by Kabir Sehgal
At the height of the global financial crisis, in the autumn of 2008, Alan Greenspan responded to an inquiring congressman as to whether the prevailing wisdom of rational markets had failed: “That’s precisely the reason I was shocked, because I had been going for forty years or more with very considerable evidence that it was working exceptionally well.”24 In his postmortem of the 2008 financial crisis, Greenspan writes that the prevailing forecasts didn’t account for the “animal spirits” that John Maynard Keynes once described as “spontaneous urge to action rather than inaction, and not as the [rational] outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”25 In sum, human behavior is guided at times not by logic and so-called rationality but by other forces, such as emotions like fear and euphoria. Greenspan summarizes his epiphany:
We like to describe ourselves as fundamentally driven by reason to an extent not matched by other living creatures. This is doubtless true. But we are far from the prototype depicted by neoclassical economists: that of people motivated predominantly by considerations of rational long-term self-interest. Our thinking process, as behavioral economists point out, is more intuitive and syllogistic… The economics of animal spirits, broadly speaking, covers a wide range of human actions, and overlaps with much of the relatively new discipline of behavioral economics. The point is to substitute a more realistic version of behavior than the model of the wholly rationality-driven “economic man” so prominent for so long in economic courses taught in our universities.26
It remains to be seen whether forecasts that incorporated more “human” factors would have predicted the financial crisis—though it doesn’t take a sophisticated model to realize that housing prices won’t continue to rise forever. Nevertheless, many forecasters recognize the failure and folly of their previous predictions. They seek new ways to understand human psychology and behavior when making financial decisions.
Oh, Behave!
In 1955, a young psychologist and lieutenant in the Israeli army, Daniel Kahneman, was tasked with determining which candidates would make successful officers. He arranged a team of eight candidates without their ranks displayed and directed them to raise a large log over a tall wall without it touching the wall or ground. Kahneman took a logical approach to evaluating the candidates: He observed who took charge and who followed others, which formed the basis of his predictions regarding who would become successful officers. When compared to the actual performance results of officers many months later, his predictions fell well short, almost no better than a guess. Despite knowing that his method of evaluation wasn’t predictive of performance, he continued doing it. His actions remind me of that often-used quotation, “The definition of insanity is doing the same thing again and again and expecting a different result.” Kahneman refers to his irrational behavior in another way, calling it an “illusion of validity.”27
The illusion of validity is a cognitive bias, which is a deviation from the expected behavior of a rational actor or blind spots to logic. Even though Kahneman was aware that his method of evaluating candidates was suboptimal, he was biased toward using the old method. Cognitive biases are a starting point for behavioral economics, which is more of a psychological than a purely economic approach to understanding how people make financial decisions. Kahneman and his colleague Amos Tversky spent years uncovering, chronicling, and explaining hundreds of cognitive biases. Both are widely credited as pioneers of behavioral economics. Tversky passed away in 1996, and in 2002, Kahneman was presented the Nobel Prize in Economics without ever taking an economics class.
In his bestselling book, Thinking, Fast and Slow, Kahneman presents a new model to understand how the mind works. He distinguishes between “System 1” and “System 2” in the way the mind works. System 1 makes automatic, fast decisions that happen subconsciously—like turning the pages of this book. System 2 makes slower, more complex decisions that happen consciously—like how to balance your retirement portfolio. We like to think that System 2 guides our financial decisions, when in fact in many cases it’s System 1.
Because they were proposing a new way of understanding human cognition, Kahneman and Tversky’s ideas have had a profound impact on a range of fields, including economics. Their paper on “Judgment Under Uncertainty: Heuristics and Biases,” published in 1974, lists twenty cognitive biases and is one of the most frequently cited across a range of academic disciplines. Kahneman explains how their research questioned the very root of traditional models used to understand human behavior:
Social scientists in the 1970s broadly accepted two ideas about human nature. First, people are generally rational… Second, emotions such as fear, affection… explain most of the occasions on which people depart from rationality. Our article questioned both assumptions… We documented systematic errors in the thinking of normal people, and we traced these errors to the design of the machinery of cognition rather than to the corruption of thought by emotion.28
The “machinery of cognition,” System 1 and System 2, presents a different way of understanding how we make decisions. Our choices aren’t just rational or irrational but are made consciously and subconsciously. Many of our financial decisions are guided by forces of which we aren’t fully aware. For example, in one study, waiters found that customers tip more when exposed to sunshine.29 The weather affects our mood, which makes us more likely to give a bigger tip. Another study reveals that weather may play a role in the performance of the market. Comparing historical weather patterns with the performances of primary stock exchanges in twenty-six different countries shows that markets outperform considerably on sunny days, an annualized return of 24.8 percent over cloudy days. No serious investor asks how the weather makes them feel before making an investment decision, but the subconscious has already answered that question and acted on it.30
The subconscious also guides the financial choices of shoppers. Researchers found shoppers were more likely to buy French wine while hearing French music and German wine when hearing German music.31 Another study finds that music can influence how wine drinkers perceive the taste of wine, describing the taste of the wine similar to the feel of the music.32 These findings are old hat to advertisers. In the television series Mad Men, Don Draper makes a bountiful living by trying to influence the subconscious of consumers with positive associations of products.
