Mapping Irrationality

An Introduction To Behavioral Economics

Uriel Soberanes | unsplash.com

On September 9, 2017, Richard Thaler earned the Nobel prize in Economics for his contributions to the field of behavioral economics. That very same week Bitcoin surged above $5000 while Jamie Dimon proclaims Bitcoin investors are stupid. How are the two developments related? Think of how emotions such as fear, greed and anger affect business outcomes and asset bubbles.

Behavioral economics, along with behavioral finance, has come to occupy an important place in explaining financial markets and asset prices. In a way,both disciliplines try to explain how human thought works using economic models. Perhaps, the future of behavioral economics is closely tied to the advances in Artificial Intelligence. At the end, both social science and science are attempting to recreate human behavior.

This article explains how behavioral economics affects your life and how it can help you understand forces that affect your financial and economic well being.

The Foundations

Economics is a study of choice. Choices have to be made because most humans have finite resources and choices have trade offs. Trade-offs or the things given up to enjoy other things are known in economics as ‘opportunity costs’. Perhaps, the most important finite resource that humans have is time. Choosing what you do with your time decides how much of a different resource you will have access to i.e. how much money you make.

How people spend economic resources can, sometimes, be explained by the study of human psychology including biases, behaviors, social and emotional factors. Every decision to spend economic resources by an individual or an institution has an effect on various variables including but not limited to asset prices, market movements and the broader economy. Today, the choices that multinational institutions or important individuals such as the chairmen of Central Banks and other such global leaders make have an impact on the global economy because of complex interlinkages created by globalization. Think of chaos theory and the effects a butterfly flapping its wings half way across the ocean can have on a seemingly unrelated variable.

The study of such choices using human psychology as the lens, in a nutshell, is called behavioral economics.

We Prefer Shortcuts

In behavioral finance as in everyday life, we use shortcuts for convenient and quick decision making:

Heuristics

Humans take roughly 95% of our decisions using ‘Rules of Thumb’. Rules of thumb may be great at coming to quick decisions but all decisions may not be correct. Some can prove very expensive. The term ‘Rule of Thumb’ is believed to have originated from carpentry where carpenters used their thumbs to measure things. Rule of Thumb is also known as an educated guess or guesstimate. Examples include estimates given by an employee to his manager on the time it would take to complete a project, not starting some work on Thursday’s out of some belief without any sound reasoning, estimating the time it would take to reach the airport after considering variables such as time of the day, weather and traffic conditions.

As you can see, heuristics encompass virtually every decision we take in our everyday life.

Framing

Based on the views of a common group or set of people, that create stereotypes or mental filters and theoretical perspectives on how life works. Amos Tversky and Daniel Kahneman (1981) demonstrated multiple studies where people’s choices change depending on how the problem was framed. Frames are therefore anecdotes, stereotypes that people use to respond to events.

Anomalies and Black Swan Events

A lot of factors can result in mispricing of financial assets such as unfair competition, financial crisis, dot com mania, regulatory events etc. The behavior of market participants such as rampant speculation in Bitcoin and other crypto currencies can be completely irrational and lead to deviations from the efficient market hypothesis.

Thought of The Ages

One of the earliest treatise that blends, Economics, politics and human behavior with Statecraft is Kautilya’s ‘Arthashastra’ composed between 2nd and 3rd century BC in ancient India. Kautilya wrote:

“The root happiness is Dharma (ethics, righteousness), the root of Dharma is Artha (economy, polity), the root of Artha is right governance, the root of right governance is victorious inner-restraint, the root of victorious inner-restraint is humility, the root of humility is serving the aged”

Classical economists such as Adam Smith closely tied behavior to microeconomics. Most notable is the concept of utility. Economics began to be thought of as a science during the neoclassical era. However, many neoclassical economists such as Vilfredo Pareto (economist behind the 80/20 rule) did emphasize psychology behind their economic theories. Harry Markowitz, whose research can be applied to stock picking marks an important milestone in modern behavioral finance. The work of Daniel Kahneman and Amos Tversky on psychology when applied to economics provided valuable inputs to the development of modern behavioral economics.

The Concept of ‘Intrinsic Value’

As per Investopedia , the intrinsic value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value.

In simple terms, anything has intrinsic value as long as you can put it to use. For instance, the intrinsic value of a metal such as gold depends on its industrial uses and on its use as jewelry in some parts of the world. Is the current market value of gold close to its intrinsic vale? Many say it is not. However, gold has a special place because it is scarce and its scarcity led to currencies being pegged to the gold in the past. The point is: determining intrinsic value is as much art as math. Three questions to bear in mind to help determine intrinsic value are:

1. Is the resource scarce?

2: Is it liquid (readily salable in a public or private market)?

