Behavioral Finance: Two Minds at Work

Behavioral Finance in Action Behavioral Finance: Two Minds at Work Understand. Act.

Decisive Insights for forwardlooking investment strategies Behavioral finance is an extension of behavioral economics, which uses psychological insights to inform economic theory. When Daniel Kahneman was awarded the Nobel Prize in economics in 2002 for his contribution to behavioral economics, he was only the second psychologist to receive the economics prize. Part of Kahneman s insight that led to the prize was his recognition of the important role of emotion and intuition in people s decision making, which in certain circumstances leads to systematic and predictable errors (Kahneman, 2003). 2

Behavioral Finance: Two Minds at Work Kahnemann uses the framework of two minds to describe the way people make decisions (Stanovich and West, 2000). Each of us behaves as if we have an intuitive mind, which forms rapid judgments with great ease and with no conscious input; knowing that a new acquaintance is going to become a good friend meeting is one such judgment. We often speak of intuitions as what comes to mind. We also have a reflective mind, which is slow, analytical and requires conscious effort. For example, financial advisors engage this mind when they sit down with clients and calculate a retirement framework based on their risk profile, current circumstances and future goals. Most decisions that people make are products of the intuitive mind, and they are usually accepted as valid by the reflective mind, unless they are blatantly wrong (Klein and Kahnemann, 2009). Indeed, intuitive decisions are often correct, some impressively so (Gladwell, 2005). However, it is the errors of the intuitive mind, along with failures of the reflective mind, that interest behavioral finance academics and have practical implications for financial investment. The Allianz Global Investors Center for Behavioral Finance is committed to empowering clients to make better financial decisions by delivering actionable insights, tools and techniques. For more information about the Center and its initiatives, visit http://befi.allianzgi.com. Prof. Shlomo Benartzi is an authority on behavioral finance. He is Professor and co-chair of the Behavioral Decision Making Group at UCLA. Here s an illustration of what is meant by intuitive mind, and how it sometimes leads one astray. Take a look at Diagram 1 below. If you haven t seen it before you will immediately see that the bottom line is longer than the top line. Now take two small pieces of paper two Post-It Notes will work and use them to cover the fins on the bottom line. As those who are familiar with the diagram already know, you will discover that the lines are in fact the same length. You are the victim of an optical illusion, the famous Müller- Lyer illusion. The visual perception part of your mind is tricked into seeing something that doesn t exist, in this case because of the effect of the fins. 3

Behavioral Finance in Action The remarkable thing about this and other optical illusions is that even when you know the truth that the lines are the same length you still see one as being longer than the other. In the framework of the two minds, your reflective mind knows the lines are the same length, but your intuitive mind sees them as being different. The output of the intuitive mind is so powerful that it overrides any attempt by the reflective mind to see the lines in any other way. You can t help yourself. Intuitive judgments tend to be held with greater confidence, too another factor making them hard to override. Loss Aversion Is Fundamental At the core of many of these powerful but erroneous intuitions is people s hyper-negative response to potential loss, or loss aversion, as described by Prospect Theory (Kahneman and Tversky, 1979). Simply put, losses loom larger than equal-sized gains. Psychologically speaking, the pain of losing $100 is approximately twice as great as the pleasure of winning the same amount. For this reason, most people are prepared to enter a 50:50 gamble of losing $100 on one hand, only if the sum to be won is at least $200. One of the insights that earned Kahneman the Nobel Prize 1 is that we humans are sometimes as susceptible to cognitive illusions as we are to optical illusions. These illusions, also known as biases, result from the use of heuristics, or, more simply, mental shortcuts. For instance, people are supposed to make decisions based on the logic and substance of transactions, not on how they are superficially described. When faced with a choice between having cold cuts that are ninety percent fat free or containing ten percent fat, people overwhelmingly select the first option. Logically, the two are identical of course, but people automatically respond negatively to containing fat and positively to fat free, and choose accordingly. This ubiquitous and powerful effect, the product of the intuitive mind, is called framing (Tversky and Kahneman, 1974). We can see, then, that intuition is a powerful force. And people typically place a great deal of faith in it. Kahneman s discovery that under certain circumstances intuition can systematically lead to incorrect decisions and judgments changed psychologists understanding of decision making, and, ultimately, economists, too. Classical economics held that people are rational, selfinterested and have a firm grasp on self-control. Behavioral economics (and common sense) showed instead that we are not as logical as we might think, we do care about others, and we are not as disciplined as we would like to be. It is not that people are irrational in the colloquial sense, but that by the nature of how our intuitive mind works we are susceptible to mental shortcuts that lead to erroneous decisions. Our intuitive mind delivers the products of these mental shortcuts to us, and we accept them. It s hard to help ourselves. Loss aversion Losses Rising losses Reduced sensitivity Happiness/ Satisfaction Pain Rising profits Marginal utility Initial investment Profits The risk profile of an investor is usually asymmetrical, i.e. losses are weighted more heavily. Source: Andrew W. Lo The Adaptive Markets Hypothesis, 2005; Illustration: Allianz GI Capital Market Analysis Loss aversion is a fundamental part of being human, and we are not alone in that. Yale economist M. Keith Chen did some ingenious preference experiments with capuchin monkeys in which they always finished up with one piece of apple. They got there in different ways, however, which affected the monkeys preferences. Sometimes the monkeys started off with two pieces of apple, one of which was taken away. At other times they started off with none, and were given one piece. The monkeys strongly preferred the second scenario, and disliked the first, where one piece of apple was taken from them (Chen, 2006). Psychologists speculate that loss aversion makes sense in terms of evolution and survival: better to be cautious and give that saber-toothed tiger a wide berth rather than take the risk of confronting it by yourself. Whatever its origin, loss aversion affects many of our decisions, including financial ones. 1 Kahneman did all the important work that underpins behavioral economics with his colleague Amos Tversky, who had died before the Nobel Prize was awarded. Nobel Prizes are never awarded posthumously. For instance, people have a tendency to hold on to losing stocks too long. Selling a losing stock is extremely unpalatable because it brings the reality of loss very much to mind. 4

