tag:theconversation.com,2011:/uk/topics/behavioural-finance-1542/articlesBehavioural finance – The Conversation2018-01-10T01:24:20Ztag:theconversation.com,2011:article/897652018-01-10T01:24:20Z2018-01-10T01:24:20ZTreasury memo misses the real impact of Labor’s negative gearing policy<p>Labor MPs might be <a href="http://www.abc.net.au/news/2018-01-08/govt-negative-gearing-claims-contradicted-by-official-advice-foi/9309736">rubbing their hands together with glee</a> at a Treasury memo that shows the federal opposition’s negative gearing policy will have a “small” impact on the property market. But insights from <a href="https://yalebooks.yale.edu/book/9780300122237/nudge">behavioural public policy</a>, as highlighted by the 2017 Economics Nobel laureate - Richard Thaler and his colleague Cass Sunstein, tell us that how people respond to this policy will be more about how the government frames it.</p>
<p><a href="https://static.treasury.gov.au/uploads/sites/1/2018/01/FOI_1876_Documents_for_release.pdf">The Treasury memo</a> showed the Labor policy of limiting negative gearing to existing homeowners will have a limited impact as the changes are unlikely to encourage investors to sell quickly. Also, owner-occupiers dominate the housing market and the costs of selling are high.</p>
<p>However, this assumes that people are forward-looking, well-informed, good with numbers and perfectly responsive to new information. <a href="https://global.oup.com/academic/product/behavioural-economics-a-very-short-introduction-9780198754992?cc=au&lang=en&">Behavioural economics</a> shows us that people do not always think so deeply and logically about their choices. </p>
<p>How any changes to negative gearing are sold to us – as a loss or gain, as a one-off or ongoing, in terms of short versus long term costs and benefits – will impact how Australians react. </p>
<p>Most of us aren’t whizzes with mathematics. As Nobel prize winner Herbert Simon <a href="http://diva.library.cmu.edu/webapp/simon/index.html">has shown</a>, in place of complex mathematical algorithms we use heuristics. These are simple rules of thumb that draw on our intuitions, experience and gut feel. </p>
<h2>Heuristics and biases</h2>
<p>One common example of a heuristic is the <a href="http://psiexp.ss.uci.edu/research/teaching/Tversky_Kahneman_1974.pdf">availability heuristic</a>. This is when we make decisions based on easily available information such as recent events and highly emotive experiences. Our brains work better with narratives and stories than with facts and figures. </p>
<p>Nobel economics laureates George Akerlof and Robert Shiller <a href="https://press.princeton.edu/titles/8967.html">have applied</a> a similar insight to analyse people’s perceptions of housing market fluctuations. They noted that we hear lots of stories about how house prices are on an upward trend. Via the availability heuristic, we easily remember these emotionally engaging stories, much better than we can remember the dry facts about the history of house price instability and housing market crashes. </p>
<p>This leads us to overestimate the chances of continuing house price rises, and to underestimate the chances of a fall, driving unsustainable house price increases – as witnessed, for example, in the American sub-prime property markets before the global financial crisis.</p>
<p>While heuristics can help us to decide quickly, they sometimes lead us into systematic mistakes – “behavioural biases”. This does not mean that we’re all hopelessly irrational. But for negative gearing it matters how a potential change is <a href="http://science.sciencemag.org/content/211/4481/453">framed</a>, and how that fits into our heuristics and biases.</p>
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Read more:
<a href="https://theconversation.com/nudging-people-towards-changing-behaviour-what-works-and-why-not-27576">'Nudging' people towards changing behaviour: what works and why (not)?</a>
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<p>Most economists (including those at Treasury) <a href="https://www.investopedia.com/terms/f/fungibility.asp">assume</a> that one dollar is a perfect substitute for any other dollar. Whether we save A$100 via a tax break, win A$100 from a scratch card or earn A$100 from working overtime, it makes no difference.</p>
<p>Contrary to this view, behavioural economics <a href="http://faculty.chicagobooth.edu/richard.thaler/research/pdf/mentalaccounting.pdf">has shown</a> that the way we treat money is different depending on the contexts in which we earn and spend it. We have different “mental accounts” for consumption, wealth, regular income and windfalls. We are more likely to splurge money we’ve won from a scratch card than money we’ve earnt doing overtime. </p>
<p>This is another reason why framing is important. How the government frames a negative gearing change will determine the mental account to which we assign it, and therefore how we respond.</p>
<p>If negative gearing changes are considered a one-off hit – the opposite of a scratch card windfall – then property owners won’t worry so much. On the other hand, if the change to negative gearing is seen as an ongoing drain on our incomes, then they will worry a lot. </p>
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Read more:
<a href="https://theconversation.com/the-promise-and-perils-of-giving-the-public-a-policy-nudge-24887">The promise and perils of giving the public a policy 'nudge'</a>
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<p>Another factor that will come into play is <a href="https://academic.oup.com/qje/article-abstract/106/4/1039/1873382">loss aversion</a> – people are much more likely to worry about losses than gains. <a href="http://www.nber.org/papers/w8143">Evidence from behavioural experiments</a> shows that home-owners over-estimate the value of their properties. This makes them reluctant to sell at reduced prices in a falling market. </p>
<p>It also means that Australians will resist negative gearing changes if these are framed as a loss, creating political pressures for a policy u-turn. It is difficult to predict how people might respond, but behavioural economics shows that any ructions might be avoided if the negative gearing change is framed as a gain. </p>
<p>For instance, Treasury <a href="https://static.treasury.gov.au/uploads/sites/1/2018/01/FOI_1876_Documents_for_release.pdf">predicts</a> that the additional revenue raised from restricting negative gearing could be up to A$3.9 billion. Therefore, the negative gearing changes could cover more than 80% of <a href="http://budget.gov.au/2017-18/content/bp2/download/bp2.pdf">federal government expenditure</a> on veterans and their families.</p>
<h2>In the long and short term</h2>
<p>Treasury’s <a href="https://static.treasury.gov.au/uploads/sites/1/2018/01/FOI_1876_Documents_for_release.pdf">modelling</a> notes there might be downward pressure on house prices in the short term from changing negative gearing, but that this will be small overall. </p>
<p>But <a href="http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.699.7719&rep=rep1&type=pdf">a range</a> of models and experiments have shown that people are disproportionately focused on tangible, short-term outcomes. For example, most of us find it hard to persuade ourselves to go the gym: the short-term costs are inconvenience and discomfort and the benefits seem intangible and distant. This is called “present bias”.</p>
<p>Recent work in behavioural economics confirms that framing (alongside a range of other socio-psychological influences) has a strong impact on our choices. Framing will determine how we perceive the policy, which mental account we will use to process it and how the various heuristics and biases identified by economics and psychologists will play out.</p>
<p>In the debates around negative gearing policy changes, these behavioural insights have not been highlighted. So perhaps Treasury could have added some psychology, alongside the economics, in arguing that house price falls are likely to be limited.</p><img src="https://counter.theconversation.com/content/89765/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Michelle Baddeley does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Treasury modelling suggests that limiting negative gearing will lead to small change in prices. But behavioural economics shows it all depends on how the policy is framed.Michelle Baddeley, Research Professor at the Institute for Choice, University of South AustraliaLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/882432018-01-04T20:32:22Z2018-01-04T20:32:22ZWhy so many tennis players go pro even though few ‘make it’<p><em>In this series we’re looking at how the <a href="https://theconversation.com/au/topics/economics-of-sport-47162">economics of sports</a> is doing away with hunches and intuition. Using data and research to evaluate players, strategies and even leagues.</em></p>
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<p>Tennis players take on a <a href="https://www.vu.edu.au/news-events/news/even-tennis-top-200-struggle-to-earn-a-living">huge risk</a> in deciding to turn pro - the odds of earning a stable income through tennis, let alone vast riches, are vanishingly small. <a href="http://people.bath.ac.uk/klp33/tennis.pdf">Our research</a> suggests it’s this very riskiness that drives tennis players to turn professional. </p>
<p>Just like gamblers, tennis players are enticed by the small possibility of a large payoff.</p>
<p>By our calculations an 18 year old boy ranked 100 in the world in 1997 had a less than one-thousandth of a percent (0.001%) chance of earning more than US$10 million in prize money over his tennis career. This isn’t a lot of money when you subtract the cost of competing - which <a href="http://www.itftennis.com/procircuit/about-pro-circuit/player-pathway.aspx">averaged</a> US$38,800 for male players and US$40,180 for female players in 2013, not including the cost of a coach. </p>
<p>We calculated the average career prize earnings of tennis players at around US$300,000. Around 80% of professional tennis players earn close to nothing, but there is a very wide range of values above this that people might earn – up to the US$65 million <a href="http://www.atpworldtour.com/en/players/roger-federer/f324/bio">Roger Federer</a> earned by the age of 30.</p>
