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The Importance of Behavioral Economics
Introduction
Behavioral Economics uses psychology, neuroscience and economics to examine how humans make economic decisions. It includes the process of studying the biases, rules of thumb, inaccurate or incomplete information, propaganda and other influences that interfere with our making optimal decisions. It also presents prescriptions for countering these irrational influences in order to make better decisions as employees, citizens, and family members.
To begin to understand this field, we should look at one of the most pervasive and consequential biases that has affected our entire economy: the oft repeated belief that a company’s purpose is to “maximize its profits” and to only look out for the owners’ and shareholders’ interests. This idea has roots in the writing of economist and Nobel Prize Laureate Milton Friedman. In an article in The New Times Magazine, Friedman stated,
…there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud (1970).
The University of Chicago Department of Economics, where Friedman taught, was (and still is) the center of conservative free market economics in the United States. His general argument was that any employee of a business or corporation is an agent of the owner or its stockholders and has no right to spend their money in any way other than to increase profit. The owners and stockholders can then do anything they want with their profits, including spending it on some “social purposes.” Whether because of simple greed or true capitalist philosophy, this became a battle cry of capitalists and was widely quoted and used in corporate mission statements. It also was used in management and finance textbooks as a fundamental guiding principle and turned up in corporate annual reports as a mission statement to “maximize shareholder value.” The problem with Friedman’s entire theory is that it is simply wrong. Since this is a text about financial literacy, I will not spend a long time discussing the Friedman’s errors. However, I will make three points:
Corporations and partnerships must apply to a state to receive the permission to incorporate. This is not a right but a privilege. For example, according to Pennsylvania state laws, the state grants the right to incorporate for the “good of the Commonwealth.”
Freidman’s view was not the majority view when he voiced it. In the mid-twentieth century, firms were an integral part of their communities and the prevailing view was that firms had a responsibility to their shareholders, employees and communities (Wells, 2020).
The “free market competition” that Friedman envisioned in his theory does not exist in most markets, It is a fiction made up by economists.
Perhaps the most telling repudiation of Friedman’s theories is that recently the CEOs of most of the largest corporations stated definitively in what can only be called a manifesto that the purpose of a corporation is not what Freidman said it was, but that corporations do have a social responsibility. The press release for this new manifesto was promulgated by the 181 CEO members of The Business Roundtable on August 20, 2019, which stated,
Since 1978, Business Roundtable has periodically issued Principles of Corporate Governance. Each version of the document issued since 1997 has endorsed principles of shareholder primacy – that corporations exist principally to serve shareholders. With today’s announcement, the new Statement supersedes previous statements and outlines a modern standard for corporate responsibility…we share a fundamental commitment to all of our stakeholders…. Each of our stakeholders is essential. We commit to deliver value to all of them, for the future success of our companies, our communities and our country (2019).
It is my sincere hope that this new philosophy will become best practice in business. However, as of this writing, this pledge is over three years old, and according to the empirical evidence, this has not been the case (Colvin, 2021).
Dennis A. Muilenburg, Chairman, President, and CEO of The Boeing Company, signed the pledge. A recent Congressional investigation on two Boeing737 MAX airplane crashes (which had been grounded by the Federal Aviation Administration due to safety issues) casts doubt on his commitment. John Cassidy, an economics reporter for The New Yorker, summarized some of the reports’ key findings:
It illustrates how Boeing’s management prioritized the company’s profitability and stock price over everything else, including passenger safety. Perhaps even more alarmingly, the report shows how the F.A.A., which once had a sterling reputation for independence and integrity, acted as a virtual agent for the company it was supposed to be overseeing (Cassidy, 2020).
This is known as a “regulatory capture”—when a company dominates the regulator that is supposed to be overseeing it.
In 2020, KKR Advisors and TCP published a more comprehensive analysis of corporate responsibility, reviewing all 500 companies in the S&P 500 and all 300 companies in the European FTSEurofirst Index. They were able to compile extensive data on 619 of these 800 companies and use a machine learning high-tech lab to analyze millions of data points. The report reached these key conclusions:
Business Round Table’s (“BRT”) Signatories’ “Purpose-Washing” Unmasked: Since the pandemic’s inception, BRT Signatories did not outperform their S&P 500 or European company counterparts on this test of corporate purpose.
