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Posts tagged ‘Kahneman and Tversky’

The Availability Heuristic: Why Your Children Probably Aren’t Going to be Murdered

Journalist Lenore Skenazy is called a number of things: “Americans Worst Mom,” “A Heretic,” and, “Abusive.” Her crime? In 2008 she left her nine-year-old son go home by himself on the New York Subway. Her son’s solo trip was made famous by a New York Sun column written by Skenazy and it’s almost too easy to imagine her critics: up-tight mothers so overly protective of their children that they wouldn’t even think of letting them wait at the bus stop alone. You know, helicopter parents. As one recent Time.com article describes, they are the type of parents who “[buy] macrobiotic cupcakes and hypoallergenic socks, [hire] tutors to correct a 5-year-old’s “pencil-holding deficiency,”… [and demand that] nursery schools offer mandarin.”

Can you really criticize overprotective parents?  They are, after all, only trying to ensure the safety of their children. But sometimes the numbers tell a different story. In regard to Skenazy’s “abusive” decision, consider that only about 100 people are abducted by a stranger every year, half of whom are eventually murdered. Factoring in that there are 50 million children in the United States, the annual homicide rate via abduction comes out to be one in a million. In other words, “if you wanted your child to be kidnapped and held overnight by a stranger, you’d have to leave the child outside and unattended for 750,000 years.” Similarly, consider that, “more than twice as many children are hit by cars driven by parents taking their children to school as by other kinds of traffic.” That is, every time a parent drives their children to school the chances that a child gets killed increases.

Unfortunately, the parents don’t usually buy these types of arguments; “those are just the numbers,” they might say, “they miss a larger point: don’t rely on statistics when it comes to your children’s safety.” But my beef isn’t with overprotective parents. The truth is, everybody does a poor job of distinguishing what is actually dangerous from what isn’t. This tendency stems from a cognitive shortcut Kahneman and Tversky call the availability heuristic. Availability describes our tendency to judge the importance or frequency of an event based on how easily the even is brought to mind. For example, in one experiment done by Paul Slovic, participants were asked to estimate the amount of people per 200 million who die annually from drowning, tornadoes, asthma and fireworks. He found that on average people believed that 1684 died from drowning, 564 from tornadoes, 506 from asthma and 160 from fireworks. Reality paints a much different picture: 7380 for drowning, 1886 for asthma, 90 for tornadoes and 6 for fireworks. It is not a coincidence that deaths from fireworks and tornadoes show up on the news more often than deaths from drowning or asthma. And that’s the problem – the media gives a false sense of what is actually dangerous in order to entertain their viewers (us).

There are negative consequences of these attention grabbing tactics. German cognitive psychologist Gerd Gigerenzer estimates that the year after the 9-11 attacks, 1,500 people died in car accidents because they chose to drive fearing that their plane might be hijacked. Add that up over the course of a few years and you’ll find that “the number of people who died by avoiding air travels was six times the number of people who died in the airplanes on September 11.” Similarly, did you know that you are eight times more likely to die from walking home drunk than driving home drunk, the chances of getting murdered from hitchhiking is virtually zero, and owning a pool is astronomically more dangerous that owning a gun.

To be sure, the availability heuristic is a vital cognitive resource. It allows us to quickly assess the frequency and importance of an event with little cognitive effort. Sometimes this is a good thing; famine, wars and natural disasters get a lot of media attention for good reasons. But sometimes availability gives us a false sense of reality, which the examples outlined here illustrate.

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The Price of Framing & Anchoring

I love wikipedia, which is why I am more than willing to donate some money. But I was a little taken back when I saw that its initial asking price is $20. I was thinking a few bucks at most, certainly not $20… that’s four Bud Lights in NYC! What’s interesting is that after seeing the initial price of $20, giving five, six, or seven dollars as opposed to one or two didn’t seem that bad. But then my knowledge of cognitive biases reminded me that Jimmy Wales was playing me.

The green box on the right illustrates a cognitive bias known as anchoring, which “describes the common human tendency to rely too heavily… on one trait or piece of information when making decisions” (I took this quote, appropriately, from wikipedia). A good bargainer uses anchoring to set the initial price high and give the buyer the illusion that he or she is getting a good deal. Likewise, Wales set the smallest donation at $20 to make, say, ten dollars seem like not that much. I mentioned anchoring about a month ago; now, I want to turn to its evil twin, the framing effect, which also distracts us with irrelevant information.