<p><iframe id="soCZX" class="tc-infographic-datawrapper" src="https://datawrapper.dwcdn.net/soCZX/4/" height="400px" width="100%" style="border: none" frameborder="0"></iframe></p>
<p>As you can see in the chart above, tennis has some of the most extreme levels of inequality in any sport. Highly ranked players, both men and women, can earn significant prize money, while those ranked between 200 and 2,000 earn almost nothing.</p>
<p>Of the 128 players that qualify for each of the four <a href="https://www.tennis.com.au/news-and-events/pro-tournaments/grand-slams">Grand Slam tournaments</a>, the winners take home around 18% of the total prize money. Those who exit in the first round get only 0.3%. This does not factor in the sponsorships and endorsements that top-ranked players receive.</p>
<p>Teenagers who are ranked very highly in the world have a better chance of becoming stars as adults, but they still face a lot of uncertainty. For example, <a href="http://www.atpworldtour.com/en/players/kristian-pless/p491/overview">Kristian Pless</a> was ranked number one as a junior but his highest rank as a professional was 65, and he earned just US$1.1 million in prize money over his ten-year career.</p>
<p>Teenagers who are ranked poorly are almost certain to make close to zero over their tennis careers. However, there remains a minuscule chance they could make it big. Our research suggests this small chance of a big payoff is why players decided to continue their tennis careers.</p>
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Read more:
<a href="https://theconversation.com/rich-rewards-for-those-at-the-top-in-tennis-but-what-of-the-rest-35961">Rich rewards for those at the top in tennis, but what of the rest?</a>
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<p>Both <a href="http://faculty.citadel.edu/sobel/All%20Pubs%20PDF/Gamblers.pdf">experimental</a> and <a href="http://www.jstor.org/stable/10.1086/250007?seq=1#page_scan_tab_contents">observational</a> studies of gambling behaviour suggest that people are attracted to a “skewed” gamble - where there is a small possibility of a big payoff. </p>
<p>For example, imagine two lotteries. One pays out either nothing or $1, each with 50% probability. The other has a 50% probability of paying nothing, a 49% probability of paying 80 cents and a 1% probability of paying out $10. </p>
<p>Even though the first lottery has a high average payoff and less uncertainty, the research suggests gamblers are strongly attracted to a skewed gamble, and so to the $10 payoff in the second lottery.</p>
<p>Our research found that this same effect is evident in players’ decisions to continue in tennis (which is a big, career-sized gamble). We found that players whose potential lifetime earnings are highly skewed – so that they had a very low probability of a high payoff – are more likely to stick with tennis for at least one more year.</p>
<p>In other words, tennis players behave the same way when choosing their career path as gamblers do when backing a horse. </p>
<p>Further, boys appear to be more attracted to highly skewed earnings than girls. If we eliminate the tiny chance that they make a massive amount of money, teenage boys would be 20% less likely to continue in tennis from one year to the next, while teenage girls would be 5% less likely.</p>
<p>These effects are much smaller in our study of tennis players than in studies of gamblers. But they are still large, and, combined with the poor earnings prospects for most tennis players, indicate that many would be better off pursuing a different career than trying to be the next Serena Williams.</p>
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Read more:
<a href="https://theconversation.com/numbers-game-the-australian-open-and-predicting-success-11442">Numbers game: the Australian Open and predicting success</a>
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<p>This same effect can be seen in many other industries and pay inequality has been increasing in many occupations in recent decades. </p>
<p>Technology, such as television and the internet, may be partly to blame. They have helped create a small number of superstars who are able to capture a lot of the earnings available in a particular occupation. For example, Taylor Swift sells millions of records across the world while countless street performers can only dream of making a living from music.</p>
<p>Our findings also suggest that the existence of superstars may attract people to a particular career. </p>
<p>This is not necessarily irrational – people get pleasure from long-shot chances. But the fact that tennis players appear to be gambling with their careers suggests that many may end up regretting their decisions.</p><img src="https://counter.theconversation.com/content/88243/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Michael Jetter is affiliated with IZA and CESifo.</span></em></p><p class="fine-print"><em><span>Kerry L. Papps and Wayne A. Grove do not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Only a few professional tennis players make a stable income, let alone vast riches. Research suggests it’s this small chance of a huge payoff that drives players to play professionallyMichael Jetter, Senior Lecturer in Economics, The University of Western AustraliaKerry L. Papps, Senior Lecturer in Economics, University of BathWayne A. Grove, Professor of Economics, Le Moyne CollegeLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/854302017-10-09T18:52:43Z2017-10-09T18:52:43ZEconomist who helped behavioral ‘nudges’ go mainstream wins Nobel<figure><img src="https://images.theconversation.com/files/189440/original/file-20171009-6960-9uqy7s.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">As a founder of behavioral economics, Thaler has helped change the way economists look at the world.
</span> <span class="attribution"><span class="source">AP Photo/Paul Beaty</span></span></figcaption></figure><p>The <a href="http://www.kva.se/en/startsida">2017 Nobel Prize in economics</a> was awarded to University of Chicago’s <a href="http://faculty.chicagobooth.edu/Richard.Thaler/index.html">Richard Thaler</a> for his work in <a href="https://theconversation.com/us/topics/behavioral-economics-14384">behavioral economics</a>, which is the integration of economics with psychology. </p>
<p>While the award was not a total surprise, since Thaler’s name was floated earlier on the <a href="https://blogs.wsj.com/economics/2017/10/03/who-will-win-the-2017-nobel-prize-in-economics/">list of potential winners</a>, it highlights the growing importance of incorporating how humans actually behave into economic thinking. It marks the second time a pioneer in the burgeoning field of behavioral economics – which hardly existed a few decades ago – has won a Nobel, the first being psychologist <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2002/">Daniel Kahneman</a> in 2002. </p>
<p>It may be hard to believe, but before these scholars came along, many economists assumed that humans acted like <a href="http://www.startrek.com/database_article/spock">Spock</a> on “Star Trek.” People were supposed to be perfectly rational calculating machines that looked at all the information and made correct choices. However, even a most casual view of the real world suggests this is not a good assumption.</p>
<p>So who is Thaler and what’s so important about his work?</p>
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<img alt="" src="https://images.theconversation.com/files/189442/original/file-20171009-6984-1ymailk.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/189442/original/file-20171009-6984-1ymailk.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=399&fit=crop&dpr=1 600w, https://images.theconversation.com/files/189442/original/file-20171009-6984-1ymailk.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=399&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/189442/original/file-20171009-6984-1ymailk.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=399&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/189442/original/file-20171009-6984-1ymailk.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=501&fit=crop&dpr=1 754w, https://images.theconversation.com/files/189442/original/file-20171009-6984-1ymailk.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=501&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/189442/original/file-20171009-6984-1ymailk.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=501&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption">Before Thaler and his peers came along, economists assumed people behaved a lot like Spock.</span>
<span class="attribution"><span class="source">AP Photo/Bob Galbraith</span></span>
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<h2>Thaler’s impact</h2>
<p><a href="http://faculty.chicagobooth.edu/Richard.Thaler/vitae/CV.pdf">Richard Thaler</a> was born in 1945 in East Orange, New Jersey. He studied at Case Western and the University of Rochester, where he earned a Ph.D. in economics in 1974. </p>
<p>His doctoral thesis offered one of the earliest <a href="https://books.google.com/books/about/The_Value_of_Saving_a_Life.html?id=luXjtwAACAAJ">estimates of the value of saving a life</a>, calculations that <a href="http://www.law.harvard.edu/programs/olin_center/papers/pdf/Viscusi_517.pdf">governments</a> and businesses use to determine how much they should spend to prevent fatalities. For example, when the government is considering new air quality regulations that will cost companies money, it compares the price tag against the value of lives saved if the changes are implemented. </p>
<p>Thaler estimated that a life saved was worth about <a href="http://www.nber.org/chapters/c3964.pdf">US$200,000</a> in 1967 dollars, or about <a href="https://www.bls.gov/data/inflation_calculator.htm">$1.5 million</a> in 2017 terms. Today, government agencies value a life <a href="http://www.nytimes.com/2011/02/17/business/economy/17regulation.html">five to six times higher</a> than that. </p>
<p>Thaler may be best-known for the bestselling book “<a href="https://yalebooks.yale.edu/book/9780300122237/nudge">Nudge</a>,” which he co-wrote with Harvard law professor Cass Sunstein. “Nudge” is credited with inspiring former Prime Minster David Cameron to create the U.K.’s <a href="http://www.behaviouralinsights.co.uk">Behavioral Insights Team</a>, which uses psychological principles to improve the effectiveness of public services. Former President Barack Obama <a href="https://theconversation.com/how-the-science-of-human-behavior-is-beginning-to-reshape-the-us-government-48145">set up a similar group</a> in the White House.</p>
