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From Homo Economicus to Homo Sapiens

February 4, 2013

This title refers to an academic journal article by Richard Thaler (2000).  I’m not an expert on academic journals, but I imagine this has to be one of the top 10 titles of all time (and would have probably been #1 if he could have somehow thrown in homo erectus).

In the article, Thaler starts out by pointing out biases we have:

1.  Optimism:  We tend to be optimistic about the future and almost all of us believe we are better than average (just as a reminder, this is statistically impossible.)

2.  Overconfidence:  We also believe we are better forecasters than what we really are.

3.  False Consensus:  We tend to think others are just like us.

4.  The Curse of Knowledge:  Once we know something we can’t imagine what life was like when we didn’t know this.  I know this fact so why don’t you know this.

Because of these biases the future of economics needs to change.  In the past the study of economics was about rationale decisions.  What is the most efficient way to use our limited resources to produce maximum utility.  Unfortunately, it is easy to see we don’t make rationale decisions all the time.  Because of this Thaler argues economics needs to study why people make the economic choices they do and how can we improve our systems to help people make the most efficient choices.  In the 12 years since this was published it is easy to see this trend is happening.  Hopefully, through this research we can restructure how we design products, services, choices to help our society improve.

Question:  Where do you see the biases we have lead us to making poor choices?

Work Cited:

Thaler R.H. (2000)  From Homo Economicus to Homo Sapien.  Journal of Economic Perspectives.  14(1):  133-141.

Is a little bit of knowledge a bad thing?

January 31, 2013

We’ve all seen the movie that didn’t end the way we thought it would.  A great storyteller can put a twist on the ending and throw us all for the loop.  I think that is one of the joys of being human.  Things don’t always go as planned.  This is also true with it comes to research on personal finance education.

A study done by Cliff Robb and Deanna Sharpe (2009) looked at the effect of financial literacy and credit card usage at a large Midwestern University.  The hypothesis was pretty much a no brainer in they guessed that students who had higher financial literacy scores would use credit cards better.

Guess what?  They were wrong.  In this research study they found that students with higher levels of financial knowledge had significantly higher credit card balances.

The conclusion was that there needs to be amore effective way to deliver personal finance education.  A little education in the current system was harmful to these students.  I don’t know why and the research for this project didn’t discover why, but maybe a little knowledge is worse than no knowledge.

With a little knowledge, individuals may feel like they can control the risk and understand how to use credit cards to their advantage.  Unfortunately they can’t.

I’ve heard of a similar situation with card counting.  When the movie 21 came out about the MIT blackjack card counters some thought the casinos would hate this as it would teach everyone how to get the advantage on the house at the casino.  Surprisingly, it seems some casinos enjoyed this movie coming out because they knew it would increase gambling and most amateur card counters lose money.  This is another situation where a little information can be harmful.

So what should we do?  Should we get rid of personal finance education?  Is a little bit of knowledge in a high school course or by playing the Stock Market Game teaching students to misuse credit and day trade to make money?  I’m not sure, but it appears if a school doesn’t embrace a full personal finance curriculum and just adds a week or two on top of another class it can actually do more harm than good.  Hopefully, the research in this field continues.

Work Cited:

Robb, C.A. and D.L. Sharpe (2009)  Effect of Personal Finance Knowledge on College Students’ Credit Card Behavior.  Journal of Financial Counseling and Planning.  20 (1), 25-43.

Money Management and Substance Abuse

January 29, 2013

Yesterday, I wrote some of the concepts researchers Chivers and Higgins (2012) had studies on how people with substance use disorder (SUD) can use behavior economic concepts to help them handle their money.  Some of these same concepts can be used by everyone.

Another concept in behavioral economics is mental accounting.  This is basically a system where you have an idea in your mind on how much you can spend in certain categories every month.  Just by thinking about this before the  month starts, you are more likely not to spend more in any one category even though you may have the money for a different reason.  If you can set up a written budget and follow it, I believe that is the most effective, but if this is a struggle at least think about how much you want to spend in different categories and by thinking about that through the month, you will handle your money a little better than having no plan at all.

A final concept is the failure to account for opportunity cost.  When we make a decision it is usually should I buy this or not.  By thinking about opportunity cost a person considers other things the person could do with the month.  If you are looking at going out to eat it is usually a yes or no answer, but if you think about all of the things you could buy with $35 or save up, then it helps people analyze what else they could do with the money and it tends to help people make better decisions.  When you are making a purchase don’t think about should I do it, yes or no, but think about everything else you might want to do with that money to help in your decision process.

