Aniket Das say it’s simply not rational to assume that human beings are rational.
Let’s start with a wager. Which of the following bets would you take?
(a) A 25 per cent chance of winning $3000;
or (b) A 20 per cent chance of winning $4000? Now for another. Which of these would you pick?
(a) A 100 per cent chance of winning $3000;
or (b) An 80 per cent chance of winning $4000? If you’re like most people, you’ll have chosen (b) in the first case but (a) in the second. This problem is Daniel Kahneman’s and Amos Tversky’s variation of the Allais paradox, first posed by Frenchman Maurice Allais in 1953. It demonstrates how people don’t necessarily make consistent choices according to the traditional “expected utility” or “expected benefit” theory used in many economic models. While the dollar amounts of the rewards remain the same in either case, the probabilities in the second case are simply four times those in the first.
According to expected utility theory, someone who prefers (a) in the first case should prefer (a) in the second case, and the same for the (b) options. However, this example shows how people are generally loss-averse – they hate losing.
The second question gives youtheoptionofaguaranteed win, with zero chance of losing. In the first, however, there is a good chance you will lose whether you choose (a) or (b). This means that you’re tempted to “go for broke” with the higher value and choose (b).
Problemssuchasthishave come to define an area of work known as “prospect theory”, which tries to understand people’s real-life choices in the presence of uncertainty. Whereas economic models dictate how people should react, behavioural models such as these try to analyse how they actually react.
Perhaps Ronald Reagan summed this thought up best when he said: “Economists are people who look at reality, and wonder whether it would work in theory.”
HOW CAN THIS HELP ME?
As many financial planners will have noticed, some people have difficulty saving adequately for their retirement. This tendency presents itself even more strongly in countries where there is no mandated saving system like superannuation. Innovative research, such as that of Richard Thaler and Schlomo Benartzi, shows how understanding human behaviour can help financial planners better service their clients.
Thaler and Benartzi demonstrated in a study that workers who were generally hesitant to save more from their current income were much more likely to agree to save more from future pay rises.
They designed a plan called “Save More Tomorrow” which called for participants to set aside a proportion of their future pay rises toward their savings.
The results of their study showed that 78 per cent of workers who were offered the plan opted to enterintoitand,further,that80 per cent of programme participants were still in the plan after four pay rises. The savings rate for participants increased from 3.5 per cent to 13.6 per cent over the course of 40 months. This study shows how obstacles – like inertia in this case – can be overcome by tailoring a solution which is acceptable to the client, rather than being completely prescriptive.
By recognising the behavioural biases that clients demonstrate, financial planners can try to either moderate the biases through counselling, or adapt financial plans to accommodate the biases. Most importantly, the choice will depend on situational factors including, but not restricted to, the client’s level of wealth, income, and spending needs.
ARE PEOPLE “RATIONAL”?
So the presence of these quirks in our thinking begs the question, are people always “rational” when making decisions? In this case, do we make decisions in accordance with economic theory? If we aren’t rational, then many of the mathematical models of finance which require us to be so may not necessarily hold.
At the heart of some of the most widespread mathematical models is the “efficient markets hypothesis” (EMH). The EMH is an assumption that stockmarket prices accurately reflect available information, effectively saying that no-one can consistently beat the market on a risk-adjusted basis.
This assumption implies that the market itself is the most optimal portfolio to hold, as there are no biases to exploit. This reasoning is the basis for index funds and exchange-traded funds (ETFs) that use market-capitalisation weighting – that is, they try their best to represent a portion of the stockmarket.
The frequent occurrence of bubbles, booms, and busts seems to suggest, however, that there quite often are times when markets can become “irrational”. Nevertheless, those who choose to trade against the irrationality often have to bear painful, if not irredeemable, losses. According to eminent economist John Maynard Keynes: “Markets can remain irrational longer than you can remain solvent.”
Some argue, however, that it is impossible to tell if we’re in the midst of a bubble at the time of its occurrence, although the number of people who profited from the sub-prime crisis would seem to contradict this belief.
CAN YOU MAKE MONEY?
Behavioural biases are among the most commonly cited reasons for why active fund managers think they can beat the market. They generally believe that the EMH doesn’t hold and that they can exploit inefficiencies in the market, which can be caused in part by behavioural biases, among other things.
By picking stocks using a systematic method based on economic theory, they hope to avoid the pitfalls faced by the more vulnerable “human” investor.