To facilitate System 1 thinking, we have created mental shortcuts to save energy to process thousands of decisions per day. These shortcuts are called “heuristics,” which are frequently defined as “rules of thumb.” Though several heuristics work well, like ducking when someone yells “Watch out,” some are less helpful and irrational, and produce cognitive biases. By observing these heuristics that result in cognitive biases, Kahneman and Tversky provided a new way of understanding how humans make financial decisions.
To illustrate the significant impact that heuristics (and resulting cognitive biases) have on financial decisions, let’s consider but four: (1) availability heuristic; (2) illusion of skill; (3) loss aversion; and (4) money illusion. The availability heuristic explains why my father always plays the lottery. I’m sure that he’s aware that there is a one in 175 million chance that he will win. But when he enters the Shell gas station to buy his ticket, he isn’t thinking about the long odds. Instead, he remembers that once he matched a few numbers and received a $475 payout. He thinks about the winners he hears about on the five o’clock news. The more readily examples are remembered, the more likely a particular outcome seems.33 Most of us are unable to calculate large statistical problem sets in our heads, so the availability heuristic guides our decisions.
Heuristics can also result in a cognitive bias known as an “illusion of skill.” Kahneman analyzed data on twenty-five investment advisers from eight years at a wealth management firm. Metrics on the data were used in determining each adviser’s yearly compensation. Incredibly, Kahneman calculated zero correlation between their advice and investment outcome
. He presented his findings to the firm’s executives and writes, “This should have been shocking news to them, but it was not.”34 The managers continued their irrational behavior, rewarding an “illusion of skill”—paying their employees compensation that didn’t reflect their actual performance.35 Unfortunately, there’s plenty of evidence to suggest that an “illusion of skill” pervades the asset management industry: 95 percent of mutual fund managers under-perform a standard index fund that has no active manager over a fifteen-year period.36 Despite poor performance, many fund managers continue to make handsome fees. The “illusion of skill” in the fund management space reveals an irrational behavior of market participants: rewarding underperforming managers. Indeed, a fund manager’s poor performance may eventually lead to withdrawals from his or her fund. But that poor performance continues to be lucrative for long periods shows how financial decisions aren’t governed by completely rational and logical forces. Kahneman explains that this bias is “deeply ingrained in the culture of the industry. Facts that challenge such basic assumptions—and thereby threaten people’s livelihood and self-esteem—are simply not absorbed. The mind does not digest them.”37 What seems like irrational behavior, disregarding the facts that reveal the poor track records of wealth advisers and fund managers, can be seen in another light. The management teams at these funds are trying to protect their own jobs and maintain their livelihoods, which is a perfectly rational and motivating factor, so they look the other way.
Another heuristic, “the money illusion,” has been widely studied by economists for almost a century.38 It holds that people think of money in nominal rather than real terms, not considering inflation, the general increase in prices in an economy. For example, Kate makes a salary of $45,000 in one year when inflation is 1 percent. The next year she makes the same amount but inflation reaches 4 percent. Kate continues to purchase the same quantity of goods and services, as if prices have not gone up, but her income in real terms has decreased. The money illusion, when widespread among many people, may lead to market manias. In 2008, two economists proposed that people may have decided whether to rent or buy property by contrasting monthly rent versus mortgage payments without properly considering how inflation affects the real cost of payments in the future.39 For example, a drop in inflation lures Kate and many others to buy property as they conjecture that low nominal interest rates have made owning a home more affordable. In reality, Kate should consider her real interest rate, which will give her a true idea of whether her mortgage is actually a better deal than renting. Without considering real interest rates, Kate and others can mistakenly believe that buying a home is the better choice, which drives up prices and can potentially lead to a housing bubble.
