- Rating: 8/10
- Last Read: June 2017
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- Misbehaving - Behavior that is inconsistent with the idealized model of behavior that is at the heart of what we call economic theory.
Economic theory is mostly flawed for two reasons:
- Optimization problems that people confront are often too hard for them to solve
- Beliefs upon which people make their choices are not unbiased.
Behavioral economics: Economics done with strong injections of good psychology + other social sciences.
The primary reason for adding humans to economic theories is to improve the accuracy of the predictions made with those theories.
Supposedly irrelevant factors (SIFs): Factors that economists consider irrelevant in influencing economic outcomes.
On the Endowment Effect
People value things they already own higher (your endowment) than things that were available but not yet owned.
Giving up the opportunity to sell something does not hurt as much as taking the money out of your wallet to pay for it. Opportunity costs are vague and abstract when compared to handing over actual cash.
Paying a surcharge is out-of-pocket, whereas not receiving a discount is a “mere” opportunity cost.
Hindsight bias - After the fact, we think that we always knew the outcome was likely.
Heuristic - Simple rules of thumb to help people make judgements.
On Value Theory
- Normative - Theories that tell you the "right" way to think about a problem. The most logically consistent explanation aka rational choice theory.
Descriptive -model how markets really behave and account for irrational market and participant behaviors that are not in accordance with expected utility theory.
People think about life in terms of changes, not levels.
Weber-Fechner Law - Just noticeable difference in any variable is proportional to the magnitude of that variable. Ex: If I gain one ounce, I don't notice it. If I buy fresh herb, the difference between 2 and 3 ounces is obvious.
Loss aversion: A loss hurts more than an equivalent gain gives please. Losses hurt about twice as much as gains make you feel good.
If learning is crucial, then as the stakes go up, decision-making quality is likely to go down.
Invisible handwave - Vague argument is that markets somehow discipline people who are misbehaving. Handwaving is a must for econs since there is no logical way to arrive at a conclusion that markets transform people into rational agents.
On Bargains and Ripoffs
All economic decisions are made through the lens of opportunity costs
If you understand opportunity costs and you have a ticket to a game that you could sell for $1,000, it does not matter how much you paid for the ticket. The cost of going to the game is what you could do with that $1,000. You should only go to the game if that is the best possible way you could use that money.
Measuring opportunity costs is virtually impossible for a human as there's no way to possibly know which of the nearly infinite ways to use $1,000 will make you the happiest.
Transaction Utility - The difference between the price actually paid for the object and the price one would normally expect to pay. Ex: beer price expectations at a fancy hotel vs bodega
- Good deals can lure all of us into making purchases of objects of little value. Ex: Buying that shirt you never wear because it was a good deal.
Sellers have an incentive to manipulate the perceived reference price and create the illusion of a "deal".
- Suggested retail price
- Limited supply
- Exclusive discount
Limited time offer
Walmart and Costco - Everyday low pricing strategy convinces consumers that the entire experience is an orgy of bargain hunting.
On Sunk Costs
When an amount of money has been spent and the money cannot be retrieved, the money is said to be sunk, meaning gone.
When you buy the ticket and then fail to use it you have to “recognize the loss” in the mental books you are keeping. Going to the event allows you to settle this account without taking a loss.
"Payment Depreciation" - People use the item they purchased more immediately after being billed. Then usage tails off as we move farther away from the time of payment.
On Betting and Poker
Compare someone who is down $50 in that night’s poker game to another who owns 100 shares of a stock that was down 50 cents at market close. Both have lost a trivial portion of their wealth, but one of the losses influences behavior and the other does not. Losing money in the poker account only changes behavior while you are still playing poker.
The odds on long shots (horses with little chance of winning) get worse on the last race of the day, meaning that more people are betting on the horses least likely to win. Players who were behind were attracted to small bets that offered a slim chance for a big win (such as drawing to an inside straight) but disliked big bets that risked a substantial increase to the size of their loss, even though they offered a higher probability of breaking even.
A good rule to remember is that people who are threatened with big losses and have a chance to break even will be unusually willing to take risks, even if they are normally quite risk averse.
The prediction from prospect theory that people will be risk-seeking in the domain of losses may not hold if the risk-taking opportunity does not offer a chance to break even.
Prospect theory: states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics.
“The pleasure which we are to enjoy ten years hence, interests us so little in comparison with that which we may enjoy to-day.”
- The basic idea is that consumption is worth more to you now than later. If given the choice between a great dinner this week or one a year from now, most of us would prefer the dinner sooner rather than later. Using the Samuelson formulation, we are said to “discount” future consumption at some rate.
On Self Control
- Dealing with self-control problems: One course of action is commitment. Remove the temptation or raise the cost of submitting to temptation.
