Written by Jayne Bills | July 7, 2021
Behavioral economics combines psychology and microeconomics to explore how individual consumers and producers make their decisions. Classical economics asserts that humans make rational decisions by weighing the costs and benefits of each available option, subject to their preferences and constraints, before choosing the one that provides the most individual satisfaction or maximum utility. This concept, referred to as Rational Choice Theory, rests on the idea that individuals are rational people who always know what is best for themselves, exercise perfect self-control, and remain unmoved by emotions and external factors. In classical economics, rational behavior tends to be narrowly defined as that which generates the most profit, while irrational decisions do not seek to optimize profit and may even reduce economic or personal welfare. Behavioral economics challenges this basic framework. People do not always act in their best interest (or at least not according to how classical economists would define it). They do not always minimize costs and maximize benefits or profits, and their preferences are often shifting. As one author/economist puts it (in response to Adam Smith's classical economics metaphor to describe the unseen forces that drive a free market economy), "irrationality is the real invisible hand that drives human decision-making." In real life, people frequently make irrational decisions, or sometimes fail to make decisions at all! Our behavior is generally less deliberate and controlled than we would like to believe. Behavioral Economics studies why and how individual decision-making tends to stray from the predictions of economic models and considers the effects of other factors - psychological, cognitive, emotional, cultural, and social - on the decisions of individuals and institutions.
To make a perfectly rational decision, a person needs access to the full array of related information in order to appropriately analyze the options. In reality, our information processing abilities are restricted by limited computational capacity, incomplete or imperfect knowledge, and insufficient feedback, each of which fosters uncertainty that could lead us down the path to irrational choices. In the 1950’s, economist Herbert Simon coined the term ‘bounded rationality’ to address the discrepancy between the perfect rationality of human behavior assumed by classical economics and the imperfect reality of human decision-making. He argued that our minds are only partly rational, and as a result, our decisions are not always optimal. To overcome the problem of imperfect information and analysis, humans take shortcuts, like trial and error or educated guesses, that may lead to suboptimal decision-making. These mental shortcuts, or rules of thumb used to make a quick decision, are known as heuristics.
‘Bounded rationality’ is particularly well illustrated by the concept of choice overload. Have you ever struggled with a never-ending diner menu and become so overwhelmed, only to end up ordering something you didn’t even really want because you didn’t want to waste any more of the server’s time? Choice overload, or ‘overchoice,’ occurs when consumers have too many available options. It can lead to unhappiness, decision fatigue, going with the default option, and choice deferral, when you simply avoid making a decision altogether. We see this happen often when clients struggle to analyze the investment options in their 401(k) plans.
How many times have you attempted to give up your nightly dessert habit, ending up sabotaged by the mere sight of your spouse settling into the couch with a bowl of ice cream or by the irresistible aroma of freshly baked chocolate chip cookies? Your logical brain knows that you should not eat dessert, but the tempting sights and smells (and possibly the envy!) simply overpower your rationality. Behavioral economics demonstrates that human decisions are strongly influenced by context. The way our options are presented to us impacts the choices we make. It’s much easier to avoid eating cookies when they are ‘out-of-sight, out-of-mind.’ This can also work in the opposite direction to help you make more positive decisions. If your partner is diligently depositing a chunk of his or her paycheck into a retirement account each month and limiting discretionary spending, you may be more inclined to do the same. Context matters. We are influenced by readily available information, and we have a tendency to live in the moment and resist change.
Buyers are influenced by the way product choices are presented. Richard H. Thaler, who received the Nobel Prize in Economics in 2017 for his contributions to behavioral economics, helped establish that people are predictably irrational in ways that defy economic theory. Thaler’s bestselling book, co-authored by Cass Sunstein, Nudge: Improving Decisions About Health, Wealth, and Happiness, introduced the concept of “choice architecture.” Thaler and Sunstein highlight that since people require structure in order to make decisions, there is an opportunity to create structures that lead people to make better decisions. “The idea of a nudge is that we never make choices in isolation,” Thaler says. “You can't avoid nudging like you can't avoid choice architecture.”
Thaler and Sunstein recommend that choice architectures should take into consideration humans' bounded rationality. They contend that if healthier food is placed at eye-level, its physical position will make it more likely that a person will choose it over a less healthy option that is farther from view, hence why the first thing you see in a cafeteria is usually the salad bar. Thaler says, “There has to be a design of that cafeteria. Why don't we make it a good one?” Critics of Nudge argue that modifying choice architectures will erode people’s decision-making abilities.
People tend to be emotional and easily distracted, which makes them likely to behave in ways that are not in their best interest. Consider again the struggles of a person trying to eat a healthier diet. You may set your mind on developing a habit to eat only healthy food, but your self-control is tested as your brain is flooded with the mouth-watering images of burgers and fries in a fast-food commercial, causing you to fall off the bandwagon.