To get a sense of the power of framing, consider Dan Ariely’s example, which appears in the first chapter of Predictably Irrational. Below are three subscription plans offered by Economist.com. Which would you choose?

  1. Economist.com subscription – US $59.00 One-year subscription to Economist.com. Includes online access to all articles from The Economist since 1997.
  2. Print subscription – US $125.00 One-year subscription to the print edition of The Economist.
  3. Print & web subscription – US $125.00 One-year subscription to the print edition of The Economist and online access to all articles from The Economist since 1997.

If you read closely, something strange should have jumped out at you. Who would, as Ariely says, “want to buy the print option alone… when both the Internet and the print subscriptions were offered for the same price?” At first it seems as if someone at The Economist may have made a mistake, after all, how could a one-year subscription have the same value as a one-year subscription and access to online articles since 1997? But after thinking for a second, you may realize that the people at The Economist are not all that stupid; they may in fact know a thing or two about human behavior.

To see just how influential the “framing” of the Economist’s subscription plans are, Ariely conducted the following experiment. First, he presented his MIT Sloan School of Management students with the options as seen on Economist.com and had them choose a subscription. Here were the results.

  • Internet-only subscription for $59 – 16 students
  • Print-only subscription for $125 – 0 students
  • Print-and-Internet subscription for $125 – 84 students

It makes sense – who would choose option two given option three? But the question is: how much did option two influence the student’s decision making? Ariely conducted a second experiment to find the answer. He gave the following subscription plan, this time without the second option, to a second group of students and had them pick one. Here were the results.

  • Internet-only subscription for $59 – 68 students
  • Print-and-Web subscription for $125 – 32 students

As you can see, by simply removing the second option the preference of the students shifted dramatically. Without the second option 68 students chose option one while only 32 students chose option two. How significant is this? Well let’s say that instead of running this experiment with 100 graduate students, you did it with 10,000 customers in the real world. And let’s say that all 10,000 customers chose to sign up for a subscription. In scenario one, where three options are presented, 8,400 people would have chosen option three, 1,600 would have chosen option one, none would have chosen option two, and The Economist would have made $1,144,400 in revenue. Let’s compare this to the second scenario; 6,800 chose option one, 3,200 chose option two, and The Economist would have made $801,200 in revenue. By simply placing a decoy option, The Economist has made $343,200 more.

So what’s the lesson? When you go out this weekend to restaurants or bars, remember that all those gimmicks are just waiting to feast on your cognitive biases. Maintain rationality!

Loss Aversion & Trains: The Psychology of Gaining and Losing an Aisle

I recently took the train from Chicago to New York. It was long, uneventful and fairly dull. I got lucky though. A few hours before we arrived in New York’s Penn Station, the person who had been sitting next to me since Chicago got off the train; I suddenly had the whole aisle to myself. There was so much space I might as well been in first class. This got me thinking: what if I began my trip with all that space, and gained an aisle mate a few hours after Chicago? Would I have had the same reaction if the opposite happened?

I think it’s obvious – absolutely not. I would’ve been much worse the other way around. But why?

As humans, we have a deep psychological tendency to handle equivalent gains and losses differently. Almost always, a loss feels more detrimental than an equivalent gain. For example, most people find that losing a $50 bill is more agitating than finding a $50 bill is gratifying. Psychologists call this tendency loss aversion, and it helps explain a lot of irrational economic behavior. Bad investors exemplify this. Often times when an investment goes down, they tell themselves that they will sell it as soon as it goes back up. But when it continues to drop, their loss aversion kicks in and causes them to hold onto the investment even longer, which ultimately results in losing a lot of money. This is referred to as “chasing a loss,” and it typifies our tendency to assess equivalent gains and losses differently.

Loss aversion is connected to another psychological tendency called framing, which anyone familiar with the psychology of decision-making should know. Here are a few examples: would you rather buy meat that is 85% lean, or 15% fat? Would you rather opt for an operation that has a 90% survival rate, or a 10% mortality rate? Would you rather get a $5 discount, or avoid a $5 surcharge? You get the idea. We don’t assess equivalent losses and gains equally.

Back to my train ride. The question that kept me up was not if I would have reacted differently to my seatmate leaving late versus arriving early, it was why I would have reacted differently. I think the answer rests in my loss aversion. The reason I felt such a sense of joy when he left rests in the fact that I gained something – the aisle. On the other hand, I would have been annoyed if he would have sat down a few hours after we left Chicago because I would’ve felt as if I lost something – the aisle. Here’s the key, in both scenarios I would have experienced the same amount of time with the aisle to myself. The only difference is that in one case I gained something and in the other case I lost something.