One strategy that has been used for SUDs individuals has been ATM therapy.  With ATM therapy, an individual gives their checkbook, ATM card, money, etc. to a therapist they are working with.  When the individual needs money they go to the therapist to get the money.  The therapist works with the individual at the start of the month to set up a budget and then reviews it with the individual throughout the month.

This therapy has proven effective for a couple of reasons.  First, by having the money in a separate place, an individual can’t access the money immediately so it removes them from making hasty decisions.  Second, by setting up a budget, the individual does use a type of mental accounting to help them in their purchases throughout the month.  By adding one more roadblock in the purchase process many people are able to step back and make a good decision.

All of us can take tips from this.  When we carry around cash, credit cards, and debit cards, the question is should I buy this or not.  Based on common biases, there are many times we make a hasty decision with money that causes us to spend more than we would like.  By adding some type of barrier and an accountability partner, it can help us prevent the purchase of impulse decisions.  If you struggle with impulse purchases, think about how you can make a barrier for yourself.  This could entail freezing your credit card to giving your cards and checks to another individual to help keep you accountable.  This may be hard to do, but it is a lot easier than spending yourself into trouble.

Work Cited:

Chivers, L.L. and S.T. Higgins (2012).  Some Observations from Behavioral Economics for Consideration in promoting Money Management among Those with Substance Use Disorder.  The American Journal of Drug and Alcohol Abuse.  38:8-19.

What can we learn from drug users about money management?

January 28, 2013

Recently, psychologist Laura Chivers and psychiatrist Stephen Higgins (2012) studies the research on money management for people with a substance use disorder (SUD).  Money management is tough and if a person struggles with addictions, a couple of hasty decisions can destroy someone’s life.  I think we can all learn a few things about money management when looking at the research conducted on money management for people with SUDs.

One of the first factors to look at is delay discounting.  With delay discounting we value things we can have right now, more than what we may have in the future.  This is why it is so difficult for many to save for larger purchases or retirement.  It is easy to value a purchase we make today, whether it is a special dessert or a new TV, more than what we might value what that money could become if we invested it for retirement in 30 years.  Research has shown that people with SUDS struggle with this even more than the normal population.

A tool to use to make sure delay discounting doesn’t harm you a lot is by setting up a commitment response.  When someone can make a commitment in a time of strength it is easier for that person to face temptation than the one who hasn’t made the commitment.  One research study showed a situation where students had 21 days to complete a task and for one group they had assigned due dates for all the tasks within the 21 days while the other group was able to set their own due dates.  One might think that the people who set their own due dates would due worse and set more lenient dates, but the study showed the ones who got to set their own dates had better work completed and met more of the deadlines.

For someone with a SUD there are a few simple solutions that can help them make a commitment.  First, they can se tup to have their paycheck direct deposited into an account.  Then, they can set it up to have money taken out of the account automatically to pay bills and go into saving.  By keep money away from themselves, some individuals with SUDs have been able to avoid making a poor decision because it took longer to get the money to make that decision.  For all of us we can set up automatic withdrawals into retirement accounts.  If we wait to see what we have left at the end of the month we usually won’t have anything, but by setting up an automatic deposit we can usually adjust the rest of our life to make it work.

These solutions also help individuals with a default bias.  As shown in the book Nudge by Thaler and Sunstein (2012) we sometime continue to do what we have always done (the default option) as opposed to what could be best for us.  By setting up these automatic deposits and withdrawals for savings, retirement, and bills, it becomes the natural for these things to happen.  When an extra step is added to make a deposit into a retirement account or write a check for a bill it isn’t as likely to happen as the automatic feature allows.

A third challenge behavioral economics can bring those with SUDs is loss aversion and the endowment effect.  With the endowment effect, we usually value things we already own more than what they are worth.  One research project showed that when college students were given either a coffee mug or a bar of Swiss chocolate they tended to value the object they got, no matter which one it was, more than the other.  I think this is why it is sometimes so difficult for us to sell a house we’ve lived in for a while.  By living there and making it a home we value it more than people who are looking at it objectively.