It’s not just the housing market that may be subject to the money illusion; in the stock market money managers may not consider the real rate of a company’s earnings. During inflationary periods, money is worth more now than in the future, so investors calculate what future payments are worth now in a process called “discounting.” Some economists contend that investors may discount with nominal rather than real rates.40 It’s hard for me to fathom professional money managers not accounting for the real rates. Yet the money illusion could lead to a situation where stock prices don’t reflect the underlying fundamental value of the company. In other words, a cognitive bias may be the root of mispriced assets or even a labor dispute: Only 19 percent of Canadian union contracts between 1976 and 2000 included cost-of-living adjustments. Maybe employers wielded a significantly stronger upper hand in negotiations, or perhaps union negotiators demonstrated a cognitive bias, forgetting about the erosion of purchasing power over time in an inflationary environment.41
Until recently, it’s been impossible to peer into the black box of the brain and glean how it weighs and makes financial decisions. Such is the province of neuroeconomists, which I’ll explain in the next section, but some brain imaging studies can help us better grasp what’s going on in the brain of someone exhibiting the money illusion. Brain images reveal the neural underpinning of this cognitive bias. In a study, the brains of participants were scanned while they were instructed to solve problems in which they could win money. In one scenario, they could earn money and buy goods that were relatively cheap from a catalog. In the other scenario, they could earn 50 percent more money and buy goods from the same catalog, except the prices were 50 percent higher. Despite the increase in nominal amounts, the participants’ purchasing power stayed constant, and they were briefed at the beginning of the experiment that the value of money wouldn’t vary. There was considerably more activity in the prefrontal cortex of the brain during the scenario involving larger nominal amounts than during the scenario with smaller nominal amounts.42 Even though the real value of money remained constant, the brain reacted to variations in nominal amounts. This study shows that higher nominal prices register more activity in the part of the brain that is involved in processing rewards and valuing goods; the prefrontal cortex is also considered the seat of reason, and its activation may induce us to be more cognizant of higher prices. It may also explain how the brain processes “sticker shock”—heightened neural activity and awareness when confronted with an unexpectedly high price of a good. Most of us have experienced sticker shock, so it may not come as a surprise that activity in the brain is heightened, but now there is brain imaging to show how the brain is processing these financial decisions, which is a first step toward making better predictions regarding human choice.
Finally, the heuristic for which Kahneman and Tversky are best known is loss aversion. It’s also known by its more academic name, “prospect theory,” which basically says that when making decisions, people value perceived gains and losses differently.43 The evolutionary logic of loss aversion seems to be to minimize harms and costs as a way to increase chances of survival. Consider a coin toss in which you could either lose $20 or win $22. Though the payoff is in your favor, and the rational model of human behavior would suggest you take the bet, most would reject this gamble. Kahneman and Tversky found that when offered a coin toss that could result in losing $20, participants asked for an average of $40 for winning.44 There is a stark unevenness in how folks value losses and gains, as they try to avoid loss even if there’s good probability of gaining.
Loss aversion may also explain widespread market behavior. Mebane Faber of Cambria Investment Management has found that there is more volatility in stock prices during bear markets than during bull markets.45 One reason for this, according to financial writers Gary Belsky and Thomas Gilovich, might be that traders make increasingly risky bets because they want to avoid realizing their losses: “If you’re a stock trader who’s lost a lot, the temptation to gamble big in the hopes of recouping money is very powerful.”46 For example, during the 1990s, the demise of Barings Bank was brought about by a rogue trader doubling his bets, trying to avoid realizing amassed losses.47 In periods of uncertainty, rational actors shouldn’t gamble more aggressively.
Loss aversion isn’t found just in the financial world. Cutting welfare benefits is difficult because the political cost of reducing is high. Those who are likely to suffer a loss are more likely to mobilize in defense of benefits. Politicians herald the expansion of benefits but duck blame when the entitlements are cut.48 Even professional golfers are subject to loss aversion. A comprehensive study of more than two million putts during PGA tournaments, controlled for location and other factors, shows that golfers are 3.6 percent more successful when putting for par, facing the prospect of underperforming on the hole, than for birdie, which could put them ahead in the round.49
Loss aversion is regulated by neurological mechanisms. Several parts of the brain are involved in weighing and making decisions, from the ventral striatum in the limbic system, which is involved with anticipated and realized gains, to the amygdala, which processes expected and realized loss.50 Researchers scanned the brains of two women with lesions to their amygdala, effectively turning it off.51 Healthy
control participants were more likely to accept a gamble in which they won $50 and lost $10 than one in which they won $20 and lost $15, whereas the two women with lesions were more likely to engage in riskier bets, even those in which the potential losses were greater than potential gains.52 The amygdala, which is known to promote fear learning, appears to play the same role in financial decisions, steering us away from loss.
These cognitive biases reveal humans for what they are—at times, unaware and irrational actors. Instead of acting according to a rational model, we show great variation in our psychology and behavior. Kahneman and Tversky recognized these differences by observing and detailing human behaviors over the years. Their findings provide a more realistic version of human behavior, something that Greenspan said was needed. But it will be difficult for economists to account for hundreds of cognitive biases in their financial models. What’s needed is a sophisticated yet straightforward way to understand how people make financial decisions.
For that, consider the work of behavioral economist Richard Thaler and his concept of mental accounting. Instead of seeing every dollar as just another dollar, people view their dollars differently, classifying them into discrete buckets like safety income and risk capital, the way a corporate treasurer classifies capital for different purposes, such as salaries, taxes, or research and development.53 People, like corporations, treat each category of money differently. My father’s decision to play the lottery can be explained not only by the availability heuristic but also by mental accounting. He explains his decision: “I’m not using my retirement money to buy tickets.” It’s as if he’s created a mental “discretionary account” with which to gamble. Even though the amount of cash in question may be the same, mental accounting makes us treat money differently. Thaler’s theory neatly illustrates that we conceive of money in different ways, and economists should recognize that not every dollar is alike.