Our goal, by the end of this post, is to help you rethink what makes you and the people around you tick.
Once you see how systematic certain mistakes are, and how we all repeat them, again and again, we hope you’ll be able to learn how to avoid some of them.
Or at least laugh when you see yourself making them in hindsight.
- Heuristics, framing and market inefficiencies are likely to influence your economic behaviour;
- Anchoring means we generally operate around the first proposed bit of information;
- Confirmation bias means we're looking for information that confirms what we already think;
- Humans feel overconfident, once an event has occurred, that the event was predictable;
- Gambler’s Fallacy, Hot Hand Fallacy and herd behaviour also nudge us towards outcomes.
Since the 1960s, behavioural economics has given us a number of ways to think about how we make financial decisions, and how those decisions are often consistently irrational.
Daniel Kahneman and Amos Tversky are often called the fathers of behavioural economics because of their seminal paper, Prospect Theory: An Analysis of Decision Under Risk.
They managed to integrate ways in which humans make decisions, when they're uncertain about something, into economic science.
In this post we’ll walk through a primer on behavioural economics and a bunch of heuristics and biases that you likely have.
The Three Themes of Behavioural Economics
There are three things that most behavioural economists agree are at the heart of behavioural economics, namely:
- Framing; and
- Market inefficiencies.
Heuristic comes from the Greek word heuriskein meaning to find. It's an approach to problem solving, learning, or discovery that uses a working method, but not necessarily a perfect one, that is sufficient for the immediate goal.
Basically, most of us are lazy and we make the vast majority of our decisions using mental shortcuts or rules of thumb.
And most of the time that’s fine, but when it comes to making financial decisions, we need to use more than heuristics. Our heuristics mainly keep us alive, not financially secure.
Money is a new invention and we’re still learning how to work with it.
Our most fundamental heuristic is trial and error, which can be used for everything from matching nuts and bolts to finding the values of variables in a math problem. And it’ll work with your finances too, that’s how most people do it. But it’s not efficient.
We want to give you better tools that you can choose to use if you wish.
Framing is a cognitive bias where people react to choices differently depending on how its presented: e.g. a gain or a loss. A good example of framing in action is in Kahneman and Tverksy’s prospect theory, where they found that people tend to avoid risk in gambles that make them money, and seek risks when gambles are framed in losses.
It’s easier to understand through example.
Which of the following would you prefer?
A. 50% chance to win $1,000, 50% chance to win nothing; or
B. $450 for sure.
If you’re like most people, you want the sure thing. Even if the expected value of option A is higher (0.5 * 1,000 = 500, which is greater than 450).
Now let’s flip the problem so it’s about losses.
Which of the following would you prefer?
A. 50% chance to lose $1,000, 50% to lose nothing; or
B. Lose $450 for sure.
This time it’s different, the gamble seems much more appealing, even though the expected value of the gamble is lower.
The takeaway here is that the way information is presented, affects our decision-making, in irrational ways.
The market is inefficient according to behavioural economists. This is contrary to the efficient market hypothesis, an investment theory that says it is impossible to beat the market because the stock price always reflects all relevant information.
As such, it would be impossible to outperform the overall market through stock picking or market timing. However, Behavioural economists believe that there can be mis-pricing because of non-rational decision making.
We rely heavily on the first piece of information given to use when making decisions. Behavioural economists call this cognitive bias anchoring.
Once an anchor is set, we use that initial piece of information to make our subsequent decisions. This means that we’re constantly adjusting away from the anchor, and we have a bias toward interpreting information around that anchor.
A real life example, when you go into a job interview and get a job offer, the initial salary offered will set the standard for the rest of the negotiation, so that the price so you won’t ask for anything super out of the ballpark of the initial offer. This is why you should always say how much you want to be paid, to anchor them at a reasonable number.
Anchoring goes beyond just money, too. A great example of this in the current press is Donald Trump, sparking the debate over whether he is worth billions, millions or somewhere in between.
Whatever the actual answer is, President Trump has cemented in our collective mind that he is a tremendously successful businessman. He made us “think past the sale”, like a good used car salesman.
Despite what you think about Trump, don’t let his bad hairstyle fool you, he is a savvy communicator, one that is highly trained in the art of persuasion. He literally wrote a book about it.
Anchoring is powerful.
We’re all mental accountants, for better and for worse.
Mental accounting was coined by Economics Nobel winner Richard Thaler. It refers to the tendency for people to separate money into several mental buckets based on a variety of subjective criteria – like where the money came from.
I know we’ve all got our tax return and then blown it on something stupid, something that we’d never buy with our pay. That’s an example of mental accounting, we value tax return money less than salary money, even though money is fungible.