Powered by Purpose: Companies with long track records of strong performance outperformed more than expected, while laggards’ underperformance became more pronounced, demonstrating how resilient companies were further fortified during this corporate purpose stress test.
Speed matters: Proactive, substantive responses to the pandemic and inequality crises had a discernible positive impact. Slow responders underperformed.
Global challenges: U.S. and European companies performed roughly the same on this test of corporate purpose.
Shareholder capitalism is no longer fit for purpose: TCP highlights the business case for ushering in a new form of stakeholder-aligned capitalism (Cassidy,2020).
There are some positive changes underway in the corporate world.
The Pandemic Recession and the resultant labor shortage have increased wages, benefits, and working conditions for workers in the U.S.
Shareholder and popular activism has prompted corporations to promote their “green” efforts.
These changes, while welcome, do not seem to be a result of the BRT’s new manifesto of the Principles of Corporate Governance. Rather, they seem to be the result of market forces and political pressure.
Decision Biases and Information Literacy
An important area of economics is the topic of making decisions based on imperfect information, or decision making under uncertainty. While decisions under risk are defined quite narrowly in economics as decisions where we know each outcome’s probability, decisions under uncertainty are decisions where we do not know all the outcomes or their probability. When trying to make a decision under uncertainty, typically the first step is to search for more information, as you want to reduce a decision under uncertainty to a decision under risk. Thus information literacy is a critical component of decision making. At the university where I teach, information literacy is a required component of every writing intensive course required of all majors.
In this “Post-Truth Era,” as some have called it, finding factual information has become extremely complicated. Nowhere is this more evident than in the media, where misinformation and conspiracy theories try to bias our opinions about everything from vaccinations, to mask-wearing, to the last presidential election. This is why information literacy is such a crucial part of decision making. The following graph from Ad Fontes Media gives an excellent analysis of the bias of media in America.
This chart is a continually updated version on the Ad Fontes Media website.
For financial literacy, you can read serious mainstream publications like the Wall Street Journal, the New York Times, and the Economist via library access or student subscriptions.
Traditional Economic Assumptions About People’s Behavior
Professor Eugene Fama of the University of Chicago originated the efficient market hypothesis. In its simplest form, the hypothesis states that today’s current stock prices have factored into them all available information, and that past price performance has no relationship with the future. This means it is impossible to use technical analysis of past price performance to achieve exceptional returns. The assumptions behind this hypothesis are that investors are rational and that markets are perfectly competitive. However, we often see bubbles and busts in the stock market, a telling criticism of the efficient market hypothesis.
Behavioral economics, on the other hand, studies how people actually make financial decisions, as opposed to how they should make decisions. It finds that people are often irrational: they have biases that skew their decisions, they use heuristics to make choices, and they are impatient for instant rewards. These tendencies can cause people to make sub-optimal choices.
However, behavioral economics is still a rigorous science. People do not have to be rational in order to develop a model of their behavior; they only have to be predictable—that is, predictably irrational. The standard economic model of consumer choice has rigid assumptions that behavioral economists believe are either inaccurate or severely limited. Below, I have listed some of these assumptions as well as my thoughts on them.
Assumption: Economic agents are rational.
- While it’s true that people sometimes behave rationally, most of the time their actions are motivated unconsciously and emotionally.
Assumption: Economic agents are motivated by expected utility maximization.
- People are often motivated by material rewards, as this assumption states. However, it is important to remember people are motivated by a whole host of non-material rewards as well.
Assumption: An agent’s utility is governed by purely selfish concerns, without taking other’s utilities into consideration.
The falsity of this assumption should be evident to you without much explanation. People care very much about others’ happiness.
Assumption: Agents are Bayesian probability operators.
This is accurate. Bayesian logic is the opposite of scientific logic. Scientific logic looks at data with no preconceptions, while Bayesian logic holds that we have preconceived notions about most phenomena. Those preconceived notions are tested, and if we get an error message, we revise our preconceived notion.
Assumption: Agents have consistent time preferences according to the Discounted Utility Model (DUM).
