July 13, 2016

Behavioral Economics: Understanding your financial behavior

brain

Your brain is a remarkable tool. So remarkable, in fact, that it has established decision-making protocols and processes that are outside of your conscious awareness. Because you have to make millions of decisions daily, your brain has developed shortcuts to help it efficiently use available information to make choices without having to stop and walk through an entire rationalization process for each little decision you have to make.

This is great when you are, say, selecting a coffee drink at Starbucks; you wouldn’t want to have to look at all of your options and compare prices, calorie counts, taste expectations, etc. Your brain knows what you’ve liked in the past, what your budget is, and what your desires are, and can make a snap decision. However, these shortcuts can pose a problem when making more serious financial decisions.

Behavioral economists have identified a number of heuristics – or cognitive shortcuts – that people are generally subject to when making financial decisions. These heuristics make decision-making easy but often irrational. It can also make us easy prey for people who understand behavioral finance. For example, imagine you walk into a store full of $10 shirts and find a shirt for $50; what a terrible price! But if you walked into another store full of $100 shirts and found the same $50 shirt, suddenly it becomes a much more appealing bargain. That particular heuristic, by the way, is called reference dependence, in which the context of a decision affects your choice.

The good news is that becoming aware of heuristics and biases is the first step toward uncovering your own tendencies to behave irrationally. Let’s take a look at a few of the most common heuristics.

Affect

The affect heuristic simply means that you pay attention to your feelings rather than carefully reflecting on a decision. For instance, imagine that you are considering purchasing stock in Disney and you recently had a great visit to Disneyland with your family; those positive feelings may make you more likely to purchase the stock outside of any objective criteria. On the other hand, if your computer just broke, you might shy away from purchasing Microsoft stock purely because it engenders a negative feeling.

Availability

What information do you have about a decision? If you use the availability heuristic, you will call to mind the most recent or available examples and use those to formulate your decision, rather than looking for a representative sample or broader information set. For instance, imagine that an investor is chatting with his colleague and hears about his friend’s frontier market stock that just collapsed. Later, when deciding whether or not to include frontier market stocks in his own portfolio, he calls that story to mind and declines. The story was the most available, but not the most representative, information.

Anchoring

Anchoring is similar to availability in that it describes the tendency to focus on a single piece of available information or reference point, even if that information is insignificant or irrelevant to the decision at hand. Sometimes called anchoring and adjusting, here’s an example: behavioral economists Amos Tversky and Daniel Kahneman did a study in which they had people spin a random wheel of fortune and then guess what percentage of African countries are in the United Nations. Those who spun a ten answered much lower (median guess of 25%) than those who spun a 65 (median guess of 45%).

Bandwagon (groupthink)

This is a well-known but often underestimated heuristic. Researchers have shown that the degree to which people are influenced by others, even when they are incontrovertibly wrong, is substantial. A famous experiment in 1956 by social psychologist Solomon Asch demonstrated the power toward social conformity by having subjects answer a simple question among a group of peers who were confederates of the experimenter. Unbeknownst to the subject, the confederates were instructed to answer the question incorrectly, thus prompting the subject to agree with them rather than provide a correct answer, which they did 75 percent of the time! Do your own research and beware of the bandwagon effect.

Choice supportive bias

How good were the last ten decisions that you made? People will tend to remember their choices as good ones, assigning positive attributes to their selections even if it means distorting their memory to do so. For instance, think of the last major purchase you made, where you compared different alternatives and made a final selection. Now, you are likely to consider all of the ways in which your decision was a smart choice, and to downplay any negative consequences of that choice. That bias will affect future decision-making.

Confirmation bias

Everyone holds certain preconceptions. Confirmation bias suggests that people will work hard to mentally confirm those beliefs, viewing information through the lens that interprets it in favor of the previously held belief. This is dangerous because people will focus on a single possibility and ignore any alternative or conflicting information. The backfire effect is a related heuristic, where presenting alternative information may cause someone to simply dig their heels in further, resulting in a strengthening of the prior belief rather than countering it.

Endowment effect & loss aversion

People are generally risk averse, and the pain of losing something tends to be greater than the happiness of gaining something. For this reason, people will require more to give something up that belongs to them than they would pay to acquire the thing in the first place. For instance, in one study, people were given either a mug or a pen, which were of equivalent value, and then offered the option to trade for the other. A purely preferential trade should have resulted in about half of subjects trading, but only 22 percent actually did so. Once they had been endowed with the object, they developed a preference for that object. In a variation of the experiment, subjects were asked to name the price at which they would either purchase a mug or would sell a mug they already had. The average price at which subjects offered to purchase a mug was $2.25, but the average price at which subjects would sell a mug they owned was almost $6.00!

Framing

Half-empty or half-full? How you see the glass may depend more on how it is presented to you than on whether you are an optimist or a pessimist. Imagine: would you prefer your bank to provide an account for free but charge a fee for a low balance, or charge for the account and offer a discount for keeping a minimum balance? Most people prefer positive framing, even though the end result is the same. For instance, politicians know that a policy described as “increasing the employment rate” will garner more support than one that “decreases the unemployment rate.” Framing is one of the strongest biases there is, and strangely, people become more susceptible with age.

Gambler’s fallacy

If you flip a coin and get tails ten times in a row, what are the chances that you will get tails on your next flip? The answer, of course, is 50%, though that flies in the face of our intuition, which suggests that the chances should be lower since it would be the 11th in a row. This is the gambler’s fallacy, in which people believe that future probabilities are affected by past events. This is one of the reasons that investment disclosures are required to include a statement like, “Past performance is not a guarantee of future results.”

Hyperbolic discounting

Why do people put off saving for retirement? The answer is hyperbolic discounting, the tendency to assign greater value to rewards in the present than rewards in the future. One can almost assign an algorithm to the rate at which future rewards decrease in value for people; many individuals would rather have ten dollars today than twenty dollars in a year, or fifty dollars in two years. You can see the illogic of that, and how it might contribute to poor financial decision-making.

Overconfidence

We all know that people naturally make mistakes; however, most people think of themselves as being right most of the time, whether or not that’s objectively accurate. In tests, individuals consistently rate their accuracy higher than their actual accuracy, implying more confidence than actual correctness. The overconfidence bias results in people having confidence in their own judgment, rather than accepting outside information or listening to conflicting opinions or ideas.

Status quo bias

Why do most retirement plan participants stay with the plan’s default option? This is the result of the status quo bias, in which the current situation is preferable to a change. This preference shows up in everything from elections, where incumbents typically have a significant advantage over newcomers, to brand loyalty, which, as most marketers understand, can be extremely powerful.

As an investor, how do you overcome your human tendencies toward irrationality? The first step is to understand, recognize, and accept that you are very likely subject to these biases. Your brain has developed these tools to help you make decisions, and much of the time they are helpful, but they can be a hindrance when it comes to smart financial choices. Once you are aware of your biases, it’s much easier to counter them with a more rational approach. One of the best pieces of advice for investors may be the ancient Greek aphorism, “know thyself.”