<p>Thaler and Sunstein argue people should not be forced to do things with bans or laws. Instead, small interventions, or nudges, that make the right choice easier are the best way to go. They offer examples such as putting healthy food where people can see and reach it easily while relegating unhealthy options to out-of-the-way spots. Since people usually make the easy choice, moving food around will result in less junk food being eaten.</p>
<p>Another example is making automatic retirement contributions the <a href="https://theconversation.com/how-the-science-of-human-behavior-is-beginning-to-reshape-the-us-government-48145">default choice</a> when someone begins a new job. This means new employees will have to fill out paperwork to stop contributions instead of to start them. As a result, more people save for retirement.</p>
<p>More specifically, the Royal Swedish Academy of Sciences selected Thaler for his <a href="http://www.kva.se/en/pressroom/pressmeddelanden/ekonomipriset-2017">work in three areas</a>: “limited rationality,” “social preferences” and “lack of self-control.”</p>
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<span class="caption">Thaler and Sunstein showed how making healthier options more visible makes it more likely people will choose them.</span>
<span class="attribution"><span class="source">AP Photo/Hans Pennink</span></span>
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<h2>Limits of our reason</h2>
<p>Thaler pointed out that because people often can’t solve many problems in their economic lives, they simplify and use rules of thumb. These simplifications, however, lead to strange and sometimes bad choices.</p>
<p><a href="http://www.washingtonpost.com/wp-dyn/content/article/2007/05/19/AR2007051900316.html">Mental accounting</a> is one area of strange choices that Thaler was the first to identify. Because our financial lives are complex, we mentally put money in separate buckets and spend only the money available in that bucket. </p>
<p>For example, <a href="http://www.economiapsicologica.com.br/wp-content/uploads/2009/05/thaler-mental-accounting-and-consumer-choice.pdf">Thaler describes a couple</a> who receives $300 in cash compensation from an airline for lost baggage. The couple takes the $300 and spends it on a fancy dinner. They splurged for the dinner only because, in their heads, they classified $300 as a windfall. But if their salaries had simply increased by a total of $300, they would likely not have splurged on eating out but instead mentally classified the extra money as spending for rent and other bills.</p>
<h2>Adding emotion to economics</h2>
<p>He also won the Nobel for his work on social preferences and fairness. </p>
<p><a href="http://www.jstor.org/stable/1806070">Thaler, with co-authors Kahneman and Canadian economist Jack Knetsch</a>, showed in 1986 how customers don’t expect companies to maximize profits in all situations. For example, when there’s a blizzard, people don’t expect stores to raise the price of shovels, even though demand will naturally soar as the snow piles up. Thaler and his co-authors showed that customers will tend to punish businesses that do. This is a surprising result since it shows that businesses that maximize <a href="http://businessmacroeconomics.com/">profits</a> in the short term, as many do, can be penalized in the long term if customers think the companies are acting unfairly.</p>
<p>This work has relevance today for understanding consumers’ reactions to drug companies pushing <a href="https://www.nytimes.com/2017/09/17/insider/insider-high-drug-prices-opioids.html">prescription drug prices ever higher</a> and to businesses <a href="http://www.businessinsider.com/price-gouging-in-texas-gas-prices-hurricane-2017-9">price-gouging</a> after hurricanes. Thaler points out <a href="http://www.jstor.org/stable/2647056">that emotions</a>, like feelings about fairness, are an important but overlooked area of economics.</p>
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<img alt="" src="https://images.theconversation.com/files/189439/original/file-20171009-6990-13dgu9j.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/189439/original/file-20171009-6990-13dgu9j.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=437&fit=crop&dpr=1 600w, https://images.theconversation.com/files/189439/original/file-20171009-6990-13dgu9j.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=437&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/189439/original/file-20171009-6990-13dgu9j.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=437&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/189439/original/file-20171009-6990-13dgu9j.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=550&fit=crop&dpr=1 754w, https://images.theconversation.com/files/189439/original/file-20171009-6990-13dgu9j.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=550&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/189439/original/file-20171009-6990-13dgu9j.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=550&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">Daniel Kahneman makes a toast with his wife Anne Treisman after winning the Nobel Prize in economics.</span>
<span class="attribution"><span class="source">AP Photo/Daniel Hulshizer</span></span>
</figcaption>
</figure>
<h2>Paying for self-control</h2>
<p>A third area cited by the Swedish Academy was the contribution Thaler and economist Hersh Shefrin made on ideas about <a href="https://www.jstor.org/stable/1806070?seq=1#page_scan_tab_contents">self-control</a>.</p>
<p>The economists noted that people spend money to avoid making poor choices or to avoid engaging in the wrong kinds of behaviors. For example, Thaler and Shefrin wrote that people “pay to go to ‘<a href="http://www.foxnews.com/travel/2013/04/22/americas-top-10-weight-loss-resorts.html">fat farms</a>’ which essentially are resorts that promise not to feed their customers.”</p>
<p>Individuals not only pay for self-control but also create special rules to ensure they don’t go beyond self-imposed limits. Smokers, for instance, often buy cigarettes by the pack instead of by the carton. This ensures they smoke less each day, even though they pay more per cigarette. </p>
<p>Thaler’s work on self-control is becoming more important as the internet and almost instant delivery make more of the <a href="https://www.amazon.com/Temptation-Finding-Self-Control-Age-Excess/dp/0143120808">world’s temptations easier to access</a> without waiting. Understanding how people actually operate results in better public policies that can achieve the same results without costing people money.</p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/189443/original/file-20171009-6999-ui1k38.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/189443/original/file-20171009-6999-ui1k38.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=388&fit=crop&dpr=1 600w, https://images.theconversation.com/files/189443/original/file-20171009-6999-ui1k38.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=388&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/189443/original/file-20171009-6999-ui1k38.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=388&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/189443/original/file-20171009-6999-ui1k38.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=487&fit=crop&dpr=1 754w, https://images.theconversation.com/files/189443/original/file-20171009-6999-ui1k38.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=487&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/189443/original/file-20171009-6999-ui1k38.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=487&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">Even though regular smokers would save money by buying cigarettes by the carton, many purchase one pack at a time as a means of self-control.</span>
<span class="attribution"><span class="source">AP Photo/Ed Wray</span></span>
</figcaption>
</figure>
<h2>It’s all about us</h2>
<p>The award is worth <a href="https://www.nobelprize.org/nobel_prizes/about/amounts/prize_amounts_17.pdf">9 million Swedish kronor</a>, which at today’s exchange rate is about $1.1 million. Unfortunately for Thaler, since he is an American, the <a href="https://taxfoundation.org/nobel-prize-award-subject-income-taxation/">entire award is taxable</a> income – unless it is donated to a charity.</p>
<p><a href="https://www.nytimes.com/2017/10/09/business/nobel-economics-richard-thaler.html?hp&action=click&pgtype=Homepage&clickSource=story-heading&module=second-column-region&region=top-news&WT.nav=top-news">Asked how he would spend the money</a>, he said: “This is quite a funny question… I will try to spend it as irrationally as possible.”</p>
<p>The Nobel Memorial Prize in Economic Science, the only award not created by <a href="https://www.nobelprize.org/alfred_nobel/will/">Alfred Nobel in his will</a>, also brings enormous prestige to the winner. Economist Friedrich Hayek, who won the prize in 1974, <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1974/hayek-speech.html">said it confers</a> on an individual an “influence over laymen: politicians, journalists, civil servants and the public generally.”</p>
<p>Beyond this influence, why should you care? The <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/">list of past economics Nobel Prize winners</a> contains many people whose work is fascinating to economists but whose relevance to the lives of regular people is tenuous. </p>
<p>Richard Thaler’s work, however, has direct relevance for pretty much everyone. His early research helps save lives. His later research helps people save for retirement and helps save us from our own worst tendencies. The Swedish Academy made an astute choice in lauding his work.</p><img src="https://counter.theconversation.com/content/85430/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Jay L. Zagorsky does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Richard Thaler won the 2017 Nobel Prize in economics for his groundbreaking work incorporating how humans actually behave into economic thinking.Jay L. Zagorsky, Economist and Research Scientist, The Ohio State UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/534232016-02-17T10:46:01Z2016-02-17T10:46:01ZOur finances are a mess – could behavioral science help clean them up?<p>The first few months of a new year can be a stressful time financially. The Christmas holidays typically lead to depleted savings and higher credit card balances, while tax season is right around the corner. </p>
