Economists have often looked to the world, not to the lab, for their wisdom. They explain human behaviour by observing and recording how a large number of people, say, select stocks to buy, choose mortgages or shop. Until about 20 years ago economic behaviour was considered a straightforward matter of logic-driven strategies like thrift, measured luxury and nest-egging.
But now lab experiments are in, and some of them are not even done by economists. They show that ‘illogical’ behaviour is every bit as natural as the ‘logical’, self-serving kind. And it took the work of psychologists like Daniel Kahneman, who shared last year’s Nobel Prize in Economic Sciences, to bring the economically irrational human element into the field.
Nowadays, there is a split in Kahneman’s realm of cognitive psychology. The argument is over methodology. On one side are the ‘natural decision making’ school of thinkers who base their work on observations in the real world, just like traditional economists do. They study people making actual decisions in real situations, in hospitals, nuclear power plants, the military, and so on (Klein, 2002). The irony is that last year’s Nobel laureate – lauded as an innovator – is of the old school, firmly lodged in the laboratory.
Just when researchers in Kahneman’s own area of cognitive psychology are moving out into the real world, economists are turning to the lab, as is the case with the economist who shared the prize, Professor Vernon L. Smith of George Mason University. The joint efforts of the disciplines have shown that the universality of some basic economic theory is a myth, and have provided related insights into intrinsic human motivation and decision making (Smith, 2000).
The standard theory about economic decisions that are taken in uncertain conditions is called expected utility theory. It assumes people make logical decisions and are motivated by the simple, unsullied urge to make – or keep – as much money as possible. This is based on comparing alternatives with outcomes valued on different dimensions. Cognitive psychologists also broadly think of people as logical information processors, with the added influence in their interpretations of emotions, attitudes and previous experience. Kahneman found that when future consequences were uncertain, we seem to lose our ability to analyse situations fully. Instead, we rely on hunches and rules of thumb (Kahneman et al., 1982; Tversky & Kahneman 1986).
Take the case of an investment fund manager who, two years in a row, beats the standard benchmarks for earnings. Most investors would conclude that he or she is systematically more competent than the competition. The true statistical implication is much weaker. The Nobel committee pointed out that these false deductions – essentially interpretative shortsightedness and overgeneralisation – are now helping analysts understand puzzling financial market phenomena, such as seemingly unmotivated fluctuations in the stock market (DeBondt & Thaler, 1985). Indeed, linking this sort of psychological insight to financial market analysis has become an active area of research, known as behavioural finance (Montier, 2002; Odean & Barber, 2002; Shiller, 2000; Tvede, 1999). There is also a growing body of research called experimental economics (see Brandts, 1989; Davis & Holt, 1993; Kagel & Roth, 1995; Smith, 1991). This field tests economic assumptions in the laboratory, again largely drawing on Kahneman’s work.
Economists have always been aware that people don’t all act alike in the same set of financial circumstances. If they did, things would be a lot easier for economists. But in the past they put these differences down to differences in values. The assumption was that people would behave ‘rationally’ but that each would, in accordance with their values, make the decisions most likely to advance their interests. Behavioural finance and experimental economics researchers study why they do not.
In one famous experiment, Kahneman highlighted a typical irrationality. In hypothetical scenarios, people say they would be willing to drive for miles to get a small discount off an already cheap item. But they would be reluctant to do the same for the same sum of money off a large purchase (Tversky & Kahneman, 1981). In other words, people seem to base their decisions on isolated cases. After all, if the saving is the same, why is the petrol money worth it for the cheap item and not for the expensive one? All of this contradicts standard expected utility theory maximisation, which is the traditional theory economists apply to this sort of behaviour.
Kahneman says such experiments gave him insight, and that he has changed from viewing the utility of wealth to viewing the utility of gains and losses as the major factor driving economic behaviour. Hence, one person may invest £10, make £5 and be happy, while another invests £40, loses £5 and is miserable. The second is still better off financially, but it seems to be human nature to focus on short-term gains and losses and not on overall wealth.
Another fascinating finding is that, everything else being equal, most people are much more interested in making sure they don’t lose money than they are in actually making any (Kahneman & Tversky, 1979; Thaler & Johnson 1990). When we mentally balance the pros and cons, we put more weight on the negative value of a loss, giving it two to three times the importance we give to the positive value of the same size of gain. Or, as economists would have it, the value function shape for losses is relatively steep. For gains it is flatter. This has been confirmed in hundreds of subsequent experiments.
Good examples of this bias are found in the work of Professor Terrance Odean of the University of California, for whom Daniel Kahneman was a mentor, advising him to pursue postgraduate study not in psychology but in finance because the research and job opportunities were far greater in the business world. In one study Odean looked at investment patterns of 10,000 US households and found that investors much preferred to sell off investments that were doing well – the ‘winners’ in their portfolio. On the other hand, they were very reluctant to cut their losses and sell off underperforming investments (Odean & Barber, 1999). In psychological terms, this is called the disposition effect. The interesting question is why does such an effect exist? Why do people tend to cling to ‘losers’?