A dollar from your salary, and a dollar from your tax return are both a dollar. But we treat them differently.
A good example of a bad use of mental accounting is people who keep investing in the stock market when they have substantial credit card debt.
The reason you don’t want to do this is because you’re unlikely to earn a better return on your investment than what your credit card company is charging you (15%+).
Yes, even celebrities like Dustin Hoffman are mental accountants.
Confirmation Bias, or the “Yes I’m right, but I’m actually wrong” Bias
Confirmation bias is the tendency to search for, interpret, favour, and recall information in a way that confirms one’s preexisting beliefs. One of our favourite authors, Tim Kreider, puts it best in We Learn Nothing:
One reason we rush so quickly to the vulgar satisfactions of judgment, and love to revel in our righteous outrage, is that it spares us from the impotent pain of empathy, and the harder, messier work of understanding.
The truth is, there are not two kinds of people. There’s only one: the kind that loves to divide up into gangs who hate each other’s guts. Both conservatives and liberals agree among themselves, on their respective message boards, in uncannily identical language, that their opponents lack any self-awareness or empathy, the ability to see the other side of an argument or to laugh at themselves. Which would seem to suggest that they’re both correct.
Confirmation bias is stronger for emotionally charged issues and deeply entrenched beliefs, like many of our beliefs about money.
This one is especially important to pay attention to, because you don’t want to make decisions based on what you already believe, if what you already believe is wrong.
Hindsight Bias, the rearview mirror
Above is the survivorship bias, but I think you can also look at it as a hindsight bias. Humans feel overconfident, once an event has occurred, that the event was predictable, even though they may have no real evidence that it was.
The hindsight bias can cause memory distortion (like the stick figure above), where recollection and reconstruction of content can lead to false outcomes. I think we all know that buying heaps of lottery tickets isn’t a good idea, but if you met someone who did it all their life and finally won, they might tell you otherwise. Be wary.
Two Sides of the Same Coin: Gambler’s Fallacy and Hot Hand Fallacy
The Gambler’s Fallacy says that humans think things that have happened more frequently than normal during some period, will happen less frequently in the future. Like if you’ve lost many bets in a row, your chances of winning the next bet are higher.
The hot hand fallacy is the opposite, when people feel like because they’ve won many times in a row they’ve increased their chance of winning the next one. Clearly, one of these is wrong. You can’t have your cake and eat it, too.
They’re both wrong. It turns out that we just see patterns in independent, random chains of events, even if they’re not actually there.
So next time you’re playing roulette and there has been a long run of reds, don’t think black is up next, it’s random. And if you’re on a streak by betting on red, maybe walk away from the table.
Baa. Baa. Baa. Herd Behaviour.
I’m sure we’ve all heard “If all your friends jumped off a bridge, would you jump too?”. It's usually as a way to persuade us not to do something.
If everyone you know is doing something, maybe it's a good thing. But maybe it isn’t. All you have to do is look at the tech bubble in the 2000’s to realise that the crowd isn’t always right.
The key thing to understand is that we have a tendency to mimic the actions, whether rational or irrational, of the larger group. It’s easier to be wrong with everyone than right and alone. But a lot of the best investments are contrarian in nature.
- Don’t get in strangers’ cars
- Don’t meet people from the internet
- Literally summon strangers from the internet to get into their car
We often assume that the data we have in front of us is a good representation of the full picture. Like the image below, it’s often not as bad as we think it is, and the event is just an anomaly.
Look past the noise and see if anything has really changed, or if you’re just suffering from the availability heuristic.
It’s Okay to be Irrational
We usually think of ourselves as sitting the driver's seat, with ultimate control over the decisions we made and the direction our life takes; but, alas, this perception has more to do with our desires-with how we want to view ourselves-than with reality – Dan Ariely, Predictably Irrational
We are far less rational than we think we are, and that’s fine. We’re predictably irrational, once we know our flaws we can set up systems that help us avoid consistent mistakes.
Understanding behavioural economics helps us avoid emotion-driven decision-making, and thus devise an appropriate approach to personal finance.
If you’re interested in learning more about behavioural economics, heuristics and biases, we recommend the following books:
- Nudge, by Richard Thaler;
- Misbehaving, by Richard Thaler;
- Predictably Irrational, by Dan Ariely; and
- Thinking Fast, and Slow, by Daniel Kahneman.
Or if you’re more interested in videos, we recommend the following TED talks to get started:
Dan Ariely: Are We in Control of Our Decisions?
Daniel Kahneman: The Riddle of Experience vs Memory.
Dan Gilbert: Why We Make Bad Decisions.
We all make the same types of mistakes over and over, because of the basic wiring of our brains. – Dan Ariely