<p>Unfortunately for most us, this isn’t a seasonal dilemma but a chronic problem that brings anxiety throughout the year.</p>
<p>Indeed, as many as <a href="http://assetsandopportunity.org/assets/pdf/2015_Scorecard_Report.pdfhttp:/assetsandopportunity.org/assets/pdf/2015_Scorecard_Report.pdf">44 percent of American households</a> don’t have enough savings to cover basic expenses for even three months. Without a savings cushion, even regular seasonal expenses like holiday celebrations may end up feeling “unexpected” and lead households to turn to credit to cover costs. </p>
<p>U.S. consumers currently hold <a href="http://www.federalreserve.gov/pubs/bulletin/2014/pdf/scf14.pdf">US$880 billion in revolving debt</a>, with an average credit card balance of almost $6,000. The picture is even more dire for lower-income households.</p>
<p>So how can we turn this around? Many tacks have been tried but fallen short for one reason or another. Fortunately, behavioral science offers some useful insights, as our research shows.</p>
<h2>What’s wrong with current approaches</h2>
<p>Typical approaches to solving problematic finances are either to “educate” people about the need to save more or to “incentivize” savings with monetary rewards. </p>
<p>But when we look at traditional financial education and counseling programs, they have had <a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2333898">virtually no long-term impact on behavior</a>. Similarly, matched savings programs are expensive and have shown <a href="http://www.nber.org/papers/w18220">mixed results on savings rates</a>. Furthermore, these approaches often prioritize the need for savings while treating debt repayment as a secondary concern.</p>
<p>Education and incentives haven’t worked because they are based on problematic assumptions about lower-income consumers that turn out to be false. </p>
<p>The truth is lower-income consumers don’t need to be told what to do. On average, they are actually <a href="http://scholar.harvard.edu/sendhil/scarcity">more aware of their finances</a> and <a href="http://pss.sagepub.com/content/early/2015/02/12/0956797614563958.abstract">better at making tradeoffs</a> than more affluent consumers. </p>
<p>They also don’t need to be convinced of the value of saving. Many <a href="http://www.pewtrusts.org/%7E/media/assets/2015/02/fsm-poll-results-issue-brief_artfinal_v3.pdf">want to save</a> but face additional obstacles to financial health. </p>
<p>For example, these households often <a href="http://www.usfinancialdiaries.org/83-charts">face uncertainty about their cash flows</a>, making planning for expenses even more difficult. More generally, they have little room for error in their budgets and the costs of small mistakes can compound rapidly.</p>
<h2>Brain barriers</h2>
<p>In this volatile context, psychological barriers common to all people exacerbate the problem. </p>
<p>People have difficulty thinking about the future. We treat our future, older selves <a href="http://www.anderson.ucla.edu/faculty/hal.hershfield/resources/Research/Journal-of-Experimental-Psychology-General-2011-Bryan.pdf">as if they are strangers</a>, decreasing motivation to make tradeoffs in the present. Additionally, we <a href="http://www.sciencedirect.com/science/article/pii/S0022103111001995">underpredict future expenses</a>, leading us to spend more than precise budgeting can account for. </p>
<p>When we do focus on the future, people have a hard time figuring out which financial goals to tackle. </p>
<p>In <a href="http://journals.ama.org/doi/10.1509/jmr.14.0455">research that we conducted</a> with Rourke O’Brien of the University of Wisconsin, we found that consumers often focus either on saving money or on repaying debt. In reality, both actions simultaneously interact, contributing to overall financial health. </p>
<p>This can be problematic when people misguidedly take on high-interest debt while holding money in low-interest saving accounts at the same time. And, once people have identified building savings or repaying debt as an important goal, they have difficulty identifying how much should be put toward it each month. As a result, they rely on information in the environment to help determine this amount (like getting “anchored” on specific numbers that are presented as suggestions on credit card payment statements).</p>
<p>Unfortunately, the way current banking products are designed often makes these psychological realities worse. </p>
<p>For example, the information on many credit card payment systems nudges consumers toward <a href="http://pss.sagepub.com/content/20/1/39.extract">paying the minimum balance</a> rather than a higher amount. Budgeting tools assume income and expenses stay the same from month to month (not true for most lower-wage workers) and expect us to monitor spending against a long list of separate, complicated budget categories. </p>
<p>On a deeper level, the fact that banks offer credit and savings products separately exacerbates the psychological distance between paying down debt and building savings, even though these are linked behaviors.</p>
<h2>Behavioral banking</h2>
<p>The good news is that a range of <a href="http://pps.sagepub.com/content/10/6/749.abstract">simple, behaviorally informed solutions</a> can easily be deployed to tackle these problems, from policy innovations to product redesign. </p>
<p>For instance, changing the “suggested payoff” in credit card statements for targeted segments (i.e., those who were already paying in full) could help consumers more effectively pay down debt, as could allowing tax refunds to be directly applied toward debt repayment. Well-designed budgeting tools that leverage financial technology could be integrated into government programs. The state of California, for example, <a href="http://sd24.senate.ca.gov/news/2015-10-29-pro-tem-de-le%C3%B3n-announces-ca-%22digital-nudge%22-initiative">is currently exploring</a> ways to implement such technologies across a variety of platforms.</p>
<p>But the public and private sectors both need to play a role for these tools to be effective. Creating an integrated credit-and-saving product, for example, would require buy-in from regulators along with financial providers.</p>
<p>While these banking solutions may not close the economic inequality gap on their own, behaviorally informed design shifts can be the missing piece of the puzzle in these efforts to fix major problems. </p>
<p>Our research indicates that people already want to be doing a better job with their finances; we just need to make it a little less difficult for them. And making small changes to banking products can go a long way in helping people stabilize their finances so they can focus on other aspects of their lives.</p>
<p><em>Katy Davis, vice president of ideas42, a nonprofit that applies behavioral economics to design solutions to social problems, coauthored this article. Davis specializes in economic mobility and education projects.</em></p><img src="https://counter.theconversation.com/content/53423/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>The authors do not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Almost half of Americans have trouble saving, while average credit card balances have swelled to $6,000. Can we turn this around?Hal Hershfield, Assistant Professor of Marketing, University of California, Los AngelesAbigail Sussman, Assistant Professor of Marketing, University of ChicagoLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/452622015-07-30T05:17:03Z2015-07-30T05:17:03ZDanger strikes when foolish humans are left in charge of their financial futures<figure><img src="https://images.theconversation.com/files/90157/original/image-20150729-30889-305smd.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Humans are irrational. Superheroes also.</span> <span class="attribution"><a class="source" href="https://www.flickr.com/photos/ontilnow/2584846077/in/photolist-4Wq1FF-5mshaL-4WpZvg-vc2bW-vc1Ff-vc26v-vc2b4-hzqmeg-vc222-3zwHUL-df5MWz-EAs9K-EApHs-4og55F-ndFvxi-q4VEiw-7adXJi-oVm4GS-df5t5j-vc21c-vc2cx-7bkZst-dfN8kD-vc2af-5vAsHA-3R2yJB-2VsXEM-vc24n-vc22P-vc256-6GrWCP-vc2da-vc23m-vc27a-vc1Cz-qVa4C-vc28z-t4rqp-6gE17e-vc29s-2Qmd2t-vc1wi-5iWxgn-5vAtYf-ASbRc-vc1Ag-dr2BYs-vc1xZ-4WERAy-vc1tz">Santi Molina</a>, <a class="license" href="http://creativecommons.org/licenses/by-nc/4.0/">CC BY-NC</a></span></figcaption></figure><p>Much standard economics research is based on the <a href="http://www.forbes.com/sites/peterubel/2014/12/15/is-homo-economicus-a-psychopath/">“homo economicus”</a> decision-maker. This is an entirely rational being. An unbiased, unemotional, non-psychological maximiser of the expected usefulness of things and events. Furthermore, this perfect decision-maker is far-sighted, and has complete self-control.</p>
<p>If that seems instinctively problematic, then you’ll be pleased to know that <a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1011976">behavioural economics</a> research instead recognises that real-world “homo sapiens” decision-makers are <a href="http://www.cii.co.uk/knowledge/policy-and-public-affairs/articles/perceived-and-actual-risk-in-financial-markets-insights-from-emotional-finance/20048">not fully rational</a>, are biased, are emotional satisfiers. Furthermore, such decision-makers are myopic, and lack self-control.</p>
<p>For a long time though, policy-makers have based policy on that “homo economicus” model, not least in the world of financial decision-making, such as investing, saving and pensions. On this basis, there has been a move to give more financial responsibility to individuals.</p>
<h2>Benefits trap</h2>
<p>In the world of pensions, this has meant moving from <a href="https://www.gov.uk/pension-types">defined benefit to defined contribution</a> schemes. In defined benefit, you know what you will end up with and it’s up to your employer to dictate the amount of pension contributions and how the fund should invest those contributions. In defined contribution, the onus is very much on the employee to decide how much to save each month and how to invest it into assets like shares which introduce an element of risk. </p>
