The Tycoon Report

Why We Often Act Against Our Own Best Interests

So here's an example of an economic policy that takes into account human psychology.  (It reminds me of the allowance approach to parenting.)  The assumption behind it is that we all need a little push in the right direction when it comes to making decisions that are in our own best interests.

Because, contrary to what we may believe about our choices, the human brain is hard-wired to make errors in judgment.

"Darling, I Don't Know Why I Go to Extremes!"

For example, one could argue that monogamy is not a natural human state, that evolutionarily we are "programmed" to propagate our genes as much as possible with as many people as possible.  DNA wants to replicate, so that's how we've been wired.  But we don't have to succumb to our DNA's wishes.  We can overcome the natural tendency by being aware of it and, in spite of it, choosing to commit to a single individual.  Historically, then, monogamy has produced stable societies with strong family ties.

There's nothing new in this idea of perceptual error.  It's actually a school of economic thought, called Behavioral Economics, that's been around since 1955.  Back then Daniel Kahneman, a young psychologist in the Israeli army, stripped eight fellow soldiers of any visible mark of rank and gave them a very difficult task to accomplish: lifting an enormous telephone pole over a six-foot wall.  Based on his observations of who took charge, of which soldiers gave up, he and his fellows decided who would behave well in combat and thus should be sent to officer school.

The problem was that the scientists, merely through observing the men at work, were horrible at discerning potential.  "[T]here was absolutely no relationship between what we saw and what people saw who examined them for six months in officer training school," Kahneman said.

But the incredible thing is not the poor judging of a man's potential ability, but the fact that, even in the face of evidence to the contrary, Kahneman's faith in his own ability was unshaken.  "The next day after getting those statistics, we put them there in front of the wall, gave them a telephone pole, and we were just as convinced as ever that we knew what kind of officer they were going to be."

This is why, for example, the minimum payments suggested on your credit card bill tend
to be low.  That number frames your expectation, so you pay less of the bill than you might
otherwise, your interest continues to grow, and your credit card company makes more
money than if you had not had your expectations influenced by the low number.

Interesting but hardly revelatory, right?  (I pay the dagnab thing off every month, whether I like it or not!)  So far, we've discovered that it takes brains to overcome some of our natural tendencies.  BD, huh?

But hold on tight.  Here's where it gets interesting.

"You Got Your Psychology in My Economics!"
"You Got Your Economics in my Psychology!"
Mmmm.

Kahneman and his associate have identified dozens of these biases and errors in judgment, but it was the economist Richard Thaler who integrated these ideas about human irrationality into economics in the early '80s. Economists of the time mostly rejected the work, believing that humans are, at heart, rational.

You see, the economic models used by economists depend on a rational human being at their center.  And, for the most part, these models work.  But another reason why economists are adverse to incorporating human foibles into their notion of the "perfect economic agent" is because economists have to believe that "markets work well because individuals can be counted on to make the best choice for themselves."

Which brings us to the crux of this article:

"Merely accepting the fact that people do not necessarily make the best decisions for
themselves is politically very explosive.  The moment that you admit that, you have to
start protecting people," Kahneman says.

In other words, if the human brain is hard-wired to make serious errors, that implies
all kinds of things about the need for regulation and protection.

If those of us who are unaware of our tendency to make logical or emotional errors need protecting from ourselves, who is best suited to protect us?  Certainly the government is made up of individuals with the same biases who can also draw errant conclusions -- can they serve the public's best interest, the common good?  Without a point of reference, how can the individual hope to overcome wrong thinking about things?  Can education or reading or research bring enlightenment?  And how can we make sure that people who know about the psychology of economics aren't using it against us?

What do you think?

I honestly believe that the first step for each of us is to desperately want to begin to see things as clearly as possible, without letting emotions or ideology getting the best of us.  And we need to spend some time considering the mechanisms that we are prone to manifest in our own choices. This will greatly inform how we invest in the market and what we expect from it in return.

And this is essential in our approach here at Tycoon: Seeing the market for what it is and acting with detachment to achieve our (and your) financial goals.

P.S. For those of you interested in this topic, check out Nudge: Improving Decisions About Health, Wealth and Happiness, a book written by Thaler and his colleague Cass Sunstein, which "looks at how many — from parents to credit card companies to policymakers — are using human psychology to help you, or sometimes to simply get what they want."