The other question is whether or not loss aversion is an “irrational” behavior. If our standard for rational behavior is the Adam Smith version, then yes, loss aversion would be irrational. However, in the hunter-gatherer lifestyle to which our genetics evolved for, loss aversion seems perfectly rational. For example, let’s say you are on the African savannah and you have a stash of food you’re trying to protect. As one author says, “having twice as much food is not necessarily twice as valuable; food is perishable and one can only eat so much of it.” In this case, it would be a good idea to treat equivalent gains and losses differently; it is ecologically rational as some have said. In other words, “the brain’s built-in loss aversion bias is probably a carryover from the days our primate ancestors made decisions that involved resources that didn’t obey the tidy linear relationships of monetary wealth or the simple maxim, the more, the better.”

Clearly, loss aversion has its pros and cons, and whether it is rational or irrational depends on what your standards are. But it does help to explain a lot of things that aren’t necessarily related to economics, like my experience on the train.

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Does Studying Behavioral Economics Improve Your Financial Decisions?

I hate behavioral economics. Not because I disagree with its’ theories or findings, but because it consistently reminds me of how stupid I am. I think I choose optimally – nope. I think I weigh all the options equally – nope. I think I am rational – nope. You get the idea, and if you’re familiar with behavioral economics, then perhaps you feel my pain.

I’ve been studying behavioral economics for a few years now. It started back in college with Dan Ariely’s Predictably Irrational, a book that really made me rethink a few things, and progressed with a few academic papers and blog posts. What exactly have I learned? Simple: we think about money relatively, not absolutely.

For example. Let’s say you are buying a stereo for $400 when someone tells you that across town is the same stereo for $300. If you’re like most people, you’ll drive across town and save the 100 bucks. Now, suppose you are buying a car for $30,000 when someone tells you that across town is the same car for $29,900. If you’re like most people, you’ll forgo the $100 discount and buy the car at $30,000. But given that each scenario is financially identical – a trip across town saves $100 – shouldn’t you respond the same? If you were rational, yes. But you aren’t, for some reason you feel that the $100 saved in the car scenario is less that the $100 saved in the stereo scenario.

Here’s one more example. Let’s say you are on your way to the theater with a ticket worth $20 and a $20 bill in your wallet. When you arrive at the theater you find that you’ve lost the ticket. The question is: Do you buy another ticket with your $20 bill? Most say no. Now take the same scenario but instead of having a ticket worth $20 and a $20 bill, you have two $20 bills. You arrive at the theater, but this time you’ve lost a $20 bill. Same question: Do you buy another ticket? Most say yes. Like the previous example, this make no financial sense because twenty dollars is lost in both scenarios. However, for some reason people feel that the lost ticket is worth more than the lost twenty. Point is, when it comes to money, we understand things relatively instead of absolutely.

Back to my hatred.

Here’s the worst part. Even though I’ve spent years reading about behavioral economics and studying scenarios like the ones I just outlined, I’m no better at deciding. So I keep asking myself: Does learning about behavioral economics improve financial decision-making?

Maybe a little bit, but in general, I think absolutely not. I know I should assess dollars absolutely, but I still assess them relatively. Put differently, I would never travel across town to save $100 on a $30,000 car because it just wouldn’t feel right. No matter what I learn, I just can’t seem to shake my irrationalities. There is a great quote, one I have used before, by Nassim Taleb that captures my point of view on evolutionary terms. He explains:

What are our minds made for? It looks as if we have the wrong user’s manual. Our minds do not seem made to think and introspect; if they were, things would be easier for us today, but then we would not be here today and I would not have been here to talk about it – my counterfactual, introspective, and hard-thinking ancestor would have been eaten by a lion while his nonthinking but faster-reacting cousin would have run for cover.

Taleb’s position is that when it comes to deciding rationally, our brains just aren’t up for the task. True, humans have the most sophisticated minds on the plant. But the mental mechanisms that biologically separate us from other species, those cognitive parts which permit us to assess the pros and cons of buying a stereo, new cars, or theater tickets are brand new; and like any first generation technology, they are prone to several systematic errors. As Jonah Lehrer says, “when it comes to the new parts of the brain, evolution just hasn’t had time to work out the kinks.”

This is precisely why I don’t think learning about behavioral economics, or the psychology of decision-making in general, helps me decide. No matter how much I learn, and no matter how educated I am, my brain will make the same mistakes over and over again because it just wasn’t designed with cars, stereos, and movie tickets in mind.

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