<p>The “homo economicus” approach is a normative (prescriptive) model: it prescribes how the perfect decision-maker should behave. Given this approach, those defined contribution schemes make sense. The fully-rational all-calculating, unemotional employee chooses their optimal pensions-saving plan. They use sophisticated techniques to calculate the correct balance between monthly consumption and savings for future retirement from monthly salary.</p>
<p>In contrast, the “homo sapiens” approach is a positive (descriptive) approach. It describes how people actually behave in the real world, given their psychological and behavioural biases and emotions, limited rationality, myopia, and lack of self-control. </p>
<figure class="align-center zoomable">
<a href="https://images.theconversation.com/files/89902/original/image-20150728-3945-gku6iq.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/89902/original/image-20150728-3945-gku6iq.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/89902/original/image-20150728-3945-gku6iq.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/89902/original/image-20150728-3945-gku6iq.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/89902/original/image-20150728-3945-gku6iq.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/89902/original/image-20150728-3945-gku6iq.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/89902/original/image-20150728-3945-gku6iq.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/89902/original/image-20150728-3945-gku6iq.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=503&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
<figcaption>
<span class="caption">Worth a gamble? Pensioners are not as risk averse as we might think.</span>
<span class="attribution"><a class="source" href="https://www.flickr.com/photos/kulor/4783406145/in/photolist-8hGcZK-3MoYY-crBXBQ-2M8Fg-5hUVq-dqivjt-9xKNji-7aoopD-4mDFSA-5nxCAW-9fnuM6-8LdNa2-7gcUX1-pubEP8-6wGrcB-achTD2-iLyUjZ-iLzsFy-52DnyL-3htGEn-6apYQd-bnaxKU-2KDGyy-6WoEqh-8LgSay-6vsdU2-achUiv-9gTvap-58F1kk-okbX94-c226ZY-47qmTe-92qCsX-5ouMU6-2W2FF6-aceyT3-6apT7L-F88b8-m1oCgZ-oBsZah-9S3fbN-8fJpJW-JLayz-4MzySv-oZNwhU-ayESs3-58Ukm3-pBpuxe-qzsT34-pCGEji/">James Broad</a>, <a class="license" href="http://creativecommons.org/licenses/by-nd/4.0/">CC BY-ND</a></span>
</figcaption>
</figure>
<p>This behavioural economics approach reveals the dangers in passing the responsibility to employees: a danger of insufficient pension-provision as myopic actors, lacking self-control and having limited financial literacy, spend too much today and save too little for retirement. Indeed, <a href="http://www.cengage.com/search/productOverview.do?N=16+4294922239+4294951890+24+4294945305&Ntk=P_EPI&Ntt=467522150824510151739903143944995312&Ntx=mode%2Bmatchallpartial">Lucy Ackert and Richard Deaves argue</a> that employees who are required to manage their own retirement accounts through a defined contribution scheme are not like other investors. They are drafted in for the job, and it is reasonable to assume that they would suffer from cognitive biases and limited financial literacy compared to other, professional, investors.</p>
<p>It was this conclusion that led behavioural economists Richard Thaler and Shlomo Benartzi to develop a practical tool to encourage saving for retirement. <a href="https://faculty.chicagobooth.edu/Richard.Thaler/research/pdf/SMarTJPE.pdf">This tool is known as SMART</a> (save more and retire tomorrow).</p>
<h2>Control</h2>
<p>Behavioural economists argue that, when faced with a lack of self-control, humans need – and indeed demand – control mechanisms to be imposed upon them. Think of Christmas Club savings plans, and fitness and diet clubs such as weight-watchers which involve people voluntarily submitting to institutional control, because they are aware that they lack self-control. We also hear this week that addicted gamblers can apply to get themselves <a href="http://www.independent.co.uk/news/uk/home-news/glasgow-gambling-addicts-will-be-able-to-ban-themselves-from-bookmakers-in-new-scheme-10420002.html">barred from their local betting shops</a>.</p>
<p>Again, the argument is that they are being invited to substitute external control for a lack of self-control. </p>
<p>In the world of pensions, defined benefit imposes control on imperfect individuals. We haven’t entirely left workers to fend for themselves as we move to a defined contribution model. The slow <a href="http://www.thepensionsregulator.gov.uk/employers/your-step-by-step-guide-to-automatic-enrolment.aspx">introduction of auto-enrolment</a> has helped to offer some external control to nudge people towards a sensible approach to retirement saving.</p>
<figure class="align-center zoomable">
<a href="https://images.theconversation.com/files/90120/original/image-20150729-30862-pb8lyx.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/90120/original/image-20150729-30862-pb8lyx.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/90120/original/image-20150729-30862-pb8lyx.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=143&fit=crop&dpr=1 600w, https://images.theconversation.com/files/90120/original/image-20150729-30862-pb8lyx.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=143&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/90120/original/image-20150729-30862-pb8lyx.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=143&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/90120/original/image-20150729-30862-pb8lyx.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=180&fit=crop&dpr=1 754w, https://images.theconversation.com/files/90120/original/image-20150729-30862-pb8lyx.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=180&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/90120/original/image-20150729-30862-pb8lyx.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=180&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
<figcaption>
<span class="caption">This little piggy went to a financial advice seminar.</span>
<span class="attribution"><a class="source" href="https://www.flickr.com/photos/swister/273156173/in/photolist-q8ZPc-9VCdNY-9VCcWs-bxDtd3-9VzKTc-cBD6Bh-7dzuyM-uRvi5f-cBD7FA-bmm6Up-bxDiow-bmm9MT-7AV3c5-fKu9zW-fKu9zy-4J4gTR-9ehVno-bgfshg-4zmP7W-8WAnHa-ahtNwe-4wysGz-ahwWjs-s5Zddj-c3sJ8W-9K2QYL-953fxF-cZ3a4m-63Nrwr-bgftmn-fKcyFM-5vWWWG-n7quSS-9VByc5-9VyHut-9VBzSG-7vGDW4-v6Mvtd-4NbDCB-czM6g-74H2vZ-fKu9B3-v8Av53-9VyNgZ-95SrE8-fKu9zd-dXpA6W-5Eut7k-bgfz6X-9dJaDZ">swister_p</a>, <a class="license" href="http://creativecommons.org/licenses/by-nc-nd/4.0/">CC BY-NC-ND</a></span>
</figcaption>
</figure>
<p>But the good news stops there. Besides the move towards defined contribution, a recent disturbing development has been the <a href="http://www.moneysavingexpert.com/savings/pension-freedom">move towards pensions freedom</a> as workers approach retirement. Once you reach the age of 55, you are no longer tied into a given regular pension payment in retirement; you have the freedom to take your pension pot and spend it any way you desire. You can even spend it all immediately: the “Lambhorgini” or “World Cruise” decision. So, in addition to insufficient savings for retirement along their lifetime career, what they have saved can now be blown at 55 years old. </p>
<h2>Making sense of it all</h2>
<p>Maybe you’re thinking that 55 year-olds are more responsible than 25 year-olds? Well, there is a body of research which investigates the effect of ageing on financial decision-making and <a href="http://crr.bc.edu/wp-content/uploads/2015/01/IB_15-1-508.pdf">which questions that idea</a>.</p>
<p>Some interesting research by Professor Bruine de Bruin emphasises the complex behavioural factors affecting decision-making in old age. Her work demonstrates that, as people age, they become better able than youngsters to engage in emotion-control. <a href="http://business.leeds.ac.uk/about-us/article/professor-bruine-de-bruin-receives-grant-to-improve-decisions-for-people-of-all-ages/">Their cognitive abilities, however, decline</a>.</p>
<figure class="align-center zoomable">
<a href="https://images.theconversation.com/files/90122/original/image-20150729-30875-1bx7cj7.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/90122/original/image-20150729-30875-1bx7cj7.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/90122/original/image-20150729-30875-1bx7cj7.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=406&fit=crop&dpr=1 600w, https://images.theconversation.com/files/90122/original/image-20150729-30875-1bx7cj7.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=406&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/90122/original/image-20150729-30875-1bx7cj7.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=406&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/90122/original/image-20150729-30875-1bx7cj7.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=510&fit=crop&dpr=1 754w, https://images.theconversation.com/files/90122/original/image-20150729-30875-1bx7cj7.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=510&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/90122/original/image-20150729-30875-1bx7cj7.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=510&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
<figcaption>
<span class="caption">Generation gap.</span>
<span class="attribution"><a class="source" href="https://www.flickr.com/photos/environment/2167097486/in/photolist-4iuWzL-hqPmA-ccEAh-KpP9H-5ANXTQ-6KoWMY-57Sn9k-aebtF2-o2YUob-vdqKYY-q3mYje-cEwUnU-5d57Wv-8tXYQN-6bph8Y-4KYwcS-dZRjFE-vQZPX-d1gbfG-g2ZVPj-dVTENx-gYd692-4LLZ1o-eLJ1eC-gYdcYp-eia6LD-bmDEtv-2L1s8J-773JFo-kutVKK-dXGqj6-81ZmVj-ocaYPY-gYdpkd-QtVDP-jLfEvp-4A2qTa-qsFZPG-6y2Q5k-6HMBr1-dHS6XC-6sUKBE-aCMJRE-8DEEi-6yVmG-52VLb-hVfsV-52VL7-6ovjvS-7mHMzs/">xflickrx</a>, <a class="license" href="http://creativecommons.org/licenses/by-sa/4.0/">CC BY-SA</a></span>
</figcaption>
</figure>
<p><a href="http://www.bbc.co.uk/news/business-31867788">Fears are building</a> that pension freedoms could lead to a generation of pensioners who <a href="http://www.bbc.co.uk/news/business-32087038">face the dangers</a>
of their pension pots running out during their retirement years. <a href="http://www.ilcuk.org.uk/index.php/news/news_posts/press_release_new_pension_freedoms_pose_significant_risk_of_consumer_detrim">According to the International Longevity Centre UK</a>, this may result in “reduced financial resilience during retirement”.</p>
