These Three Questions Can Give You Unique Insight into Clients’ Time Preferences and Risk Attitudes

You can use a simple test, called the Cognitive Reflection Test, to better understand, and thereby better serve, your clients.

There are various versions of Cognitive Reflection Test. Here I present one version (from the Shane Frederick article mentioned below) that consists of three questions that are designed to distinguish between respondents who make snap decisions and those who reflect long enough and carefully enough to see past the surface to the underlying facts.

Research has found strong associations between the results of this simple test and subjects’ time preferences, and their attitudes toward risk.

Here are the questions. You can take the test for yourself. You can also use it with clients and prospects. Answers are at the end.

(1) A bat and a ball cost $1.10 in total. The bat costs $1.00 more than the ball. How much does the ball cost?

Answer: _____ cents.

(2) If it takes 5 machines 5 minutes to make 5 widgets, everything else equal, how long would it take 100 machines to make 100 widgets?

Answer: _____ minutes.

(3) In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake?

Answer: _____ days.

Please try the test yourself, and write down your answers. Each correct answer is worth one point. Your score on the test is the sum of the points. Possible scores therefore are 0, 1, 2, and 3.

A variety of studies over the years (for example, Shane Frederick in a 2005 article in Journal of Economic Perspectives, and John Nofsinger in various articles including the 2007 “How analytical is your financial advisor?”) have found that there are certain systematic tendencies among the ways that people answer the Cognitive Reflection Test.

Understand Your Clients

The three questions above are mathematical questions, and each has a single, provably correct, answer. However, studies have found that the Cognitive Reflection Test is no so much a math test as a test that reveals, astonishingly, time preferences.

Time preferences, of course, are at the heart of investment decisions.

Have you answered the questions yet? If not, please do so. You don’t have to share the answers with anyone.

Shane Frederick reports that in a study conducted at Princeton, people who answered “10 cents” to question (1) “were found to be significantly less patient than those who answered ‘5 cents’.” (Five cents is the correct answer).

And more generally, low scores on the overall test (especially zero) tend to correlate with people who are impatient on other measures. Impatience can be incompatible with many long term investment strategies.

Some investment strategies require more patience than others. If you have clients who take the test and score low, you might want to spend extra time with them teaching them of the role of patience in investing, and possibly, adjusting their investments to be more compatible with their impatience.

In addition, some impatient people, as revealed by relatively low scores on the Cognitive Reflection Test, also display “irrational” attitudes toward risk.

These results are less clear, but it might be worthwhile for an advisor to learn a client’s score on the Cognitive Reflection Test, and if the score is low, to spend extra focus making sure the client understands the “rational” way to think about risk. When we say “rational” we mean, in general, expected value analysis for relatively small changes in wealth, and for most people, risk aversion toward large (in terms of total client wealth) potential losses. There’s a lot going on here, and we can cover only a small fraction in this post.

A Note on Average Scores

The possible scores on the three question test are 0, 1, 2, and 3. If you want to know “am I smarter than a Princeton student?” you might want to consider that the 121 Princeton students who took the test (reported by Frederick) scored as follows:

0 18%

1 27%

2 28%

3 26%

Here are the answers:

(1) 5 cents

(2) 5 minutes

(3) 47 days.

© 2022 Roger D. Silk, Lifetime Perspectives, Inc. Blog Post 22.02

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