Companies incorporate behavioral economics to increase sales of their products. When the iPhone was first introduced in 2007, Apple set the price at $600 before quickly reducing it to $400. Had the phone been originally priced at $400, the initial market reaction might have been negative if potential buyers thought it was too expensive. By quickly dropping the price so significantly, consumers believed they were getting a good deal. This nudge resulted in surging sales for Apple.
Thaler has offered an explanation for why some people make irrational investment decisions: “What we've found is that there are classes of situations where investors make systematic errors and those create buying opportunities.” He highlights two categories of errors: overreaction and underreaction. “People are reluctant to sell a stock that they've lost money on,” he says. “If you sell a stock that's gone down, you have to admit to yourself that you made a mistake. Whereas if you hold onto it, there's always hope that it could come back.”
When it comes to saving for retirement, Thaler notes, “My mantra in designing policies is if you want to get people to do something, make it easy. And we've made retirement saving easier.” He pioneered the ‘Save More Tomorrow’ program, which aims to help employees save more money by exploiting or avoiding certain behavioral biases, including commitment. Three strategies make it simple for employees to decide how much to save and how to invest, helping to nudge people closer to a healthy retirement plan: automatic enrollment, automatic escalation, and the creation of default investment vehicles. Since participants have to actively opt-out of the savings program, they are more likely to stick with it, failing to overcome their inertia enough to abandon it. Automatic escalation gives employees the option to pre-commit to a gradual increase in their future savings rate to coincide with each time they get a raise. This helps avoid the perception of loss that employees would feel when their disposable income is reduced, because they have already committed to saving future increases in income. Lastly, default investment vehicles help participants who become easily overwhelmed by too many choices.
Thaler and Sunstein explained that experience, good information, and prompt feedback are critical elements required for prudent decision-making. In today’s fast-moving, instant gratification society, people want immediate results. Consider the issue of climate change. Not only is the progression of climate change difficult to observe on a day-to-day basis, but the individual actions a person can take to prevent climate change, like commuting to work by bicycle rather than car or buying used clothes over new ones, do not immediately lead to a noticeable change in our environment. When both the issue at hand as well as the impacts of the solutions implemented to address the problem are not easily observable, individuals are disincentivized to do anything about it.
A similar conundrum often exists related to matters of personal health. It can be difficult to obtain easy to understand, accurate, prompt feedback when it comes to various health issues. Take cigarettes as an example. When people smoke cigarettes, the damage to internal organs begins accruing immediately, but smokers may not notice any negative impact for many years. Simply being aware of the dangers of smoking is not enough to make most people stop. These days, modern smartphone apps designed to help you quit take an extra step beyond merely providing general information about health improvement and disease avoidance. They shower the users with positive and personalized behavioral feedback, like the number of cigarettes not smoked and the amount of money saved in concrete dollar terms. These extra, easily observable nudges can help smokers drop the addictive habit for good.
Information avoidance refers to situations in which people choose not to obtain knowledge that is freely available or to simply ignore it. Take the climate change and cigarette smoking problems in the previous section. Some people simply refuse to accept the existence of climate change in order to avoid both the anxiety it causes and the major changes it necessitates to combat it (more: see our environmental investing service). Similarly, if the smoker actually calculated the amount of money he spent on cigarettes each month, he might be induced to cut back. Instead, he ignores reality so he can feed his addiction without the nagging nuisance of a dwindling bank account on his mind, not to mention the ill health effects he chooses to disregard. In the short-term, avoiding information can yield pleasurable outcomes when a person escapes the negative psychological consequences of knowing the information. However, this behavior tends to have a detrimental impact in the long-term, as the lack of information and feedback often leads to poor decision-making.
The opposite outcome could also be true. If a young, risk-averse investor knows that she needs to stick with her long-term investment plan and avoid trying to time the market, but she also has enough self-awareness to realize that volatility in her portfolio makes her extremely anxious, she may choose to ignore financial news media. This is a wise decision for the young investor (with a long time horizon until retirement), knowing that a barrage of negative market headlines makes her highly susceptible to committing the emotionally-induced behavioral mistake of liquidating her portfolio at the worst possible time, causing her to miss out on big gains. This kind of information avoidance can have positive long-term effects; hence, we encourage our clients with significant anxiety related to market volatility to tune out the financial news noise and avoid obsessively checking their account balances. In fact, one of the primary reasons many investors hire an investment advisor in the first place is to help them reduce or eliminate behavioral errors related to their portfolios. This is one of our major goals for all One Day In July clients. Our fiduciary financial advisors help clients weather the storm of market volatility. See also: Avoiding Action Bias Investment Mistakes Through Patience and Planning.
Do you ever wonder how large-scale unethical behavior and corruption goes on for years, unchallenged or undetected? How exactly was Bernie Madoff able to swindle so many investors? Unethical situations can be ambiguous, and, with the right motivations, people could maintain a belief of propriety. An experienced investor or financial advisor should have suspected that the purported returns Mr. Madoff achieved were too good to be true, which should have prompted additional due diligence. A type of information avoidance, referred to as ‘bounded ethicality,’ is at play when people are motivated not to closely examine suspicious behavior in order to avoid revealing something unethical. Failing to discover the unethical behavior in the first place may lessen the harsh criticism down the line if and when the poor behavior is eventually exposed. Some organizations may even be deliberately structured to foster an environment of ‘distributed ignorance.’ This happens in big organizations when executives maintain ‘plausible deniability.’ If you are not aware of poor behavior, you may be less inclined to be punished for not doing anything to change it.
