The Theory of Reflexivity & Your Savings

“For as long as I can remember, compound interest has been at the center of my own investment thinking.” – John Bogle


Researchers from Washington University in St. Louis are conducting an experiment to determine the impact of savings on child development.  Contributions of $1,000 are made towards a child’s college fund when they are born.

Then they track these children to test their development and progress. Here’s what they have discovered so far:

“The theory behind SEED OK is that accumulating assets within a household may positively affect the family’s outlook on that child’s future,” said Michael Sherraden, PhD, the Benjamin E. Youngdahl Professor of Social Development and director of the CSD. “Now, seven years later, we’re beginning to see this work yielding promising results.”

The program has shown that those parents whose children received this money for college reported that their kids are more socially and emotionally developed than the ones who in the study who were not given the money.

The best results have come from those in lower income households.

This is impossible to gauge with any precision, but the authors of the study feel that these parents see more potential in their children because they have the savings started for their education.

The expectations have been raised.

So whether the children are more developed or not, the parents are treating them as if they are. It’s a virtuous cycle that compounds and could actually mean a better life down the road for these kids.

Stay with me here as I’m about to make leap in my conclusion from this study (just go with it).

Saving money can act as a form of George Soros’s theory of reflexivity.

Reflexivity states that the valuation of any market can create a virtuous circle that alters that market in the future based on the actions of investors.

Basically, Soros is saying that the biases and views of investors can actually change the fundamentals that determine the prices in a market.

So higher stock prices can lead to increased investment by company management which could increase economic activity and thus lead to even higher stock prices.

Positive and negative feedback loops can cause prices to take off in either direction.

This is an important idea to grasp when trying to understand manias and panics that evolve from greed and fear. Soros has said that this is a common sense idea, but one that many don’t take the time to understand.

It’s not a perfect comparison with saving money because booms lead to busts and vice versa, but the self-reinforcing process is the link.

Studies have shown that saving money can lead to an increase in happiness. This seems obvious, but how much money people have saved has a much larger impact on well-being than income level.

Happiness levels off at a certain income threshold, but that’s not the case with how much you save.

Not only does your money compound when you save and invest for the future by delaying current consumption, but your happiness and perception of the future changes as well.

This is exactly what is happening with the college savings study.

The money in these savings accounts give the parents hope that their child will go to college someday, which in turn leads to positive reinforcement that can increase self-confidence and snowball from there.

There’s no guarantee that this has to work, but it’s an intriguing idea.

We’ve seen how behavioral biases can affect our decisions in a negative way, but in this instance, having an optimistic bias of the future is actually a good thing.

That’s why it’s so important for people to simply start saving so they can see some results and allow the positive feedback loop to kick in.

Coming up next week, how you can use the Black-Scholes option pricing model to get a new job…okay maybe not.

Source:
Child savings accounts promote social-emotional development, study finds (Washington University)

Listen to Dan Ariely’s podcast for more on this study:
Small savings, big difference (Dan Ariely)

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