<p>The changes have also <a href="http://www.ft.com/cms/s/0/b1fb7b12-2f90-11e5-8873-775ba7c2ea3d.html#axzz3h64R4h8Z">introduced more complexity</a> at a time when evidence should be pushing us towards simplification. Take <a href="https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/214406/WP109.pdf">Rob Hardcastle’s 2012 report</a> for the Department of Work and Pensions: he argues that, faced with complex financial decisions, people tend to rely on heuristics (rules of thumb), which can lead to bad decision-making. He also argues for keeping pensions as simple as possible. </p>
<p>Just as the government imposes more complexity in pensions, it is ironic that in the past years, it has commissioned a series of <a href="https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/191721/sergeant_review_simple_products_final_report.pdf">reports into “Simple Financial Products”</a> in order to encourage long-term savings, and which appear to recognise the lessons from behavioural economics that complexity, combined with psychological biases, emotions and lack of self-control, has reduced saving, and increased myopia. Freedom is an appealing idea, but handing over complete liberty in retirement planning to us poor, imperfect decision-makers is a huge risk that has implications for the country as a whole – and not just for the individuals forced to trade-in a used Lamborghini to heat their house through the winter.</p><img src="https://counter.theconversation.com/content/45262/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Richard Fairchild does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Let’s face facts. Behavioural finance shows you are not to be trusted with your retirement planning.Richard Fairchild, Senior Lecturer in Corporate Finance, University of BathLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/421212015-06-24T20:15:13Z2015-06-24T20:15:13ZEconomic theories that have changed us: efficient markets and behavioural finance<figure><img src="https://images.theconversation.com/files/85493/original/image-20150618-23243-1vesnd7.jpg?ixlib=rb-1.1.0&rect=31%2C184%2C4195%2C2221&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Two theories - efficient markets and behavioural finance - attempt to explain how our sharemarkets work.
</span> <span class="attribution"><span class="source">Image sourced from www.shutterstock.com</span></span></figcaption></figure><p><em>Welcome to our series on economic theories that are changing the way we think. Today, Richard Holden explains two hotly contested theories that attempt to explain the behaviour of our sharemarkets.</em></p>
<hr>
<p>Whether you realised it or not, if you’ve ever invested in the stock of a company, or have mutual funds in your superannuation, you’ve taken a stance on one of the biggest economic debates of the last 50 years.</p>
<p>That debate is about whether stock prices (or bonds, or even property for that matter) reflect all available information. Another way to frame it — as <a href="http://research.economics.unsw.edu.au/richardholden/popular-articles/nobel-prize-shows-both.pdf">Justin Wolfers and I did when discussing the 2013 Nobel Prize in Economic Sciences</a> — is whether prices reflect the wisdom of crowds, or the madness of crowds.</p>
<h2>Efficient markets</h2>
<p>The starting point in this debate was the extraordinary contribution of <a href="http://www.chicagobooth.edu/faculty/directory/f/eugene-f-fama">Eugene Fama</a> (of the University of Chicago) who developed the “efficient markets hypothesis”. According to this view, stock prices do incorporate all available information and hence there are no profitable arbitrage opportunities.</p>
<p>How would one go about demonstrating this? After all, in economic scholarship one doesn’t just get to argue in prose. What Fama showed was that at any moment in time the next movement of a stock price is just as likely to be up as down. Or, at little more formally, stock prices follow a “random walk”. This finding is probably the most successfully, repeatedly replicated finding in all of the social sciences.</p>
<p>Now that’s the short run. Even Fama himself (with coauthor <a href="http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/">Kenneth French</a>) found that stock prices are predictable in the long run. They showed that small market capitalisation stocks outperform large ones, and that high market-to-book value stocks also outperform. Their interpretation is that this is compensation for taking on extra risk, and is thus consistent with efficient markets.</p>
<h2>Behavioural finance</h2>
<p>Beginning in earnest in the early 1990s, however, a different set of theories emerged. Economists such as Richard Thaler (of “Nudge” fame), Robert Shiller, and Andrei Shleifer began to take seriously the role of psychology among investors.</p>
<p>Social psychologists such as Nobel Laureate Daniel Kahnmenan (with whom, interestingly, Thaler was an important collaborator, thus providing the bridge from psychology to economics) had long documented human departures from rationality. For example, people tend to overweight recent events relative to equally important past events. People are “loss averse” in the sense that they overweight losses relative to equal-sized gains. People often attribute events to skill when they are actually the product of luck. And so on.</p>
<p>These sorts of cognitive biases have profound implications for asset pricing. If people overact to information then we would expect companies that report unexpectedly bad earnings to suffer a big hit and then bounce back over time. We would similarly expect companies that announce unexpectedly good earnings to get a big bump and then drift back down over time. And indeed we do. The empirical evidence is overwhelming on this point.</p>
<p>Loss aversion should mean that stocks that have dropped from when most people bought in behave differently from those that have risen. Again, the evidence is in and it confirms the psychological insights.</p>
<p>The list goes on. Indeed, tracking down and documenting these kinds of effects is what modern day empirical asset pricing is largely about.</p>
<h2>Index fund or hedging strategy?</h2>
<p>Now, back to stock picking and mutual funds. If one subscribes to Fama’s efficient markets view of the world then stock picking is a fools errand. Even if you end up doing well, all that has happened is that you have been compensated for taking on extra risk. Things could have turned out really badly, and you were lucky. For instance, maybe you invested in Australian mining companies during the early 2000s. We now know that was a very profitable investment — but it could have been different, and nobody knew ahead of time. Under the Fama view the best thing to do is invest in the whole market — buy a low cost index fund.</p>
<p>If you take the behavioural finance view, then there are profitable opportunities beyond investing in the whole market. But that doesn’t mean that it’s easy for individual investors to take advantage of those. OK, people are loss averse, now what? Taking advantage of these takes a fair degree of sophistication, and it also typically requires have low enough trading costs to be able to trade often without wasting a lot of money on fees. This is why there are hedge funds that specialise in this kind of investing.</p>
<p>Whichever view you subscribe to there are two things that never makes any sense: investing in a stock because you think it’s a good company (I like shopping at David Jones, but that doesn’t make it a good investment) or picking an industry that you think is going to do well.</p>
<p>Efficient markets devotees will tell you that information is already factored in. And behavioural finance aficionados will tell you that it is you that is suffering from a cognitive bias.</p>
<hr>
<p><em>Read more in the series<a href="https://theconversation.com/au/topics/economic-theories-that-have-changed-us"> here</a>.</em></p><img src="https://counter.theconversation.com/content/42121/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Richard Holden is an ARC Future Fellow.</span></em></p>Do our share prices effect the wisdom of crowds, or the madness of crowds? It’s the perennial economic debate.Richard Holden, Professor of Economics, UNSW SydneyLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/268432014-05-16T14:34:15Z2014-05-16T14:34:15ZThe markets are close to record highs, but they’re still the best long-term bet<figure><img src="https://images.theconversation.com/files/48729/original/2ftw26j9-1400246702.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">With stock markets close to record highs, should we be running for cover?</span> <span class="attribution"><a class="source" href="https://www.flickr.com/photos/ahmadnawawi/3808452611/in/photolist-bH1jW6-bta4vZ-6Nxjh4-5ZE85d-jcnfQU-fSAzj7-fSBDCP-7o9nna-6arYmX-8R1C1w-2EPQo-b8ndh4-5UqPpb-DiXYE-fSAAUv-41LMv-7gi33H-7gvpU-azKr2q-5mCd6i-bzd4M8-aeenJC-aEK49F-edJ1JT-2fsf8-6bxWCY-ir8RG8-5NgGbq-b8m6b6-91LSvi-91PE5J-9gi26F-b8n78K-ahM4qb-fKwPcL-b8kEYe-5gQECw-7bJuYE-7bEEMF-7bEEUr-7bJuGQ-7bJu7E-7bEEGB-7bEFsK-7bJuC3-7bEEPp-7bJutC-7bJux5-7bEF2e-7bEFgc">Ahmad Awawi</a>, <a class="license" href="http://creativecommons.org/licenses/by-sa/4.0/">CC BY-SA</a></span></figcaption></figure><p>The FTSE 100 <a href="http://www.thisismoney.co.uk/money/investing/article-2575754/he-UKs-blue-chip-index-reach-record-highs-Footsie.html">reached 6877.39 points</a> last week. It was the highest since its all-time peak of 6950.60 on December 30 1999 before the start of the deflation of the great dotcom bubble in January 2000. It is currently trading <a href="http://www.bbc.co.uk/news/business/market_data/stockmarket/3/default.stm">about 50 points lower</a>, but many analysts believe it will break 7000 before the end of the year. What does this mean for stock market investors, if anything?</p>
<p>To put this into perspective we have to remember that the stock market is the best asset class for investors with very long time horizons. To see this, suppose that for every year over the next 40 years you put £2500 into just one of the following asset classes:</p>
<p>(i) Gold
(ii) Property
(iii) The stock market</p>