With loss aversion we are more afraid of loss than we may be of the same gain.  When statistics are framed as a loss or negative  we are less likely to choose this than something is framed as a gain or a positive.  For individuals with SUDs it is important to try to replace the bad behaviors with good behaviors.  If the individual is thinking about the loss of their perceived benefits of drug use it is more difficult for them to abstain, than if they can think about the benefits they have from no using drugs.  This can be better family relations or even the opportunity to get into better physical shape.

I haven’t seen any research, but I think this is a big reason it is so difficult for those who have lost a job to get another one.  It is easy to spend a lot of time thinking about the job that was loss or overstate the value of that job since it was one the person had previously had.  When individuals can move from thinking about the loss to potential future gains it is easier for them to make better decisions.

Tomorrow, we’ll look at how mental accounting and analyzing opportunity cost can be used to help those with SUDs and some overall tips that can be used for individuals with addictions or even adjusted to help you.

Works Cited

Chivers, L.L. and S.T. Higgins (2012).  Some Observations from Behavioral Economics for Consideration in promoting Money Management among Those with Substance Use Disorder.  The American Journal of Drug and Alcohol Abuse.  38:8-19.

Thaler, R.H. and C.R. Sunstein (2009).  Nudge.  New York: Penguin Group

Your fear of loss may be costing you

January 27, 2013

Do you always make rationale decisions?  We may like to think so, but research shows otherwise.  In the past, economics usually assumed everyone would make rationale decisions on what gives people the most utility.  Economists Daniel Kahneman and Amos Tversky have shown this isn’t always the case.  In one of their famous research journals on prospect theory Kahneman and Tversky (1979) show that we aren’t always rationale.

First, in general we are loss averse.  Let’s say you had a 50-50 chance of getting $1,000 or a 100% chance of getting $500.  In the long run, these should be just about equal situations as your long term expected payoff in both examples is $500.  If you are like most though you probably chose the $500.  In the experiments by Kahneman and Tversky, 84% of those surveyed took the sure thing in the $500.

When looking at losses the results were the opposite.  If you had a sure $500 loss or a 50-50 chance of losing a $1,000 or losing nothing, 69% of people choose the 50-50 gamble on the loss as opposed to the sure $500 loss.

The general idea behind this is we are loss averse.  We generally take the sure thing even if it isn’t the best in the long run.  For example over the last 50 years the S&P 500 has had an average return of 9.8%.  It has a standard deviation of 15% meaning that 68% of the time in one year the S&P 500 will range from a loss of about 5% to a gain of 25%.  95% of the time the annual return will be between a loss of 20% and a gain of 40%.

It is easy to see in the long run your expected return in around 10% which is a good long term investment.  The problem is if the S&P 500 has a 10% loss one year, it scares many people.  In turn these people make their own choice, do they want to take a chance where they could gain a lot or have a small chance of losing money or do they want a sure thing with a much smaller return.

When the market decreased a great deal in the last five years many people said we don’t want to take that risk anymore and moved their money into investments with very small returns.  When looking at the rationale this doesn’t make sense, but because many people are loss averse they’ll trade the long term expected gains due to the fact they don’t have the chance to loss an money on an investment with a smaller return.

Be aware of your loss aversion and don’t let this harm your long term retirement or college savings.  If you are putting your retirement savings into savings accounts, money markets, or CDs and have over 10 years until you retire you probably won’t lose the money, but your expected return isn’t large enough for you to beat inflation.

Work Cited:

Kahneman, D. and A. Tversky.  (1979)  Prospect theory:  An analysis of decision under risk.  Econometrica  47(2), 263-292.

Your brain may be playing tricks on you

January 23, 2013

Quick, answer these questions:

1.  A bat and ball cost $1.10 in total.  The bat costs $1.00 more than the ball.  How much does the ball cost?

2.  If it takes 5 machines, 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?

3.  In a lake, there is a patch of lily pads.  Every day, the patch doubles in size.  If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half the lake?

Thaler and Sunstein (2009) use these questions to examine intuitive thinking.  There is so much information coming at us on a daily basis that we can’t think about everything in depth.  We need to be able to react to help us survive from the stone age to the Facebook age.  Most people on this test come up with the answers $0.10, 100 minutes, and 24 days on their first thoughts, but these are all wrong.

Our reflexive nature sometimes gets in the way of making wise decisions.  Thaler and Sunstein (2009) point out a couple of different ways this happens.