Odean believes it has nothing to do with an attachment to the underdog. It is simply because we don’t want to admit our mistakes. We go into denial and ‘regret avoidance’. We are reluctant to experience the obvious pain of admitting a mistake and are afraid that as soon as we sell poorly performing stock, the price will bounce back up again. Selling ‘winners’ however, has an obvious ‘feel-good’ factor, even if we then go on to invest less profitably – which Odean and Barber (2000) have found we usually do!
Even stockbrokers, with their wealth of financial information and experience, are very flawed moneymakers, subject to the influences of fear, greed and regret. Crucially, they tend to be overconfident about their decisions. We are all terribly prone to taking credit for gains but blaming unpredictable market forces for our losses.
In practical terms, some investors are now trying to avoid the obvious psychological pitfalls, such as trading too frequently, selling ‘winners’ too soon and hanging on to ‘losers’ too long. In this respect, women tend to do better than men because they tend to trade less frequently, which correlates with better returns (Odean, 2001). Good old-fashioned experience helps too, mostly because very experienced traders are more realistic about their capabilities. We need frequent, immediate and clear feedback to learn to curb our tendency to overestimate ourselves. But in the financial arena feedback is often ambiguous and comes well after a decision is made (Belsky & Gilovich, 1999; Gilovich et al., 2002). This may be one of the reasons financial decisions are particularly prone to the ‘irrationalities’ Kahneman identified.
Another important Kahneman insight is the tendency we have to view our beliefs as reality – what he calls ‘the illusion of validity’. Among other things, this helps explain the overconfidence Odean found in investors. We simply impute far more probability of truth to our personal opinions than they warrant. It also explains the ‘planning fallacy’, in which we exaggerate our confidence in our plans. The very existence of a plan tends to inspire overconfidence (Kahneman & Tversky, 1979).
Although Kahneman’s major contributions are in the in realms of heuristics and biases, prospect theory and experienced utility, he has worked in diverse areas of psychology (see boxes). He believes winning the Nobel Prize was as much a result of his choice of journal as the actual content of his paper. Speaking at his Nobel Prize bash at Princeton University, Kahneman said: ‘Because it was published in an economics journal, it had a fair amount of influence on the profession and it sort of legitimised a certain approach to thinking about decision making, which eventually, through the work of other economists, became influential in economics itself. The same would not have happened if exactly the same paper had been published in a psychological journal.’
Cross-fertilisation between disciplines is much vaunted nowadays. Psychologists working in human resources and careers counselling emphasise the desirability of dual-dimensional, or even multidimensional, education and training. But Kahneman was one of the first to walk across the campus and make his voice heard. The study that opened the faculty-fusing floodgates was Kahneman’s paper on decision making in circumstances where there is uncertainty (written with Amos Tversky, and published in Econometrica in 1979).
One reason these psychological ideas had not permeated economic thinking sooner is that economists are traditionally averse to experiment-based theories, seeing them as too removed from reality to have any validity. But still it’s surprising, particularly to psychologists, that this expected utility theory view persisted as long as it did. After all, we are all confronted with daily examples of seemingly irrational financial decision making, including our own, as Kahneman’s drive-for-a-bargain study plainly shows. By putting the psychological and economic research together, theorists have come up with many potent ideas, such as bounded rationality, restricted self-interest and limited self-control, all of which are important factors behind a range of economic phenomena. Overall, psychologists still tend to study the behaviours of small groups of individuals, whereas economists concentrate on statistical studies of markets. But the amalgamation of ideas has brought recognition that individually and collectively our emotions often distort our reasoning. The psychology/economics blend seeks to illuminate the method in our money madness.
- Jean Nicol-Maveyraud is a psychologist and writer based in Hong Kong. E-mail: [email protected].
Box: Colonic hedonics
In a renowned study of 682 colonoscopy patients, the procedure – in which a scalpel-armed tube is forced far into the colon – was prolonged for half of them by an extra pain-free minute before the colonoscope was removed (Kahneman et al., 1993). This changed the experience from high-peak intensity and a very painful ending to high-peak intensity but a less excruciating, if not happy, ending.
Those patients with the longer but pain-free end procedure were consistently more positive about the experience and were also more likely to choose to go through it again, given a choice of a non-intrusive alternative using barium and X-ray.
This focus on end moments in an episode, Kahneman believes, could help economists predict decisions. The phenomenon also has obvious implications for healthcare practitioners and beyond, raising ethical questions about the manipulation of pain, discomfort and pleasure to ensure more positive evaluations.
Box: You’re happy – though you may not know it
People in sunny California are no happier than those in the cold Midwest, Kahneman recently found, even though both groups imagine that Californians would be happier because of the weather. He concludes that nothing is as important as it seems when you’re thinking about it (Schkade & Kahneman, 1998).