People have a very strong present bias, so future rewards are not anywhere near as salient as present rewards.
Assumption: All income and assets are completely fungible. Fungible means that they are completely substitutable.
Assets are equivalent to income in that they generate an income dividend. That is, assets times an operator equals income (e.g., at a 10 % return an asset investment paying $1,000 per year would be worth $10,000: $10,000 × 0.10 = $1,000 annual return). However, people use mental accounting. We consider money we earn different from money we get as a gift and money in a savings account different from money in a checking account. We then treat this money differently (Wilkinson, 2008).
Irrational (biases, heuristics, etc.)
Nobel Prize winner Herbert Simon referred to the sometimes irrational cognitive processes that humans use to process information and make decisions as “bounded rationality.” However, current day behavioral economists are more focused on irrationality than bounded rationality. There are plenty of examples of people letting their biases and heuristics wrongly influence their decisions and opinions. For starters we merely need to pay attention to the partisan interpretation of everything each of the Presidential candidates says in the 2020 election cycle. Some other anomalies that violate the assumptions of the standard economic model:
If you take a weekend trip to New York City and eat at a restaurant you will likely never visit again, why do you leave a tip?
Why is the average return on stocks so much higher than the average return on bonds?
Why are people willing to drive across town to save $5 to purchase a $15 calculator but not willing to drive to save $5 on a $125 jacket?
Why do people forever make resolutions to stop smoking, to join a gym, to go on a diet, but it lasts about three weeks?
Why are people willing to pay $8 for a hot dog at a sports stadium but not from a street vendor?
Why do people buy a new TV on credit when they have plenty of cash in their savings accounts to afford the TV?
When people go to an event and go to purchase a ticket for $30, and find there is, say, $50 missing from their wallet 88% say they will still buy a ticket.
However, if they already bought the ticket and find the ticket missing from their wallet only 46% said they would buy another ticket (Tversky and Kahneman, 1981).
Homo sapiens have been around for 900,000 years. Over time, evolution has endowed us with deep impulses that guide our decisions. The following are a few examples of these impulses:
Humans use heuristics to make decisions, not rational thought.
Humans approach and are impatient for expected rewards.
Humans avoid expected losses.
Humans place more importance on relative income than absolute income.
Humans feel an actual loss twice as much as an equivalent gain.
Humans hate uncertainty.
Humans are a super-cooperative species.
Humans have a profound sense of fairness.
Humans are willing to punish third-party cheaters.
Humans have inertia; they resist change.
Humans act into a new way of thinking, rather than think into a new way of acting.
Peoples’ financial decisions are a good example of this kind of irrational behavior. Nowhere is this more evident than in the stock market, especially by investors who are not professionals and even by investors who are professionals. Meir Statman, a finance professor at Santa Clara University, catalogues some of the erroneous beliefs that biased individuals hold about the stock market in a Wall Street Journal article (2020). After publishing an earlier article debunking five myths that amateur investors believe, Statman received feedback from amateur investors who still believed they could “beat the market” (that is, they could beat the performance of market indices, such as the Dow Jones Industrial Average, the S&P 500 Index, or the NASDAQ Composite Index). He aggregated these contrarian comments into six main categories, and I have summarized his response to each.
Average is for losers.
By definition, diversified investors earn average returns. If they choose an Index Fund or an Exchange Traded Fund (“ETF”) they earn the returns of the market. Some stocks deliver low returns and others deliver high returns; these average out to the market return. Undiversified investors attempt to pick good stocks and shun bad ones, leading to higher than market returns. In reality, though, they only think they earn higher returns.
OK, but I know what I am doing.
One reader contended that a person who has run a business will have acquired skills such as reading a financial statement, knowing what makes a company successful, or other types of business acumen that will help them pick good stocks. Statman retorts that playing the stock market game as an amateur is like playing tennis against a top-seeded professional.
Reward requires risk.
Another reader says that to reap higher returns you have to take higher risks, and that this is just the nature of the market. Statman says that in order to reap higher returns with an undiversified portfolio, you need luck not skill. A diversified portfolio will gain when the market gains. An undiversified portfolio may take a dive even when the market is gaining and decimate your portfolio.
Time itself is a diversification.
