The Disposition Effect

A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.

(Kahneman and Tversky, 1979) 

Stock brokers prefer to sell stocks that rise in price than stocks that fall in price. The preference for 'winners' over 'losers' is driven only by the desire to realise gains over losses. This is called the disposition effect, and it is likely to lead to lower profits.

This is because attitude to risk is different for losses than gains. Behavioural economics has shown that people tend to be risk seeking when it comes to losses, but risk averse when it comes to gains. For example, a stock that depreciates in value will be seen as a loss, making the stock broker more risk seeking and therefore more likely not to sell it (it may go up in value again). But if the stock rises in value then the stock broker is more risk averse and therefore more likely to sell it (to avoid the risk of it falling in value).

The disposition effect increases taxable income (Odean, 1998). If stock brokers realise 'winners' they have to pay tax on the gain. But stock brokers do not have to pay tax on 'losers'. Thus stock brokers could put off paying tax (and thus earn money) by holding 'winners' for longer. And by selling 'losers' taxable income reduces; if stock brokers sell the 'losers' and buy almost identical stocks taxable income actually falls. Thus the disposition effect is irrational for stock brokers (but good for the Inland Revenue!).

The disposition effect is a violation of fungibility because investors view units of money either side of the gain/loss boundary as qualitatively different. This is an example of non-fungibility causing market failure. If investors were aware of this non-fungibility they might be less likely to exhibit it.

Remember Remember...

If we are rational creatures then we need to be able to remember accurately. Interestingly, however, our memory is as complex as a Rubik's cube in a maze.

One rule of thumb initially discovered by Daniel Kahneman is the peak-end rule. He got patients undergoing a painful operation to note down the amount of pain (out of ten) they were in, minute by minute. Thus he was able to create graphs of the sum total of pain patients experienced. For example (my data):

The patients were then asked after the operation to remember how much pain they went through. To be consistent they should have given the average amount of pain they recorded during the operation (here 5.5). But they didn't. Instead they tended to report the average of two points: the most memorable (the peak) and the end of the operation (here 5).

Thus our memory tricks us. We do not remember a how a whole experience (good or bad) was, instead averaging the best/worst bit and the end. This is a challenge to those who defend human rationality. If we do not remember accurately, then how can we make decisions that maximise our personal benefit/satisfaction/goals?

Kahneman then decided to prove the peak end rule (using, in my opinion, ethically dubious methods). He asked the surgeons to extend the operations subjects went through by leaving their instruments in the patient at the end for a couple of minutes. This increased the length of the operation. It also meant that the pain experienced in the final couple of minutes of the operation fell. In accordance with the theory, although the total amount of pain experienced went up, the amount of pain patients remembered fell. Gruesome but true.

The Endowment Effect

I am very pleased to introduce a guest blog by Alex Silk. Alex is somewhat of an expert on the endowment effect and I have been bugging him for months to write this post: Enjoy!

The endowment effect is demonstrated in a really simple experiment that was conducted by an economist called Jack Knetsch back in 1989. The experiment had three separate treatments. In the first treatment each participant was given a (identical) mug, they were told that this was a gift. They were then each given the option of switching the mug for a bar of Swiss chocolate (which could be bought at the same price as the mug). The second treatment was the reverse of this; each participant was initially given the chocolate bar and was then asked whether or not they wanted to exchange it for the mug. Standard economic theory predicts that the proportion of subjects who end up leaving the experiment with a mug should be equal in both treatments (allowing for random error) – this appears to be a fairly reasonable assumption. So what do you think happened?

Well what Mr Knetsch found was that in both treatments 90% of people kept the item which they were originally given. Furthermore, in a third treatment where each participant was given a straight choice between the mug and the chocolate bar 56% of people chose the mug (where again economic theory predicts the proportions should be the same as in the first two treatments).

What the experiment demonstrates is something called the endowment effect: people value a good more highly when they are in possession of it. While this is a significant violation of some important economic theories (something that for your sake I hope you are not too concerned about!), on one level this may not seem that surprising to you: a child would value her favourite teddy bear more than an identical one sitting on a shelf in a shop. However, what may be surprising is the fact that other experiments have shown that virtually as soon as you take ownership of a good you value it more (unless you expect to sell it in the near future).

So the next time you buy a can of baked beans remember that, subconsciously at least, you value that can slightly more than each of the cans you left behind you in the shop. Isn’t that useful to know?

- Alex Silk

Book Review - Nudge

Daniel Kahneman called Nudge the bible of behavioural economics. He wasn't far wrong. It is the defining literature on behavioural economics of our generation. And given that our generation is the pretty much the first generation to have used behavioural economics, that makes it the defining book on behavioural economics. And it isn't hard to understand why.

Let's start with the authors; Richard Thaler and Cass Sunstein. Thaler is one of the godfathers of behavioural economics and the book is brimming with his expertise, while Cass Sunstein, a political scientist, is now employed by Barack Obama to implement 'nudges'. They communicate clearly and with humour. Nudge is a book you will devour in days, and it may just change the way you approach life...

A key concept in Nudge is 'choice architecture'; the context in which a choice is presented, or framed (for more stuff on frames see You've Been Framed - American Idiot). They demonstrate that it isn't possible to present a choice in a way that has no influence over the decision. We are fickle creatures. Neutrality is just not attainable.