<p>Based on the historical record of over 200 years, how much can you expect to have at the end of 40 years, after adjusting for the loss in value due to inflation?</p>
<p>The answers are surprising. Over the 40-year period you have invested a total of £100,000. <a href="http://www.amazon.co.uk/Stocks-Long-Run-Definitive-Investment/dp/0071800514">The expected value of your £100,000 investment at the end of 40 years is</a>:</p>
<p>(i) Gold: £100,000 </p>
<p>(ii) Property: £240,000</p>
<p>(iii) The stock market: £500,000</p>
<p>All of these figures are adjusted so that they are not distorted by inflation. What they show is that over the very long term, gold holds its value but doesn’t add anything. </p>
<p>The same is also true of property. The extra £140,000 comes from 40 years of reinvested rental income. The stock market is different. Over the very long term, it outperforms every other major asset class.</p>
<h2>Dark side of the boon</h2>
<p>These conclusions about investment performance are based not merely on the historical record but are predicted by standard financial theory. The stock market is the only major asset class that allows us to invest directly in human capital. A block of gold or a block of flats cannot write <a href="http://darkside40.pinkfloyd.com/">The Dark Side of the Moon</a>, invent the iPhone, television, motor cars, debit cards, ice cream or anything else.</p>
<p>In a mixed economy, value is created (and sometimes destroyed) by both the private and public sectors. In the private sector, value is created by businesses creating new products and services whose value is greater than the costs of creating them. </p>
<p>The simplest and most direct way of investing in this value creation is to buy shares in companies listed in the stock market. When a company creates value, the price of its shares goes up. After 40 years, the value of your shares will reflect 40 years of value creation by the companies you invest in.</p>
<p>So what meaning can we attach to the fact that stock markets in the UK and around the world are now approaching or exceeding their historic highs? </p>
<p>In actual fact, it is not really true. After adjusting for inflation, the UK and US stock markets are respectively about 25% and 5% below their dotcom peaks. The salient fact here is not that stock markets are high, but that they are only now approaching the levels achieved 14 years ago.</p>
<p>Stock markets move in slow cycles, with long <a href="http://www.investopedia.com/terms/b/bullmarket.asp">bull markets</a> and long periods, up to even 20 years, where they go nowhere. <a href="http://www.irrationalexuberance.com">As predicted</a> by behavioural finance, stock market bubbles are followed by extended periods when the market deflates to, or even falls below, fair value. </p>
<h2>The long retrenchment</h2>
<p>In the great dotcom bubble we witnessed <a href="http://www.irrationalexuberance.com">the greatest ever stock market over-valuation</a> in recorded history. An extended period of miserable returns is exactly what was predicted by behavioural finance theorists back in 2000.</p>
<p>On long-term measures of value, the UK stock market is now at fair value or even below fair value. One way of showing this is to <a href="http://www.fool.co.uk/investing/2013/08/13/this-pe-suggests-the-ftse-100-is-a-buy/">look at the long-term average for the UK ratio of stock market prices against the listed companies’ earnings (P/E)</a>. It is around 12 to 15, depending on which measure you use, while for the FTSE 100 it is currently around 13. </p>
<p>The long-term <a href="http://www.investopedia.com/terms/d/dividendyield.asp">dividend yield</a> (how much a company pays out in dividends each year relative to its share price) is around 4% and for the FTSE 100 it is now just below 4%. Looked at as a whole, over the next 10 years we can expect the FTSE 100 to deliver good investment returns that are in line with its long-term average.</p>
<p>But even a 10-year investment horizon is somewhat speculative when it comes to the stock market. Paradoxically, the stock market becomes more predictable the longer into the future that we look. While good returns over the next 10 years appear to be quite likely, excellent returns over the next 40 years appear to be a virtual certainty.</p><img src="https://counter.theconversation.com/content/26843/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Arief Daynes does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The FTSE 100 reached 6877.39 points last week. It was the highest since its all-time peak of 6950.60 on December 30 1999 before the start of the deflation of the great dotcom bubble in January 2000. It…Arief Daynes, Principal Lecturer of Economics and Finance, University of PortsmouthLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/54652012-02-29T19:46:47Z2012-02-29T19:46:47ZMood swings and the market: how to understand irrational investor behaviour<figure><img src="https://images.theconversation.com/files/8231/original/c4w9htrx-1330495145.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Irrational decision-making can have significant consequences for financial markets.</span> <span class="attribution"><span class="source">AAP</span></span></figcaption></figure><p><em>Fred Tomczyk, a 20-year veteran of the financial services industry, has his finger on the pulse of investor sentiment: “ … the preference for cash that we’re seeing among new investors suggests a stronger risk aversion coming out of this downturn than we have seen in the past.”
USA Today, November 1, 2010.</em></p>
<p>BROKERS like Tomczyk are well aware of the relevance of investor moods. When the market is surging investors will flock to it, expecting ever more unrealistic gains and allocating their portfolios accordingly. When the inevitable downturn follows, investors will turn increasingly pessimistic yet surprisingly hold on to their risky portfolios to avoid capitalising losses. When they finally reallocate their portfolios to low-risk cash investments, they subsequently refuse to respond to a market turnaround. Smart money should be able to exploit those biases by selling (buying) over (or under)valued risky assets. Yet, even smart money seems unable to go against the grain, as moods are often persistent and the eventual turnaround is always hard to predict. These two phenomena are known as cognitive biases and <a href="http://en.wikipedia.org/wiki/Limits_to_arbitrage">limits to arbitrage</a>, which underpin the new discipline of behavioural finance.</p>
<p>Investors’ cognitive biases – such as over-confidence in their ability to forecast; using rules of thumb in investment allocation; using historical “anchors” as benchmarks; or alternatively, an excessive reliance on recent past performance – are well documented. Finance academics and commentators use these psychological traits to “explain” irrational anomalies such as herd behavior or speculative bubbles and crashes.</p>
<p>Unfortunately, it has not been straightforward to incorporate these irrational investor traits in standard <a href="http://en.wikipedia.org/wiki/Rational_agent">rational-agent </a>finance models to assist portfolio allocation, option pricing or the identification of arbitrage opportunities. After all, the typical investor’s behaviour is most likely a potpourri of psychological traits. Some combinations of cognitive biases reinforce a particular valuation error, other combinations are contradictory and may even lead to a valuation that is perfectly indistinguishable from the rational investor solution. </p>
<figure class="align-right ">
<img alt="" src="https://images.theconversation.com/files/8232/original/978h256v-1330495268.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/8232/original/978h256v-1330495268.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=900&fit=crop&dpr=1 600w, https://images.theconversation.com/files/8232/original/978h256v-1330495268.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=900&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/8232/original/978h256v-1330495268.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=900&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/8232/original/978h256v-1330495268.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=1131&fit=crop&dpr=1 754w, https://images.theconversation.com/files/8232/original/978h256v-1330495268.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=1131&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/8232/original/978h256v-1330495268.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=1131&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption"></span>
<span class="attribution"><span class="source">AAP</span></span>
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<p>Furthermore, it is not at all clear whether or when a particular cognitive bias dominates among a heterogeneous and diverse set of investors, ranging from “mum and dad” investors to sophisticated institutional investors. It has been suggested that cognitive errors are more commonly made by less sophisticated retail investors, and are reflected in more obvious mispricing of small, relatively unknown and financially distressed stocks. Unfortunately, these are also the very stocks that are hardest to value accurately because of a lack of liquidity, highly speculative forecast earnings, and general lack of fundamental information. Attributing perceived mispricing to investor irrationality is therefore hardly robust science.</p>
<p>The behavioural finance literature, initiated by Nobel laureate <a href="http://www.nobelprize.org/nobel_prizes/economics/laureates/2002/kahnemann-lecture.pdf">Daniel Kahneman and Amos Tversky</a>, proposes stylistic models that capture psychological behavioral traits. Based on plausible behavioural parameter values, these models can predict under-diversified portfolio allocations and various price distortions. These irrational financial outcomes are then compared and matched to real world portfolio allocations and mispricing by changing the behavioral parameters. This is a rather indirect and imprecise inference of behavioral biases. </p>
<p>Unfortunately, cognitive biases are not readily observed directly from investor behaviour. Investor surveys and carefully designed experiments have been used to “measure” behavioural parameters for risk aversion and various risk premia. While these techniques have merits to determine ballpark values, they are not particularly insightful if these values are in fact time-varying (reflecting investor mood swings). Surveys and experiments also seem to elicit behaviours from participants that are distinctly different from how they behave under real-life circumstances. </p>
