11 Mar From psychology to economics (Daniel Kahneman) | Part B’
We can already see how these biases and errors in thinking affect the way that people make financial decisions. When a large number of people and businesses are making these mistakes there is clearly the potential for these to impact on the wider economy and on financial stability. The list of biases is long and growing. But there are some that have particularly affected the way that economists have looked at how people take financial decisions, which we will look at in more detail.
One is the optimism bias. In terms of its consequences for decisions, the optimistic bias may well be the most significant cognitive bias. This exploits the fact that most of us view the world as more benign than it really is, our own skills as more valuable than they truly are, and the targets we set as more achievable than they are likely to be. We also tend to exaggerate our ability to forecast the future, which in turn fosters overconfidence.
There are many more biases that show that people make decisions in a way that reveals that people’s preferences are not stable, as classical economists say, but can shift according to how they understand the choice open to them (i.e. because they have reframed it). These include:
Hindsight bias, which encourages people to infer their own skills from successes that were down to luck or timing. A stockbroker who rode a share price boom will believe he is a genius, which in turn fuels his optimism bias.
Confirmation bias, or the tendency to place more emphasis on evidence that favours your existing view and ignore that which does not. An investor with a negative view of a company will tend to read and remember negative news and brush over positive developments.
Status quo bias – a preference to stick with what we know, which means we discount the value of alternatives even if we are assured they are much better. This can help explain the relatively small number of people who switch banks or energy providers despite evidence that there are cheaper alternatives.
Kahneman and Tversky argued that people made choices as the result of a two-stage process.
First they frame the choices as gains or losses relative to a reference point, which may often be the gambler’s current wealth rather than zero.
The second stage is to evaluate the prospects to identify the one with the greatest value. This involves both an assessment of the mathematical probabilities but also a subjective view of the outcomes, particularly set against the reference point. They found that people were more worried about suffering a loss then they were about making a gain, that they valued a sure gain over a probable gain (the certainty effect) and that they preferred a probable loss over a certain loss.
Adam Smith had alluded to this idea of loss aversion when he said, ‘we suffer more … when we fall from a better to a worse situation than we ever enjoy when we rise from a worse to a better’. Kahneman said that people were driven more strongly to avoid losses than to achieve gains. A reference point is sometimes the status quo, but it can also be a goal in the future: not achieving a goal is a loss; exceeding it is a gain.
The significance is that assumptions of rational behaviour that simply look at the chances of a particular gamble coming off without any reference to the financial position of the gambler ignore the impact that the phrasing of the bet can have, and the way that people’s aversion to suffering losses can alter the way they make decisions.
The danger of loss aversion is that it leads us to try to minimise these feelings of loss – even when it does not make financial sense to do so. Loss aversion has a noticeable effect in the housing market as evidence suggests that people are often unwilling to sell their home for less than they paid for it. Their reference point is what they paid for it in the past rather than its current value, which may be about to fall further.
This problem is compounded by the endowment effect, a bias that makes people give a higher value to something that they now own compared with before they acquired it. In other words they value things more simply because they own them.
The research carried out by Kahneman with various partners, and especially with Tversky, clearly challenged the traditional model of rational choice that had underpinned thinking since Adam Smith. By carrying out copious and repeated experiments using real people making decisions in laboratory environments, he was able to show how these heuristics and biases revealed fundamental weaknesses in the rational theory and explained how people really make decisions. By doing this he was able, as his Nobel citation said, to lay the foundation for a new field of research.
Kahneman can therefore be seen as the father of behavioural economics, which is now seen as a field in its own right.
The Great Economists