Another reader advocates holding stocks for five years or more, implying that the risk of any portfolio declines over time. This is not true, says Statman. Even a diversified portfolio can lose value over time, due to some companies going out of business. But a single stock or a small portfolio can be subject to many things over a longer horizon that can decrease its value. Competition could rise, or perhaps an innovation disrupts its market. Even Tesla, a current high-flying stock, is about to get a deluge of electric vehicle competitors from 2021 to 2025.
Dollar-cost averaging is another form of diversification.
One reader suggested you invest the same amount every month in an S&P 500 mutual fund. This is known as “dollar cost averaging.” Statman argues that the only value of dollar cost averaging is reducing your regret should you change your mind over the course of a year. For example, if you invest 10% of your cash on the first of every month, you will still have 100% of your money invested at the end of 10 months. If you invest in a diversified fund, you have the lower risk of a diversified fund. If you invest in an undiversified portfolio, you still bear the higher risk of that undiversified portfolio.
Just pick stocks of good companies.
Is Tesla a better company than General Motors? Maybe, by environmental criteria. On the other hand, is General Motors stock a better buy than Tesla stock? Definitely yes, by any standard fundamental stock market analysis. Tesla is way overvalued in relation to its earnings; GM is not. Whether a company is “good” is certainly important, but whether or not a stock is a good buy is much more important to investing. That is, if you want to make money on your investment. Statman reports that a study of Fortune magazine’s “America’s Most Admired Companies” found that these companies’ stocks had lower returns on average than stocks of spurned companies. Further, there was a correlation between increases in admiration over time and lower returns. (It should be noted, though, that this could be caused by investors bidding up the price when the firms get publicity and therefore reducing the returns).
Biases
Behavioral economics has studied many biases that influence our decisions. The following are some of the more common ones.
| Bias Type | Definition | Example |
|---|---|---|
| Anchoring Bias | Cognitive bias that causes us to rely too much on the first piece of information on a topic. Subsequent information is interpreted based on the reference point of our “anchor.” | The first price a dealer gives us for a car sets our interpretations of the price of the car. If they lower the price, the price seems more reasonable, regardless of whether the price is too high. |
| Confirmation Bias | Cognitive bias in which we seek out information and notice it if it confirms an existing point of view. We tend to ignore or reject conflicting information that does not fit with our view. | Picking a specific news or media source can limit what an individual is exposed to. People who have pre-existing party biases may tend to watch only networks that support their party and views, while rejecting or ignoring opposing channels. |
| Actor-Observer Bias | Bias where we attribute our own actions to external causes or situational factors while attributing others actions to internal causes, such as personality traits or motives. | If you are scheduled to interview someone, but they show up 30 minutes late, you may attribute their lateness to their personality. However, if the roles were switched and you were the one running late, you might not blame yourself but rather attribute it to traffic or other situational factors. |
| Correlation Causation | A bias where someone inaccurately perceives a cause-and-effect relationship based on an assumed association or correlation between two events. | As ice cream sales increase, crime rates increase. However, ice cream sales do not “cause” crime. Rather, there is another variable likely affecting each, such as the summer heat. |
| Rhyme as Reason | A cognitive bias where rhyming statements are more easily remembered, repeated, and believed. | O.J. Simpson’s lawyer, Johnnie Cochran, used the phrase “If it doesn’t fit, you must acquit.” Cochran was referencing the gloves that were left at the murder scene. This phrase was considered a vital part of his defense. |
| Loss Aversion | Choosing to avoid a loss, even with potential to make an equal or even greater gain. | Investors may hold their stock even if they are taking a loss so they can “at least breakeven” and sell for the price they bought. If they sell below the price they paid, they are experiencing a loss. |
| Herd Instinct | Tendency for individuals to think and behave like the people around them. | During the first few months of the COVID-19 pandemic, Robinhood and other trading platforms experienced a marked increase in new accounts, primarily new investors with little to no experience. |
| Information Bias | Using extra information to increase your confidence in a choice, even if the information is irrelevant. | For example, believing that the more information that can be acquired to make a decision, the better, even if that extra information is not related to the decision. |
