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“The emotional tail wags the rational dog.”
—Jonathan Haidt
In countries where one has to opt in to become an organ donor, there is a shortage of donors. In Germany, for example, the organ donation consent rate is a mere 12%. In dramatic contrast, those countries with opt-out donor legislative systems in place have significantly higher donor rates; in neighbouring Austria, the consent rate is more than 99%1.
Why is there such a significant difference between these two concepts, given both effectively offer the same choice framed in different ways? The reason is that we human beings are not always as rational or logical as we might imagine—or traditional economic models might suggest. We are often influenced by biases—in this case, the “status quo” bias—and heuristics. Put another way: We take mental shortcuts.
Behavioural economics shines a light on such shortcuts and the psychology of those who participate in financial markets, both individually and as part of a crowd. In particular, it seeks to understand how markets might be distorted or inefficient due to the influential biases of its participants. (As Warren Buffet once said: “I would be a bum on the street with a tin cup if markets were always efficient.”)
As a historian, I am particularly interested in booms, bubbles, and busts in market cycles. These are often viewed simply in terms of fear and greed, but in reality they reflect many underlying behavioural patterns, such as the ‘herd instinct’, that were just as prevalent in the Tulipmania bubble of 17th-century Holland as they were during the dot-com boom of the 1990s. As Mark Twain is alleged to have said: “History does not repeat itself, but it does rhyme.”
Psychologists estimate that the human brain is potentially subject to more than 120 different biases, including ‘base-rate neglect’ (ignoring the statistical facts and figures, often in favour of an emotionally appealing or attractive story—a real-life example is the popularity of some ‘pseudo-sciences’ despite minimal supporting evidence) and ‘anchoring’ (consciously or subconsciously latching onto a preliminary figure as a reference point for decision-making). A pioneer of behavioural economics, Professor Daniel Kahneman, once conducted an anchoring experiment by asking his subjects what percentage of African nations were members of the United Nations. On average, those who were asked whether it was more or less than 10% guessed the answer was 25%, whilst the answers of those asked if it was more or less than 65% averaged 45% 2.
This brings us nicely to observe one area in financial markets that is coming under increasing scrutiny: the inefficiency of market capitalization-weighted equity benchmarks. Almost by definition, such benchmarks will overweight what is overvalued and underweight what is undervalued. It can be enlightening to see how poorly these market-cap benchmarks generally perform in comparison to those constructed using different methodologies. Indices containing low- and medium-volatility stocks, for example, have generally had superior risk-adjusted returns compared to higher-volatility stocks over most meaningful time periods and across most countries and regions.
Human biases can also lead to sub-optimal decision-making around board tables and within committees, so understanding key aspects of social psychology—above all recognising and preferably avoiding mental shortcuts—is an important defence against what is often referred to as “groupthink”. Conformity is another bias to be particularly wary of, and the importance of having someone play devil’s advocate in a decision-making group cannot be underestimated, if only to challenge the consensus.
Kahneman was awarded the Nobel Prize for Economics in 2002—no mean achievement for a psychologist. The message is that behavioural economics is important because it relates to real people in the real world, and challenges the traditional economic models that assume people are always rational decision-makers who fully analyse data and act logically to reach conscious decisions. Indeed, whether in the fields of investment or more general decision-making, behavioural economics demonstrates the importance of challenging our hardwired beliefs and in-built biases, in order to optimise our chances of reaching the correct conclusions.
Paul Craven, former Head of EMEA Institutional business at Goldman Sachs Asset Management, will be leaving GSAM in 2014 to promote behavioural economics in business.