“Watching soccer is punishingly boring unless you root for one side. Without an emotional draw it is literally impossible to follow the game.” (Nassim Taleb)
The World Cup semi-final between Brazil and Germany would surely refute Taleb’s comment made a few days before the game, although he might counter with the observation that the result was a ‘black swan’ event. The fact is that most rational commentators and football experts could never have conceived in their wildest dreams that Brazil would concede seven goals.
Yet it happened. Conventional wisdom was overturned.
In like manner, behavioural economics has overturned traditional economic models although not because of extraordinary exceptions; but because it better relates to real people in the real world. Traditional models assume that people are always rational decision makers who fully analyse data and act logically before they reach conscious decisions. Behavioural economics refutes this by demonstrating that human beings both have hardwired biases and also make mental shortcuts.
Nowhere are mental shortcuts more evident than in people’s attitude towards wealth, savings and investment. This article highlights seven common cognitive biases.
A foundation of the psychology of investment is Prospect Theory. Multiple experiments and academic research, coupled – importantly – with real life examples show that investors dislike losses with around double the intensity compared to how much they like gains of the same magnitude. Traditional economic theory would suggest this should not happen.
It’s always interesting, therefore, to see how investors approach unrealised book losses on a stock they have previously purchased, for example. Do they still believe in a particular stock that has disappointed? Will they buy more, and risk succumbing to the sunk cost fallacy? Or do they particularly dislike crystallising losses – loss aversion – and start to hope for, as opposed to honestly anticipate, price improvement? And if they were setting up a new portfolio, would they buy the same stock; if not, why not? There are a lot of potential biases and heuristics possible in these circumstances.
Human beings have an instinctive, hard-wired reactive way of thinking, as well as a more recently evolved rational, analytical side – what Nobel Prize winner, Daniel Kahneman, calls System 1 and System 2. We all like to think that we are constantly using System 2. But the hard-wired, emotive and unconscious System 1 can never be switched off and we accordingly rely on it far more than we believe. This can sometimes lead investors and savers to make decisions that are irrational at worst and sub-optimal at best. In Jonathan Haidt’s words, “the emotional tail wags the rational dog.”
Having worked in the investment industry for 27 years at three great asset management firms – Schroders, PIMCO and Goldman Sachs – and in my time witnessed in the markets a variety of financial bubbles and credit crunches, I am convinced that insights from psychology are equally important as economics, indeed probably more important, in understanding how financial market participants act, both individually and in aggregate. Partly as a result of the global credit crisis, and partly because of a growing interest in the psychology of investments, a lot of private investors, as well as institutional pension funds and their consultants, are increasingly interested in the fresh perspective it offers.
Psychologists estimate that the human brain is potentially subject to over 150 different biases, and other examples include base rate neglect (ignoring the statistical facts and figures, often in favour of an emotionally appealing or attractive story – a real life example is the popularity of some ‘Pseudosciences’ such as astrology or homeopathy, despite minimal supporting evidence); or anchoring whereby we might consciously or subconsciously latch on to a number as a reference point. In one experiment, Daniel Kahneman, asked his subjects what percentage of African nations were members of the United Nations. Those who were asked whether it was more or less than 10% guessed on average the answer 25%; whilst the answers of those asked if it was more or less than 65% averaged 45% (1).
Another psychological insight relating to money and savings is confirmatory bias – a common feature in our industry. We often come to an investment conclusion quite quickly. But then we tend to find reasons to back it up and we often filter out things that do not quite fit our story or our argument.
There are perfectly good evolutionary reasons to be confident and even optimistic. Without optimism, a form of “mental time travel,” as Tali Sharot notes, “our ancestors might never have ventured far from their tribes and we might all be cave dwellers still, huddled together and dreaming of light and heat.” (2). But the optimism bias and confirmatory bias can lead to mistakes. You could imagine a situation in which an optimistic investor has lots of good reasons to own a stock, having done the research. Now what happens if that person is faced with contradictory evidence or opinion? Often people will reject something that doesn’t agree with their view rather than genuinely re-evaluate the situation.
I have always therefore liked the John Maynard Keynes comment: “When the facts change, I change my mind. What do you do, Sir?” We need to question our assumptions.
As a historian, I am particularly interested in booms, bubbles, and busts in market cycles. These are often viewed simply in terms of fear and greed, but in reality they reflect many underlying behavioural biases such as the bandwagon effect, that were just as prevalent in the ‘Tulipmania’ bubble in seventeenth century Holland as they were during the 1990s ‘Dot-Com’ boom. As Mark Twain is alleged to have said: “History does not repeat itself, but it does rhyme.”
Behavioural Economics in the business world is becoming increasingly important, providing individuals and firms with a competitive advantage. Above all, it emphasises the importance of challenging our in-built biases, in order to optimise our chances of reaching better conclusions.
Behavioural economics is certainly gaining ground, not just in the financial industry (regulatory bodies such as the FCA are very keen), but also in media and advertising, as well as in society at large. The behavioural insights team in the Cabinet Office, colloquially called the ‘Nudge Unit’, have found plenty of ways to encourage people to do the right thing for everyone’s benefit, through understanding better how people make decisions. It has looked at everything from school meals to tax collection to health, to savings – and the results are very encouraging. These ideas are gaining ground everywhere.
For example, in the country which won the 2014 World Cup, Germany, one has to ‘opt in’ to become an organ donor and the consent rate is around 12%. In Austria, where you have to tick a box to ‘opt out’, their consent rate is over 95% (3). Why the difference? Because of the status quo bias. A similar strategy from ‘opt in’ to ‘opt out’ resulted in the UK’s adoption of auto-enrolment in DC schemes, with beneficial consequences.
Behavioural economics is relevant to everyone; it is fascinating and often fun, and it is backed up by psychology and academic research. Above all, do not underestimate how much being aware of your biases could improve your business and investment decision-making.
July 14th, 2014
(1) Amos Tversky and Daniel Kahneman, Judgment under uncertainty: Heuristics and biases (1974).
(2) Tali Sharot, The Optimism Bias (2012)
(3) Richard Thaler, Opting in vs. Opting Out. The New York Times (2009).