| Status Quo Bias | Preferring to keep things the same as they are. | Rejecting new ideas just because they are new. |
| Halo Effect | Extending positive attributes of a person or brand to the things they promote or the opinions they hold. | For example, any celebrity and athlete endorsement that creates goodwill for a brand. |
| In-group Bias | Preferring people who are part of your “tribe” and acting in ways that confirm membership in the group. | For example, always trusting the views of your political party and voting accordingly. |
| Bizarreness Bias | Remembering material more easily if it is unusual or out of the ordinary. | For example, remembering facts about dinosaurs more readily than those about more academic topics. |
| Google Effect | Not bothering to try to remember information that can be found online. | For example, not caring about historical events because, “I can always look them up!” |
| Picture Superiority Effect | Learning and recalling concepts more easily when they are presented as a picture rather than as words. | Advertising uses this to great effect. For example products are shown in the midst of very happy people. However, if an ad contained the words, “Beer makes you happy,” many people would disagree. |
| Humor Effect | Remembering things easier if they are presented in a funny or entertaining way. | Believing that political cartoons are true and unbiased because they are funny. |
| Peak-end Rule | Judging an experience by its peaks (highs and/or lows) and how it ended. | “All’s well that ends well!” |
Sources: Coglode Ltd. (2021); Kendra Cherry (2020); The Decision Lab (2022); Shahram Heshmat (2015); Connie Mathers (2020); Gretchen Hendricks (2021); Daniel R. Stalder (2018); Anthony Figueroa (2019); Itamar Shatz (2022); Craig Shrives (2022).
As the field of Behavioral Economics expands, researchers identify more and more biases that humans have. Thus far, researchers have found that humans have 188 cognitive biases.
Nudges in Behavioral Economics
The co-author of Nudge, Cass Sunstein, describes nudges as, “‘Nudges’ are “choice-preserving approaches that steer people in a particular direction, but that allow them to go their own way” (Thaler and Sunstein, 2008). They are not mandates but important “gentle pushes” that help people make good decisions. Nudges are very important in motivating people to take action on behaviors that are good for them. As one classic example of a nudge, a company automatically enrolls its employees in a retirement plan but allows them to opt out. In one experiment, this increased employee participation in contributing the maximum amount matched by the company from 40% to over 90% (Thaler and Sunstein, 20028).
Default rules (e.g., providing automatic enrollment in programs, including education, health, and savings).
Simplification of current requirements (in part to promote take-up of existing programs).
Reminders (e.g., emailing or text messaging for overdue bills and coming obligations).
Eliciting implementation intentions (e.g., asking ‘‘do you plan to vote?’’).
Uses of social norms (e.g., saying ‘‘most people plan to vote,” “most people pay their taxes on time’’ or ‘‘most people are eating healthy these days’’).
Increases in ease and convenience (e.g., making low-cost options or healthy foods visible).
Disclosure (e.g., sharing the costs associated with energy use), or as in the case of data.gov and the Open Government Partnership.
Warnings, graphic or otherwise (e.g., putting warning labels on cigarettes).
Precommitment strategies (e.g., having people commit to a certain course of action).
Information on the consequences of past choices (e.g., the use of ‘‘smart disclosure’’ in the US or the ‘‘midata project’’ in the UK).
Nudging Yourself
Humans are creatures of habit. When left to our own devices, we will more often than not fall back into our old habits, no matter how good our intentions. Setting up external nudges for ourselves can help us gain new and better habits. For example, you can set up a savings account connected to your checking. Then the checking account can “pay” your savings account a certain amount every month. This builds up your savings, which then can be used as an emergency fund or to invest in the stock market.
Another way you might nudge yourself is to make to-do lists, both a daily list and a separate list for long term projects. These lists should be numbered by priority, but keep in mind that it will only work if you look at them regularly. Usually when we try to consider what task to do next, we will be subject to availability bias. Instead of focusing on the highest priority, we will work on the first thing that comes to mind. This first thing is often the easiest. Unfortunately, we have to do the hard things in life. Setting an alarm with a snooze function or, even better, two alarms fifteen minutes apart recognizes that we’d all prefer to turn off the alarm and sleep another hour in the morning. It will nudge us to eventually get up around the right time.