Anchoring -  Here’s another question for you.  Do you think the population of Canada is more or less than 10,000,000?  Now, what do you think the population of Canada is?  Do you think the population of Iraq is more or less than 60,000,000?  What do you think the population of Iraq is?  Iraq has a population of around 33,000,000 and Canada has a population around 34,500,000.  They are about the same size, but I’m guessing you guessed low on Canada and high on Iraq.  When we get a number our next number is usually based on that even if the first number had nothing to do with the second number.  This can affect our thoughts on pricing, estimates, and a wide variety of factors.

Availability - Based on recent events, as a society we are very concerned with the threat of gun violence.  It is an important discussion to have, but most Americans are more likely to be impacted by heart disease, but since it is a more common occurrence we spend our time worrying about recent events we see in the news instead of the threats we may actually face based on years of bad choices.

Representativeness - What do you think is the profession of the following person:

Lin

 

 

 

 

 

 

 

 

 

 

Unless you are a fan of professional basketball you probably wouldn’t guess Jeremy Lin a professional basketball player.  Why?  His looks don’t fit the image (representation) we have of what a professional basketball player has.

Overconfidence - Do you think you are an above average driver?  90% of Americans do so if you answered yes, you have a 40% chance of being wrong.  50% of marriages end in divorce, but almost everyone who enters marriage would predict it would not end in divorce.  We are overconfidence in our own abilities and frequently remember our wins while forgetting our losses.

These are just some of the biases we have.  These biases help us to quickly analyze a situation, but it is important to remember it may lead us to a faulty conclusion.

Answers to the first three questions:  If you still aren’t sure what the answers to the first three questions, they are $0.05, 5 minutes, and 47 days.

Your Turn:  Where do you notice some of these own biases in your life?  I know I don’t eat as healthy as I should or exercise as much as I should.  I guess I’m overconfident about my health and because of availability I don’t think of the risks of heart attacks and diabetes as much as I should.

Work Cited

Thaler, R.H. and C.R. Sunstein (2009).  Nudge.  New York: Penguin Group

Do you need a little Nudge?

January 22, 2013

This semester I’m taking a graduate class where I need to do a lot of research.  I haven’t been blogging in a while and I need to keep track of the articles and books I read so I thought I would share them on here.

The first book I read was Nudge by Richard Thaler and Cass Sunstein (2009).  These are two leading behavioral finance experts with Richard Thaler being a distinguished professor at the University of Chicago’s Graduate School of Business and Cass Sunstein being a law professsor at Harvard (I guess those are O.K. schools).

The basic premise of the book is we should have the freedom to choose what we want, but organizations should help us in our choices by giving us a wise default.  The term they use for this is liberal paternalism.  For example, if you started working for a company they would automatically enroll you in the 401(k) plan instead of you having to choose to enter the 401(k) plan.  If you wanted to opt out you could, but the default option would be to be enrolled.  They cite one story by Madrian and Shea (2001) that points out that when individuals had to opt in to the retirement program there was a 20% enrollment rate after three months and a 65% rate after thirty six months.  When individuals were automatically enrolled there was a 90% enrollment rate after three months and a 98% rate after thirty six months.

Thaler and Sunstein go on to show how a nudge can be used to help the public good in everything from investing, to the Medicare Part D plan, to organ donors, to school choice.  These nudges are needed because of our thought processes.  The way our brain is wired we sometime make decisions that aren’t in our best interest because it is a little more convenient at the current time.  These nudges don’t take away our freedom not to be nudged, but make us work a little harder to choose the lesser option.

When looking at your own life are there defaults you can set up to help you.  For example, if you aren’t saving for retirement, can you set up an automatic withdrawal into an IRA that would happen every month without you having to do a thing?  If you have trouble with snacking food that isn’t the best for you, can you surround yourself with raisins and carrots so you are snaking on something healthy instead of chips and cookies?  If there is a certain bad habit you have, how can you change your environment to make it more difficult for you to partake in that habit?

This was a great book to start out with my research.  It really has made me think about my environment from what I do with my money to my eating habits.  I plan to use some of the ideas of liberal paternalism to help improve my life.

Let me know how you change your environment to make yourself make wise decisions because it is the default option.

Works Cited

Mandrian, B.C. and D.F. Shea.  (2001) “The Power of Suggestion:  Inertia in 401(k) Participation and Savings Behavior.”  Quarterly Journal of Economics  116:  1149-1225.

Thaler, R.H. and C.R. Sunstein.  (2009) Nudge.  New York:  Penguin Group.

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