Classical economic theory assumes that humans make choices in isolation. Homo Economicus, or the ‘economic man,’ is a consistently rational, narrowly self-interested agent who seeks to maximize utility as a consumer and profit as a producer. In contrast, behavioral economics recognizes that, in reality, people’s decisions are impacted by various social forces, like trust and reciprocity. It’s not just money that talks. We are social animals and most of us are subject to societal norms.
Trust is one of the primary engines that keeps social interactions humming. Financial transactions are dependent on maintaining a certain level of trust. You are more likely to purchase goods and services from a person or company that you know and trust. But, if a skillful salesperson gains your trust, it’s easier to take advantage of you (like when your local financial advisor sells you a high-fee annuity!). Reciprocity, the tendency to return the favor when someone acts generously towards you (or vice versa, getting someone back for a wrongdoing), is another social norm that can lead to some irrational decision-making. For example, a consultant who typically charges money for working with a client might occasionally give that same client some free advice, with the hope that the client will reciprocate the favor in the future. Such goodwill may never be returned, and the consultant will have wasted his time, potentially forgoing other paying gigs.
Individual behavior is often susceptible to ‘groupthink,’ which is a version of information avoidance that can be particularly destructive. This social phenomenon occurs when collective opinion on an issue tends toward unanimity, and people find it sensible to adopt the common belief as their own instead of doing their own research. This can happen even when the shared opinion is irrational. The lack of new information makes it difficult for the group to correct their irrational belief. Interpersonal relationships and interactions can increase the motivation to avoid information. Individuals have an innate longing to “fit in” and tend to avoid driving wedges between themselves and the groups with which they identify.
Groupthink manifests itself in the markets in the form of herd behavior, when the actions of collectively delusional investors contribute to extreme price swings, causing bubbles and panics. The dot-com stock market bubble of the late 1990s and housing bubble of the mid-2000s are two such examples. The economist Robert Shiller, who warned of both of these events, contends that contagious investor enthusiasm and stories to justify rising prices fuel speculative bubbles. In these cases, powerful emotions, including envy and excitement (FOMO!), trump any concerns about the real value of a particular investment. Economic bubbles tend to be followed by crashes, or sudden and sharp decreases in prices.
Many people exhibit ‘confirmation bias,’ which is the tendency to seek out, interpret, and rely on information in such a way as to confirm the beliefs or values that we already hold. In other words, some individuals are prone to prematurely make up their minds without taking into consideration complete information in a neutral way. They search for data or expert opinions that will strengthen their own, while ignoring diverging views or evidence, or they interpret ambiguous data to support their existing beliefs. This irrational behavior reflects our limited capacity to process information, which prevents us from undertaking an unbiased investigation into the facts in order to make a rational decision. Instead, we tend to become overconfident in our personal beliefs even in the face of contrary evidence.
Confirmation bias leads to flawed decision-making in many areas, including political, organizational, financial, and scientific contexts. For example, errors in scientific research occur when scientists fail to challenge their own beliefs or update them in response to valid challenges from others. Similarly, a police detective that identifies a suspect at the onset of an investigation may look only for confirming rather than disconfirming evidence.
Many media companies exploit people’s tendencies toward confirmation bias. If folks don’t want to hear the other side of the story, the media will not supply it. Instead, they are incentivized to feed the demand for media content that strengthens their target audience’s already held views. Social media users will find that the algorithms are structured in such a way that they are more likely to scroll though content that is already aligned with their perspectives rather than that representing divergent views. Media bias is both a derivative of and contributor to political polarization. There are people on both sides of the political divide who become so partisan in their views that they are inclined to vote against their own best interest.
There is a plethora of typical human behavior patterns that can lead to suboptimal, or even irrational, decision making. Maintaining an awareness of these natural tendencies, which are found at both the individual and group levels, can lead to more prudent behavior and better economic outcomes.
Sources:
https://www.investopedia.com/terms/b/behavioraleconomics.asp
https://en.wikipedia.org/wiki/Behavioral_economics
https://daily.jstor.org/from-the-horses-mouth-richard-h-thaler/
https://www.ubs.com/microsites/nobel-perspectives/en/laureates/richard-thaler.htm
https://www.behavioraleconomics.com/resources/introduction-behavioral-economics/
https://www.wired.com/2007/09/iphone-price-cu/
https://pubs.aeaweb.org/doi/pdfplus/10.1257/jel.20151245
https://en.wikipedia.org/wiki/Homo_economicus
https://en.wikipedia.org/wiki/Confirmation_bias
https://www.tandfonline.com/doi/full/10.1080/1331677X.2018.1439396
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