We all know-except maybe tobacco company lawyers and CEO's-that smoking cigarettes is not conducive to good long-term health.  Far from it...and thankfully the message has gotten out.  Adult smoking rates have declined from over 40% in the 1960's to below 20% today.

Yet many people choose to smoke, or more likely find it difficult to quit. Lots of things have been tried over the years, including willpower, hypnosis, acupuncture, patches and multi-billion dollar drugs.

But what about cold, hard cash?

Recently, the New York Times reported on a research study conducted to investigate whether financial incentives would assist smokers in kicking the habit.  2,500 CVS Pharmacy employees (including their friends and relatives) were randomly assigned to different programs and voluntarily decided if they would participate.  The programs were structured like this:

The first option required a $150 deposit which would be returned after six months of no smoking, along with a $650 reward.  However, the deposit would be forfeited if the person smoked during the six month period.  

The second option had no deposit but paid a higher $800 for six months of no smoking.  Only 14% of those randomly assigned to the first option ($150 deposit) agreed to sign up, compared with a 90% acceptance rate among people assigned to the second option (reward only).

Guess which group had a higher success rate?  Of course, the one with a higher payout of $800 versus $650, right?  Wrong.  The $800 reward only group's success rate was an abysmal 17% compared to over 50% for the $150 deposit group.

Why did the deposit group achieve a much higher success rate?  Something behavioral economists (yes, these people do exist) call Loss Aversion.  Which means that people feel the sting of losses much more heavily than the joy of gains.  So the deposit group put more emphasis on not losing their $150.  The no-deposit bunch didn't have any money at risk, and probably wasn't as psychologically committed to the program.

Investors can learn a thing or two from these experiments.

Many bad ideas begin with a good one.  Being concerned about losing money is a good idea.  But taken to the extreme, it can lead early retirees, pension plans, endowments and others with very long time horizons to fail to achieve long-term goals because they have hesitated to make the commitment to invest. 

It can also lead investors to sell stocks during bear markets, creating short-term pleasure but long-term pain when retirement time rolls around.

A better idea is to be objective about risks and rewards.  Balance out the concerns and risk of loss with the realistic potential for opportunity on the other side of the coin.