially federal office, without making all these promises and plans. Candidates who get branded as “single-issue” candidates—maybe their entire campaign is based on health care reform, or combatting climate change, or some other big issue—they virtually never get elected. So candidates for elected office try to be—really, they have to be—all things to all people.
I think also, we expect overconfidence from our leaders. That’s why we never see any president go into a summit meeting with the head of a foreign country saying, “There’s no chance this is going to be successful. This meeting is a waste of everyone’s time.” It’s why, when they come out of the meeting, they always say, no matter how badly it went, something like, “We made great progress and I look forward to continued discussions.” Politicians just always have to exude confidence that the solution is just around the corner.
Mark: Mike, this has been great. Thanks for stopping by.
Mike: Thanks so much for having me, Mark.
Mark: I can’t think of a single form of investing or financial planning that isn’t, at least potentially, influenced by politics.
The financial services industry is heavily regulated. That means the politicians who write the laws and the regulators who execute those laws shape the environment in which individual investors make their decisions.
The decisions of politicians and regulators also affect the economy. There are even studies that show that periods of policy uncertainty have a negative impact on the performance of investments.6
However, politicians and regulators ultimately derive their authority from the voters. Because of this, both groups make frequent attempts to convince the public that their actions are correct.
When listening to these proposals, it’s important to recognize that Washington insiders are subject to the same biases as the rest of us. But they’ll also try to use what they know of our biases to make their proposals look more attractive to us. Our advice is not to be a cynical listener, but instead to be a critical listener in the sense of critically examining proposals to better understand what’s really happening. If you do that we think you’ll be better able to separate the signal from the noise.
If you’d like to keep up with Mike Townsend’s reporting out of Washington, you can follow his new podcast at Schwab.com/WashingtonWise or just search for “WashingtonWise” in Apple Podcasts or your favorite listening app. You can also follow Mike on Twitter @MikeTownsendCS.
That’s it for this episode. On our next episode, we’ll discuss which biases are most common according to a survey of independent financial advisors.
Thanks for listening. We enjoy your feedback, so let us know how we’re doing by leaving a review on Apple Podcasts or your favorite listening app.
If you’re new to the show, you can always go back and listen to previous episodes at Schwab.com/FinancialDecoder.
For important disclosures and a transcript, see the show notes and Schwab.com/FinancialDecoder.
1 https://hti.osu.edu/sites/hti.osu.edu/files/galileo_galilei.pdf
2 Abigail Sussman and Christopher Y. Olivola, “Axe the Tax: Taxes are Disliked More than Equivalent Costs,” Journal of Marketing Research, 2011.
3 Daniel Kahneman and Amos Tversky, “Advances in Prospect Theory: Cumulative Representation of Uncertainty,” Journal of Risk and Uncertainty, October 1992.
4 Daniel Kahneman and Amos Tversky, “Choices, Values, and Frames,” American Psychologist, April 1984.
5 Eytan Bakshy, Solomon Messing, and Lada A. Adamie, “Exposure to Ideologically Diverse News and Opinion on Facebook,” Science, June 5, 2015, pp. 1130-1132.
6 Scott Baker, Nicholas Bloom, and Steven J. Davis, “Measuring Economic Policy Uncertainty,” Quarterly Journal of Economics, November 2016.