In general, says Kahneman, we don’t have a clue about our own happiness. We evaluate our past experiences imperfectly and we usually don’t know what makes us content. We tend to focus on key moments and underestimate the importance of duration and our own ability to adapt. Most of us simply adjust to conditions and revert to our usual level of happiness.
Belsky, G. & Gilovich, T. (1999). Why smart people make big money mistakes: And how to correct them. New York: Simon & Schuster.
Brandts, J. (1989). Economía experimental y teoría de juegos: Un panorama. Cuadernos Económicos de ICE, 40, 253–276.
Davis, D. & Holt, C. (1993). Experimental economics. Princeton, NJ: Princeton University Press.
DeBondt, W. & Thaler, R. (1985). Does the stock market overreact? Journal of Finance, 40, 793–807.
Gilovich, T., Griffin, D. & Kahneman, D. (Eds.) (2002). Heuristics and biases: The psychology of intuitive judgment. New York: Cambridge University Press.
Kagel, J.H. & Roth, A.E. (Eds.) (1995). The handbook of experimental economics. Princeton, NJ: Princeton University Press.
Kahneman, D., Fredrickson, B.L., Schreiber, C.A. & Redelmeier, D.A. (1993). When more pain is preferred to less: Adding a better end. Psychological Science, 4, 401–405.
Kahneman, D., Slovic, P. & Tversky, A. (Eds.) (1982). Judgment under uncertainty: Heuristics and biases. New York: Cambridge University Press.
Kahneman, D. & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica 47, 263–291.
Klein, G. (2002). Intuition at work: Why developing your gut instincts will make you better at what you do. New York: Doubleday.
Montier, J. (2002). Behavioural finance: A user’s guide. New York: Wiley.
Odean, T. & Barber, B. (1999). Do investors trade too much? American Economic Review, 89, 1279–1298.
Odean, T. & Barber, B. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. Journal of Finance, 5(2), 773–806.
Odean, T. & Barber, B. (2001). Boys will be boys: Gender, overconfidence, and common stock investment. Quarterly Journal of Economics, 116(1), 261–292.
Odean, T. & Barber, B. (2002). Online investors: Do the slow die first? Review of Financial Studies, 15(2), 455–487.
Schkade, D.A. & Kahneman, D. (1998). Does living in California make people happy? A focusing illusion in judgments of life satisfaction. Psychological Science, 9, 340–346.
Shiller, R.J. (2000). Irrational exuberance. Princeton, NJ: Princeton University Press.
Smith, V.L. (1991). Papers in experimental economics. New York: Cambridge University Press.
Smith, V.L. (2000). Bargaining and market behavior: Essays in experimental economics. New York: Cambridge University Press.
Thaler, R.H. & Johnson, E.J. (1990). Gambling with house money and trying to break even: The effects of prior outcomes on risky choice. Management Science, 36, 643–660.
Tvede, L. (1999). The psychology of finance. New York: Wiley.
Tversky, A. & Kahneman, D. (1981). The framing of decisions and the psychology of choice. Science, 211, 453–458.
Tversky, A. & Kahneman, D. (1986). Rational choice and the framing of decisions. Journal of Business, 59(4), S251–278.
A comprehensive guide for bringing the power of money under control.
By her count, BBC Radio host Hammond (Time Warped: Unlocking the Mysteries of Time Perception, 2013, etc.) discusses 263 experiments by psychologists and neuroscientists that demonstrate how science can illuminate our many foibles and obsessions about money and deal with them effectively. The author—who has won awards from the British Psychological Society, the British Neuroscience Association, and other medical, psychological, and publishing associations for her contributions to the public understanding of science—reviews their insights, which range from the best ways to encourage children to improve their grades at school and teach them how to manage their pocket money to lessons about older, unconscious processes gleaned from Yale University’s work with token-managing monkeys. The primates, hoping for grapes, are taking part in experiments on loss aversion similar to those conducted on humans by neuroscientist Daniel Kahneman. “Just like humans, [the capuchins] seem to hate a loss” rather than seek the pleasure of a potential gain. Whether shopping or eating out, the motivation seems to be the same. Case studies illustrate how to make decisions about which kind of all-you-can-eat buffet to visit. Spending more for the buffet, for example, and really enjoying the food, works out better than eating from the cheaper spread. Pleasure, enjoyment, and good memories seem to be preferable as time passes, so for people who want to spend money on themselves, Hammond recommends buying “experiences rather than material goods.” In a practical, sometimes-amusing narrative, Hammond provides a valuable summary of work in psychology, behavioral economics, and more, and her numbered “Money Tips” are particularly helpful.
A delightful treatment of a subject many of us would prefer to ignore, gently subversive in its undermining of preconceptions and prejudices.