“The idea of self-control is paradoxical unless it is assumed that the psyche contains more than one energy system, and that these energy systems have some degree of independence from each other.”
Planner and Doer: Each individual has two selves. The forward looking "planner" has good intentions and cares about the future. The "doer" lives for the present.
planner - prefrontal cortex (slow). doer - limbic system (fast).
Partial naivete: Most of us realize we have self-control problems but we underestimate their severity.
For such cases we may need a planner to have established a rule—no midweek beer and pizza outings—and then to think of a way of enforcing that rule.
Ski Resort Real World Example
Ski Resort example - Resort offered 10-pack ski tickets at a 40% discount in advance. This worked for a number of reasons:
- The discount was a great deal and had a lot of transactional utility.
- The advance purchase decoupled the purchase decision from the decision to go skiing. Skiers used mental accounting to view the tickets as an "investment" that saves money aka a sunk cost.
- Selling in advanced hedged against a warm winter w/o much snow.
- Skiers might bring along a friend who would pay full price
- Those who didn't use their tickets blamed themselves, not the resort.
- Only 60% actually redeemed their tickets. So they sold tickets at full price and got the $$ several months earlier.
Auctioning something is fine if the proceeds go to charity, unless the "charity" is the owner's wallet.
In many situations, the perceived fairness of an action depends not only on who it helps or harms, but also on how it is framed.
Any firm should establish the highest price it intends to charge as the “regular” price, with any deviations from that price called “sales” or “discounts.” Removing a discount is not nearly as objectionable as adding a surcharge.
Endowment effect in play: Both buyers and sellers feel entitled to the terms of trade to which they have become accustomed, and treat any deterioration of those terms as a loss.
There is clear evidence that people dislike unfair offers and are willing to take a financial hit to punish those who make them. It is less clear that people feel morally obliged to make fair offers.
Conditional cooperators - People are willing to give peers the benefit of the doubt, but if cooperation rates are low, these conditional cooperators turn into free riders.
people are more likely to keep what they start with than to trade it, even when the initial allocations were done at random.
Status quo bias - People stick with what they have unless there is some good reason to switch, or perhaps despite there being a good reason to switch
Formal models need not be rational; they don’t even have to be sensible. So we should not defend the rationality assumption on the basis that there are no alternatives.
Formal models need not be rational; they don’t even have to be sensible. So we should not defend the rationality assumption on the basis that there are no alternatives.
Confirmation bias: people have a natural tendency to search for confirming rather than disconfirming evidence
On Narrow Framing
- Purpose of narrow framing is understanding when people get themselves into trouble by treating events one at a time, rather than as a portfolio.
Inside vs Outside view: People lock into inside views and get caught up in unimportant shit. Taking an outside view allows you to zoom out and flesh things out carefully and reliably.
The problem is that the inside view is so natural and accessible that it can influence the judgments even of people who understand the concept.
Ex: Looking at one investment at a time (inside) versus looking at the performance of a portfolio (outside).
In order to get managers to be willing to take risks, it is necessary to create an environment in which those managers will be rewarded for decisions that were value-maximizing ex ante, that is, with information available at the time they were made, even if they turn out to lose money ex post.
The bottom line is that in many situations in which agents are making poor choices, the person who is misbehaving is often the principal, not the agent.
"dumb principal" problems - failing to create an environment in which employees feel that they can take good risks and not be punished if the risks fail to pay off
An implication of this analysis is that the more often people look at their portfolios, the less willing they will be to take on risk, because if you look more often, you will see more losses.
Whenever anyone asks me for investment advice, I tell them to buy a diversified portfolio heavily tilted toward stocks, especially if they are young, and then scrupulously avoid reading anything in the newspaper aside from the sports section.
On Beauty Contests
Beauty Contest - You have to guess what other people are thinking that other people are thinking.
who are the other players, and how much math and game theory do they know?
Keynes believed that as shares became more widely dispersed, “the element of real knowledge in the valuation of investments by those who own them or contemplate purchasing them . . . seriously declined.”
Beauty contest analogy is an apt description of what money managers try to do. They are trying to buy stocks that will go up in value—or, in other words, stocks that they think other investors will later decide should be worth more. And these other investors, in turn, are making their own bets on others’ future valuations.
On the Stock Market
Graham - father of “value investing,” in which the goal is to find securities that are priced below their intrinsic, long-run value.
One of the simple measures that Graham advocated in order to decide whether a stock was cheap or expensive was the price/earnings ratio (P/E), the price per share divided by annual earnings per share.
Price/Earnings ratio (P/E): The price per share divided by annual earnings per share.