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<img alt="" src="https://images.theconversation.com/files/8233/original/qy5wscbd-1330495699.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/8233/original/qy5wscbd-1330495699.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=900&fit=crop&dpr=1 600w, https://images.theconversation.com/files/8233/original/qy5wscbd-1330495699.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=900&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/8233/original/qy5wscbd-1330495699.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=900&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/8233/original/qy5wscbd-1330495699.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=1131&fit=crop&dpr=1 754w, https://images.theconversation.com/files/8233/original/qy5wscbd-1330495699.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=1131&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/8233/original/qy5wscbd-1330495699.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=1131&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<p>Hence, we have arrived at a crossroads. We all know that financial market participants are not always rational in their decision-making, yet our standard toolkit (equity and fixed-income pricing and allocation models, risk management models, derivatives pricing models) is not easily accommodated to account for this. The popular use of sentiment indices as an aggregate representation of investor mood in those models might seem attractive, but fails to provide a better understanding of the underlying dynamics in investor behavior.</p>
<p>A way forward is provided by the ready availability of traded option prices for pretty much every financial asset. Option prices for various strikes reflect the option trader’s assessment of a range of possible underlying asset values at expiration of the option. By comparing the option-implied (subjective) probabilities with observed (objective) probabilities of underlying asset values, we get instant insight in and quantification of the investors’ cognitive biases.</p>
<p>Recent derivatives research indicates that loss aversion (as opposed to traditional risk aversion, where gains and losses are considered symmetrically) and Kahneman and Tversky’s <a href="http://www.princeton.edu/%7Ekahneman/docs/Publications/prospect_theory.pdf">prospect theory </a>(where unlikely outcomes are attributed unrealistically high likelihoods) are driving the well-known <a href="http://en.wikipedia.org/wiki/Volatility_smile">volatility smile</a> in option prices, which occurs in a derivatives market where option prices reflect investors attaching too high probability to increasingly unlikely future returns. </p>
<p>More importantly, the intertemporal dynamics of option-implied cognitive biases will help forecast the extent and persistence of irrational behaviours. An ability to forecast investor behaviour could help overcome the limits to arbitrage and thus avoid costly bubbles and crashes.</p><img src="https://counter.theconversation.com/content/5465/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Paul Kofman receives funding from the Australian Research Council Discovery Grant Scheme.</span></em></p>Fred Tomczyk, a 20-year veteran of the financial services industry, has his finger on the pulse of investor sentiment: “ … the preference for cash that we’re seeing among new investors suggests a stronger…Paul Kofman, Professor of Finance, The University of MelbourneLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/35952011-09-28T03:43:15Z2011-09-28T03:43:15Z‘Dreaming’ of recession: what to make of market makers and their noise?<figure><img src="https://images.theconversation.com/files/3919/original/Screen_shot_2011-09-28_at_11.53.35_AM.jpg?ixlib=rb-1.1.0&rect=19%2C5%2C623%2C382&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">London trader Alessio Rastani has told the BBC he "dreamed" of recession. But traders often don't know how they'll react to losses. </span> <span class="attribution"><span class="source">YouTube</span></span></figcaption></figure><p>Trading in financial securities has sometimes been regarded as a <a href="http://www.investopedia.com/terms/b/blackbox.asp#axzz1ZD3FQmUg">“black box”</a>. </p>
<p>This is particularly the case in markets where there is increased uncertainty. The current world economy is a prime candidate for increased uncertainty. Ever since the global financial crisis the market has had the jitters. </p>
<p>But markets don’t get jitters; <a href="http://brokershandsontheirfacesblog.tumblr.com/">it’s the individuals in them</a>.
This is not helped by negative media reports of losses in confidence, and once the ball begins to roll we get waves of panic selling and <a href="http://www.bloomberg.com/news/2011-09-28/euro-retreats-against-yen-dollar-amid-concern-at-europe-economic-slowdown.html">markets fall</a> until rational investors begin to consider the lower prices represent good value and buying pressures correct the falls. </p>
<p>When the uncertainty is high then markets can see <a href="http://news.sky.com/home/article/16074598">large swings in prices</a> as buyers and sellers move in and out. </p>
<p>As a result of the increased uncertainty we are likely to see stories of <a href="http://youtu.be/qhB9B8p5FX0">some individuals such as London trader Alessio Rastani dreaming of making lots of money</a>, some losing lots of money and <a href="http://www.guardian.co.uk/business/2011/sep/22/kweku-adoboli-faces-fourth-charge?newsfeed=true">rogue traders like Kweku Adoboli</a> trying to recover losses but failing and being exposed. </p>
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<img alt="" src="https://images.theconversation.com/files/3920/original/Screen_shot_2011-09-28_at_12.20.46_PM.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/3920/original/Screen_shot_2011-09-28_at_12.20.46_PM.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=659&fit=crop&dpr=1 600w, https://images.theconversation.com/files/3920/original/Screen_shot_2011-09-28_at_12.20.46_PM.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=659&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/3920/original/Screen_shot_2011-09-28_at_12.20.46_PM.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=659&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/3920/original/Screen_shot_2011-09-28_at_12.20.46_PM.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=828&fit=crop&dpr=1 754w, https://images.theconversation.com/files/3920/original/Screen_shot_2011-09-28_at_12.20.46_PM.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=828&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/3920/original/Screen_shot_2011-09-28_at_12.20.46_PM.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=828&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption">Former UBS trader Kweku Adoboli lost US$2 billion.</span>
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Generally, the increased risks mean that the number of individuals in the tails of the distribution increase and some of these are going to be involved in large amounts of money. </p>
<p>As bad news sells newspapers, we are likely to see increased reports of losses. Although a million dollars - or a trillion dollars - is a lot of money to most people, in the whole scheme of things these amounts are relatively small. </p>
<p>Providing there isn’t a complete loss of market confidence there will be a future point where prices stabilise. </p>
<p>No one knows when this will occur because no one can predict the future. So what do you do in such a volatile market? It depends upon your preference for risk.</p>
<p>In traditional finance, risk aversion is measured by the <a href="http://moneyterms.co.uk/utility-curve/">curvature of the utility function</a> for wealth. A different view as proposed in <a href="http://prospect-theory.behaviouralfinance.net/">prospect theory</a> is that people are not consistently risk averse. </p>
<p>Although they are more sensitive to losses than to gains, they are also risk-seeking in their attraction to long shots and in their willingness to <a href="http://www.spiegel.de/international/zeitgeist/0,1518,788462,00.html">gamble when faced with near-certain loss</a>. </p>
<p>In addition we know that investors do not take a global view of their assets. They hold separate mental accounts and are more likely to gamble from some accounts over others. </p>
<p><a href="http://wws.princeton.edu/people/display_person.xml?netid=kahneman">Princeton Professor Daniel Kahneman</a> (one of the forefathers of prospect theory) takes this even further by suggesting that these theories are exclusively concerned with the moment of the decision, not with the moment of truth when consequences are experienced. </p>
<p>They tacitly assume that individuals correctly anticipate their reaction to possible outcomes and incorporate valid emotional predictions into their investment decisions. </p>
<p>But people are poor forecasters of their future emotions and future tastes. When there is increased uncertainty in the market it may make some traders take more explicit consideration of the regret they will face when the market goes against them. </p>
<p>Regret that is anticipated is more likely to be avoided. However, some traders will have no regrets and enjoy the adrenalin rush that the increased uncertainty brings. </p>
<p>Unfortunately, since we are poor forecasters of our future emotions, traders do not have a good idea of how they are going to react when they face losses. </p>
<p>Some of those that will suffer losses in the current market are going to face a lot of regrets.</p><img src="https://counter.theconversation.com/content/3595/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Barry Oliver does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Trading in financial securities has sometimes been regarded as a “black box”. This is particularly the case in markets where there is increased uncertainty. The current world economy is a prime candidate…Barry Oliver, Associate Professor, The University of QueenslandLicensed as Creative Commons – attribution, no derivatives.