So what is a 'nudge'?

"A nudge, as we will use the term, is any aspect of choice architecture that alters people's behaviour in a predictable way without forbidding any options or significantly changing their economic incentives. To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting the fruit at eye level counts as a nudge. Banning junk food does not."

Sunstein

Some example nudges include encouraging healthier eating, increased  retirement saving, greener living and increased organ donations.

Thaler and Sunstein describe their approach as libertarian paternalism; using the oxymoron to communicate the fact that, while they believe people's decisions can be improved for their own welfare, they respect the freedom to choose. In short, they advocate the use of behavioural economics to improve people's lives, but in a libertarian way. Genius.

Unsurprisingly, since it was first published in 2008 Nudge has been incredibly influential; Downing Street even has a special 'nudge unit'.

The only poor chapter is the one on privatising marriage which, quite frankly, isn't worth the paper it's printed on. It feels like post-modern propaganda, shoehorned into the book for ideological reasons, which is a shame, because the rest of Nudge is so well thought out and scrupulously non-political. But one poorly researched chapter aside, Nudge really is a ground-breaking work.

Thaler

Nudge is so brimming with ideas that I'm struggling to keep this review short(!). Safe to say that it will inspire many a guruhogg blog post to come. I cannot recommend Nudge enough; such a good read. If you only read one book about economics in your lifetime (not a bad policy, per se), make it Nudge. It is Required Reading.

Genre: Behavioural Economics
Accessibility: 10/10
Accuracy: 8/10
Readability: 9/10
Usefulness: 10/10
Verdict: Required Reading

Book Review - Predictably Irrational

Predictably Irrational is a fantastic name for a book about behavioural economics. If you are looking for an easy read that will introduce you to many behavioural concepts using quirky yet illuminating stories, then this is the book for you. Dan Ariely takes us through all his research in a gripping tour of the wacky world of behavioural economics, finishing with an insightful take on the credit crunch. If nothing else, Predictably Irrational will convince you of the need for behavioural economics.

Predictably Irrational will not, however, give you a solid academic overview of the subject. The author's approach is to take us through his own wide-ranging research, but this means that genuinely ground-breaking stuff from other authors is sometimes omitted. For example, his chapter on anchors is well-written but illustrate matters with a flawed experiment (incentives were purely hypothetical - see Incentives - Ante Up). (Daniel Kahneman did not have this problem with his book.)

Ariely also includes the single most stupid experiment I've ever seen: it turn out that men, when sexually aroused, are less rational... well, DUH!

Another issue is one of his pieces of advice: hang around with a friend that is slightly less attractive than you in order to make yourself look more attractive (and whatever you do don't tell them, because that ends badly according to one of his readers). While this probably works, it is manipulative. I would not advise following all of the advice in Predictably Irrational. I do not advocate people using and manipulating their friends (or anyone)!

I will, however, end on a positive note. The chapters on cheating and honesty were genuinely new to me. Ariely's research showing that people cheat less shortly after being asked to recall the 10 commandments (or similar) is both credible and important.

Thus Predictably Irrational, while being occasionally frustrating, is well-written, easily accessible, often amusing and incredibly interesting. It is a good read, but it could be better.

Genre: Behavioural Economics
Accessibility: 9/10
Accuracy: 6/10
Readability: 9/10
Usefulness: 6/10
Verdict: A Good Read

PS Ariely has a blog, too: danariely.com

Book Review - Thinking, Fast and Slow

 

Daniel Kahneman is a world-renowned psychologist who won the Nobel Prize for Economics in 2002 for his contribution to behavioural economics. Thinking, Fast and Slow is his summary of his lifetime's work into understanding the human brain - it is required reading for anyone who wishes to understand how we make decisions. Kahneman effortlessly keeps you gripped as he conducts his whistle-stop tour of your mind. Reading this will improve how you understand the decision-making process, and might just help you make better decisions in future. Leaders take note!

The title comes from the way psychologists separate brain functions: two systems are in operation, one is incredibly fast but prone to making errors, while the other is more accurate but slower and lazier. Kahneman reveals how the interaction of these systems results in systematic errors in our thinking and quirks in our decision-making.

For example, we have a fantastic tendency to fail to look beyond the obvious. Kahneman uses the phrase 'What you see is all there is' to describe our thinking so often he actually shortens it to WYSIATI. His expertise combined with a wonderful turn of phrase results in highly enjoyable quotes, such as:

"Our comforting conviction that the world makes sense rests on a secure foundation: our almost unlimited ability to ignore our ignorance."

However, just because Daniel Kahneman has written something doesn't make it true. There are alternative theories (certainly within behavioural economics) worthy of equal attention that don't make the book. Those interested in behavioural economics should not rely on Thinking, Fast and Slow alone. Although, a really nice touch is that the two main papers for which Kahneman received his Nobel Prize are reproduced at the back for those who are really interested.

Given the sheer quantity of material packed into the 400+ pages it may take a while to digest, but don't let that put you off - it's well-worth a read. I thoroughly recommend Thinking, Fast and Slow.

Genre: Psychology
Accessibility: 7/10
Accuracy: 8/10
Readability: 8/10
Usefulness: 10/10
Verdict: Required Reading