3. Is it widely perceived to have application as an input?

Bitcoin: The Classic Debate

One of the key tenets of economics is that every individual acts rationally. When you extend that to behavioral finance, it means every individual is acting rationally taking into account his risk profile or risk appetite ie how much is he willing to lose. Bear in mind, risk should always be looked at from a time perspective. Even if you invest in a blue chip index fund at its peak and the market goes down, you will not have enough money to recover your initial investment. In short, what appeared as a less risky bet when you bought the index fund could turn out to be a bad risk if you cannot use the money when you need it the most.

As per classical economics, if a rational person chooses an apple over an orange and an orange over a melon, he should prefer an apple over a melon as well. However, what would you call a person who prefers a bond over equity and equities over crypto currencies but when making an investment decision, invests all his savings in Bitcoin for fear of missing out.

On the one hand, there are experts proclaiming bitcoin as a bad investment despite the fact that it has doubled in value every year since 2009. On the other hand, there are proponents of cryptocurrencies who think bitcoin represents an alternative to fiat currencies.

The answer may lie in acceptance by governments. However, if you are confused as most people are, apply Warren Buffet’s rule of investing ONLY in assets you understand.

That is not to say a lot of people will invest when bitcoin reaches an all time high for fear of missing out on exponential profits later even though they are at a risk of losing all their money in pursuit of a 4500% return.

Bitcoin can have an intrinsic value if it begins to be accepted universally as a medium of exchange, a store of value or a unit of account. Whether it will be accepted as such is a billion dollar question. In Bitcoin’s case, therefore, the answer to question 3 above is vital.

How Behavioral Economics Affects Your Life

Marketing Ploys

Ever wondered about the old practice of pricing products with a price that ends in 9 eg $9.99, $2.99, $0.99 etc. affects buying? These prices are intended for your brain to apply heuristics and quickly jump to a conclusion that $0.99 is better than a $1 which it is but only by $0.01. These are small “prompts” to your brain to produce a behavior intended to buy the product because it is cheaper if only infinitesimally. What really makes a person irrational is buying things just because they are priced with a price ending in 9 even though they don’t need it.

Advertising, marketing and sales have used subliminal messaging that affects your subconscious mind.

Investment Management

In their book “What They Do With Your Money”, Stephen Davis, Jon Lukomnik and David Pitt-Watson explain that over time the innocuous looking 1.5% in investment management fees that managers charge, can Over the years, eat up to 38% of your savings. That’s not to say that you wouldn’t have entrusted your money to a manager if you were equally capable. However, understanding this subtle computation can incentivize you to look at other options.

Corporate Fitness Programs

The above two examples illustrate some pitfalls to avoid. However, there are positive applications too. For instance, companies that run health programs giving rewards or incentives to quit smoking or to encourage employees to compete against other employees in running or maintaining a healthy lifestyle are all prompts to induce healthy behavior.

Business Decision Making

Justin Fox, former editor at Harvard Business Review outlined three basic decision making philosophies which can be applied depending on the context:

Conclusion

Economic models are meant to explain the rationale behind economic decisions made by individuals at the micro level and nations at a macro level. The trouble is very often, decisions are emotional and not necessarily rational. Fear, greed, instinct, approximation, desperation, anger could be produced by external stimuli and change which is anything but constant while economic models are based on the assumption “all else remaining equal”.

George Soros, hedge fund manager of the Quantum hedge fund explains in his theory of Reflexivity how rising stock prices prompts more buyers to buy the stock because of the fear of missing out (FOMO). This behavior creates a cycle where the effect becomes the cause and more buyers drive up the prices further. Soros applied the principles of behavioral finance extensively throughout his career to profit from market behavior at a macro level.

However, making bets on economic behavior is harder than making bets using raw data and news. Again, rational is a very relative term because in hindsight anything can be rationalized but paying attention to your emotions when making economic or financial decisions is key. It’s impossible to control our emotions all the time but being conscious of our biases can improve the odds of making sound investment decisions.

Richard Thaler’s book “Nudge” is a call to nudge people in the right way to avoid systematic biases (same mistakes that occur in particular circumstances) and to produce rational behavior.

Mapping the causes of irrational human behavior to correct it is like mapping the neurons in the human brain and stopping them or diverting them midway. With evolution in technology and a multidisciplinary approach, behavioral economics can become more of a science. Till then, the work of economists such as Richard Thaler remind us that the human desire to understand things outweighs the complexity involved in economic decision making. So, the next time you buy that unwanted item priced at $0.99, your behavior is an example in a study to map the unmapped and possibly unmappable terrain of the human mind.

Writer @ The Intersection of Finance, Tech & Humanity. Stories of a Global Language: “Money”. Contributor @ Startup Grind, HackerNoon, HBR. Twitter@akothari_mba

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