Financial decision making and human nature

27 Oct 2008

THE global financial crisis has exposed far more than just the number of bad risks on the books of our major financial institutions. As billionaire investment guru Warren Buffet has said, “It’s only when the tide goes out that you learn who’s been swimming naked.” As market confidence continues to plunge some of modern economics’ most popular notions are now looking a little under-dressed. The myth that has received most exposure is of course that of the self-managing market. It is now clear that our long-term economic resilience depends on the capacity of governments and regulators to spot and reign in market instability and excess. Tom Murphy, former head of private wealth management for Deutsche Bank has said that “we are going to see radical change and if there has ever been a time for regulation it is now.” Even the conservative President of France, Nicholas Sarcozy has proclaimed the end of the laissez-faire era: “the all-powerful market that is always right, that’s finished.” Another popular economic idea has also found itself stuck without a fig-leaf in this chilly economic climate: the myth that market participants are always rational decision-makers who act to maximise their own best interests. Behavioural economists - who study how humans actually behave in markets rather than how they would behave if they were automatons - have long questioned this assumption, and provided evidence that participants do not always act rationally. The past few years have provided a dramatic demonstration of their findings. In his paper for the Centre for Policy Development You Can See a Lot By Just Looking, economist Ian McAuley sums up some of the main implications of behavioural economics for financial decision-making. Overconfidence: When classes of students are asked to compare their skill levels with others in the class, the majority rate themselves as above-average. A survey by the Australian Financial Literacy Foundation last year found widespread overconfidence among consumers, manifest as large gap between people’s self assessment of their financial management skills and their revealed abilities. The fact that we tend to overestimate our own knowledge and understanding could explain a lot about why investors can initially be dismissive of warning signs when a bubble is fully inflated. Consideration of sunk costs: Rational decision-makers would never throw good money after bad. Our decision to hang on to a stock or an investment property would be guided only by our expectation of the future costs and benefits of doing so. But we find it very difficult to abide by this principle, particularly when it means losing face by implicitly admitting that we have made poor decisions in the past. The “disjunctive bias”: We can display a poor grasp of statistics, underestimating the combined probability of disconnected events. For example if four separate possible disasters each have a 20 percent chance of occurring, then the probability of none of them occurring is only 41 percent. But most people would guess a much higher chance of smooth sailing. This bias has broader implications. We assume that two-income households are more financially resilient, but if both of those incomes are required to meet expenses it makes it twice as likely that a household will get into financial strife, for example through one partner getting sick or losing their job. Mortgage stress and myopia: People are likely to become over-committed in their borrowing because of short-sightedness (also known as “hyperbolic discounting”) and a lack of understanding of the difference between real and nominal interest rates (that is, the impact of inflation on real interest rates). Myopia leads to decisions based on immediate affordability, rather than value for-money and capacity to pay. The aptly named “teaser loans” with low introductory interest rates appeal to this bias. Perhaps the most important implication is that we are all subject to these biases - whether rich or poor, financially literate or not. Our departures from rational decision-making result from an innate tendency to use short-cuts (“heuristics”) in situations where more deliberation would lead to better decisions. Higher incomes provide more of a buffer against the impact of poor choices, rather than preventing us from making such choices in the first place. This point should be brought to the attention of anyone who argues that the current financial situation is all the fault of the high-risk borrowers who took out sub-prime loans. The bubble was inflated by both borrowers and lenders, but it could have been popped much earlier had we not built blindness to our own biases into the design and regulation of financial markets. As a result we are now finding out the true cost of poor financial decision-making for both consumers and financial institutions. It is in everyone’s long-term interests to help people make better decisions, and since economic theories built on the assumption of rationality have failed to explain or prevent our current predicament, we should heed the lessons learned from behavioural economics as we attempt to design a smarter system. McAuley’s paper flags a couple of ideas, like the clever use of default options to frame decisions while retaining individual choice, simpler disclosure statements to avoid distracting consumers from the most important information, and a fresh take on competition policy which acknowledges the common “choice not to choose.” In their recent study of the role of emotions in stock-market bubbles psychoanalysts David Tuckett and Richard Taffler found: “What happens in a bubble is that investors detach themselves from anxiety and lose touch with being cautious... Lack of understanding of the vital role of emotion in decision-making, and the typical practices of financial institutions, make it difficult to contain... excessive risk-taking. Those who join a new and growing venture are rewarded and those who stay out are punished.” In the long run we can build more stability into the system by compensating for our biases, but our first step should be to remove the various incentives in place that actually amplify them. Everything from executive remuneration based on share price to performance pay based on loan volumes should now be up for review. Given that most of us tend to prefer to keep things pretty much as they are (which behavioural economists charmingly call “status quo bias” rather than laziness), we should probably get cracking as soon as possible.

Miriam Lyons is executive director of the Centre for Policy Development, and James Murray is its research director. This article first appeared in the Age.

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