On the other hand, people often sell winning stocks too soon because the act of selling a winning stock realizes a gain, and that gives us pleasure. We feel pain when we realize a loss and pleasure when we realize a gain. The mistake people are making here is one of mental accounting: instead of looking at their portfolio as a whole they look at each stock separately, and make decisions based on these separately perceived realities. Loss aversion also makes people reluctant to make decisions for change because they focus on what they could lose more than on what they might gain. This is called inertia, or the status quo bias (Samuelson and Zeckhauser, 1988). Inertia is at play when people know they should be doing certain things that are in their best interests (saving for retirement, dieting to lose weight, or exercising), but find it hard to do today. Procrastination and lack of self-control rule the day. However, people are usually willing to say they will do the right thing at some point in the future: I ll start that exercise program next week, I promise! We make intuitive judgments all the time, says Nicholas Barberis, a behavioral finance researcher at the Yale School of Management, but it s very hard for us to tell which ones are right and which ones are wrong 2. Behavioral finance researchers have identified many circumstances in which the intuitive mind leads people to make money-related mistakes. SMarT: A Powerful Example Richard Thaler of the University of Chicago and Shlomo Benartzi of UCLA 3 used some of the above psychological insights in one of the earliest, and most successful, applications of behavioral finance, the Save More Tomorrow program (SMarT). The problem is widespread: An alarmingly large proportion of employees fail to participate in their company s defined contribution retirement plan, often forgoing matching funds (free money) from employers. SMarT effectively removes psychological obstacles to saving in the short and longer term, and helps people overcome them with very little effort on their part. SMarT was designed around the psychological principles of inertia, loss aversion and immediate gratification. In the first case study of SMarT, employees at a midsize manufacturing company increased their contribution to their retirement fund from 3.5 percent to 13.6 percent of salary over a three-and-a-half-year period (Thaler and Benartzi, 2004). This is a remarkable improvement in saving behavior. As a result, the program is now offered by more than half of the large employers in the United States, and a variant of the program was incorporated in the Pension Protection Act of 2006 (Hewitt, 2010). The lesson of the experience with the SMarT program, therefore, is general and powerful, says Benartzi, the strategic application of a few key psychological principles can dramatically improve people s financial decisions. People can take advantage of such insights to help themselves to make better decisions which, ultimately, should lead to better financial outcomes. Save More Tomorrow 15 12 9 6 3 0 3.5 % 6.6 % 6.5 % 6.5 % 9.4% 6.8 % 11.6 % 6.6 % 13.6 % 1998 1999 2000 2001 2002 with Thaler, Benartzi (2004) without Behavioral Finance in Action Framework 6.2 % Two minds: Intuitive mind (fast, automatic, effortless): Can often lead to wise decisions, but sometimes leads systematically to irrational, poor financial decisions. Reflective mind (slow, conscious, effortful): Can lead to more thoughtful, rational decisions. People should engage their reflective minds to improve outcomes by correcting the mistakes of the intuitive mind. 2 Cf. Kahnemann and Klein (2009). 3 Shlomo Benartzi is the Chief Behavioral Economist for the Allianz Global Investors Center for Behavioral Finance. Richard Thaler is a member of the Center s Academic Advisory Board. 5

Behavioral Finance in Action References: M. K. Chen, V. Lakshminarayanan and L. R. Santos (2006): How Basic Are Behavioral Biases: Evidence from Capuchin Monkey Trading Behavior, Journal of Political Economy, vol. 114(3), pp. 517 537. M. Gladwell, Blink (2005): Blink: The Power of Thinking Without Thinking. Hachette Book Group USA. Hewitt Associates (2010): Hot Topics in Retirement. D. Kahneman (2003): Maps of Bounded Rationality: Psychology for Behavioral Economics, The American Economic Review, vol. 93(5), pp 1449 1475. D. Kahneman and G. Klein (2009): Conditions for intuitive expertise: A failure to disagree, American Psychologist, vol. 64(4), pp. 515 526. W. Samuelson and R. Zeckhauser (1988): Status Quo Bias in Decision Making, Journal of Risk and Uncertainty, vol. 1(1), pp. 7 59. K. E. Stanovich and R. F. West (2000): Individual Differences in Reasoning: Implications for the Rationality Debate, Behavioral and Brain Sciences, vol. 23(5), pp. 645 665. R. Thaler and S. Benartzi (2004): Save More Tomorrow : Using Behavioral Economics to Increase Employee Saving, Journal of Political Economy, vol. 112(1), pp. 164 187. A. Tversky and D. Kahneman (1974): Judgment under Uncertainty: Heuristics and Biases, Science, vol. 185, pp. 1124 1131. D. Kahneman and A. Tversky (1979): Prospect Theory: An Analysis of Decisions under Risk, Econometrica, vol. 47(2), pp. 263 291. Do you know the other publications of Capital Market Analysis the investment think tank? Other Publications about Behavioral Finance Outsmart Yourself! Investors are only human too Behavioral Finance and the Post-Retirement Crisis 6

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