If the P/E ratio is high, investors are paying a lot per dollar of earnings, and implicitly, a high P/E ratio is a forecast that earnings will grow quickly to justify the current high price. If earnings fail to grow as quickly as anticipated, the price of the stock will fall. Conversely, for a stock with a low price/earnings ratio, the market is forecasting that earnings will remain low or even fall. If earnings rebound, or even remain stable, the price of the stock will rise.
Companies that are doing well for several years in a row gather an aura implying that they are a “good company,” and will continue to grow rapidly. On the other hand, companies that have been losers for several years become tagged as “bad companies” that can’t do anything right. Think of it as a form of stereotyping at the corporate level. If this corporate stereotyping is combined with the tendency to make forecasts that are too extreme, as in the sense of humor study, you have a situation that is ripe for mean reversion. Those “bad” companies are not as bad as they look, and on average are likely to do surprisingly well in the future.
To this day, there is no evidence that a portfolio of small firms or value firms is observably riskier than a portfolio of large growth stocks.
But because we don’t exactly know how much a given stock will pay in dividends over time, the stock price is really just a forecast—the market’s expectation of the present value of all future dividend payments.
This lack of precision means that the long-term price/earnings ratio is far from a sure-fire way to make money. Anyone who took Shiller’s advice in 1996 and bet heavily on the market falling would have gone broke before he had a chance to cash in.
It is much easier to detect that we may be in a bubble than it is to say when it will pop, and investors who attempt to make money by timing market turns are rarely successful.
SIFs are noise, and a noise trader, as Black and Summers use the term, makes decisions based on SIFs rather than actual news.
*Open-end fund: investors can at any time put money into the fund or take money out, and all transactions are conducted at a price determined by the value of the fund’s underlying assets, the so-called Net Asset Value (NAV) of the fund.
Close-end fund: Managers of the fund raise an initial amount of money, say $100 million, and that is it. No new money can be invested, and money cannot be withdrawn.
Close-end funds strategy: Buying the funds with the biggest discounts earned superior returns.
When prices start to move against a money manager and investors start to ask for some of their money back, prices will be driven further against them, which can cause a vicious spiral. The key lesson is that prices can get out of whack, and smart money cannot always set things right.
My conclusion: the price is often wrong, and sometimes very wrong. Furthermore, when prices diverge from fundamental value by such wide margins, the misallocation of resources can be quite big.
If policy-makers simply take it as a matter of faith that prices are always right, they will never see any need to take preventive action. But once we grant that bubbles are possible, and the private sector appears to be feeding the frenzy, it can make sense for policy-makers to lean against the wind in some way.
The 3 essential elements of behavioral economics: bounded rationality, bounded willpower, and bounded self-interest.
the real point of behavioral economics is to highlight behaviors that are in conflict with the standard rational model.
If it were possible to change the perception of the chance of getting caught by just changing the color and location of parking tickets, without changing the actual probability of being caught, then it might be possible to do the same for more serious crimes.
5 findings from decision-making psychology that support early picks are too expensive:
People are overconfident. They are likely to think their ability to discriminate between the ability of two players is greater than it is.
People make forecasts that are too extreme. Scouts are too willing to say that a particular player is likely to be a superstar, when by definition superstars do not come along very often.
The winner’s curse. When many bidders compete for the same object, the winner of the auction is often the bidder who most overvalues the object being sold.
The false consensus effect. People tend to think that other people share their preferences. When a team falls in love with a certain player they are just sure that every other team shares their view.
Present bias. Teams want to win now.
This binding budget constraint means that the only way to build a winning team is to find players that provide more value than they cost.
High picks end up being expensive in two ways. First, teams have to give up a lot of picks to use one (either by paying to trade up, or in opportunity cost, by declining to trade down). And second, high-round picks get paid a lot of money.
In reality, across the entire draft, the chance that the earlier player will be better is only 52%. In the first round it is a bit higher, 56%.
Two simple pieces of advice to teams. First, trade down. Trade away high first-round picks for additional picks later in the draft, especially second-round picks. Second, be a draft-pick banker. Lend picks this year for better picks next year.
When you give up a bunch of top picks to select one player, you are putting all your eggs in his basket, and football players, like eggs, can be fragile.
Coaches are Humans. They tend to do things the way they have always been done, because those decisions will not be second-guessed by the boss. As Keynes noted, following the conventional wisdom keeps you from getting fired.
On saving for retirement: Participation rates depended strongly on the ease with which employees could learn about the program and sign up.
Humans make errors. If we can anticipate those errors, we can devise policies that will reduce error rate. Ex: bumper strips on highways.
Nudge - influence choices in a way that will make choosers better off, as judged by themselves. Ex: fly in urinal.
If you want people to comply with some norm or rule, it is a good strategy to inform them that most other people comply.
If you want to encourage someone to do something, make it easy.
Good leaders must create environments in which employees feel that making evidence-based decisions will always be rewarded, no matter the outcome.