Posts Tagged ‘rationality’
“We cannot reason ourselves out of our basic irrationality. All we can do is to learn the art of being irrational in a reasonable way.”*…
Classical economists posit that investment decisions are driven by rationality — a clear-eyed evaluation of risks and rewards… but then, meme stocks.
Kwabena Donkor, an assistant professor of marketing at Stanford Graduate School of Business has just unveiled some new research that suggests that identity distorts our financial choices, leading us to overvalue investments that reinforce our sense of self…
People don’t just invest with their wallets — they invest with their identity,” says Donkor, a faculty fellow at the Stanford Institute for Economic Policy Research.
In a novel field study involving soccer fans, Donkor and several colleagues uncover evidence of how identity can skew economic thinking. The researchers ran a series of experiments focused on fans who placed nearly 40,000 bets on English Premier League matches during the 2021-22 season. Participants — nearly 800 from Kenya and 1,600 from the United Kingdom — were given a budget and asked to place bets on upcoming matches. They received winnings based on the outcomes of randomly selected games.
Most of the participants were longtime supporters of a particular team. (Manchester United was their top favorite.) They were more optimistic about their favorite teams, betting 20% more on them. They rated their teams as having a 10% to 18% higher chance of victory than other teams, even when presented with forecasts from professional oddsmakers suggesting otherwise. These results persisted even after accounting for factors such as personal beliefs and appetite for risk.
The study also finds that participants placed a lower value on gains not aligned with their identity — what the researchers referred to as an “identity tax.” Fans effectively devalued these neutral bets by 17% to 27%. For poorly performing teams, this “tax” could soar as high as 47%, reflecting a strong emotional impulse to support their favorite team even when the odds were against it
The research, detailed in a paper cowritten with Lorenz Goette of the National University of Singapore, Maximilian Müller of the Toulouse School of Economics, Eugen Dimant of the University of Pennsylvania, and Michael Kurschilgen of UniDistance Suisse, shows that identity-driven preferences explain much of the gap in bettors’ behavior. Simulations showed that distorted beliefs due to identity account for as much as 44% of the difference in fans’ betting behavior. The remainder stemmed from preferences rooted in identity itself — people were willing to sacrifice potential gains to support options that aligned with who they are…
… The study’s findings have far-reaching implications for understanding economic behavior, particularly in areas like consumer finance, brand loyalty, and even political decision-making…
… the research hints at how consumers view different products. Items that align with a person’s identity are likely to be seen as complements rather than substitutes. For example, Donkor says a consumer who identifies strongly with sustainability might view eco-friendly products as essential enhancements to their lifestyle, even if they’re similar to comparable, less expensive goods.
Ultimately, these findings could improve our thinking about the biases that influence our financial lives. As the researchers point out, acknowledging the role of identity in decision-making is one key to designing better policies, creating more effective financial products, and ultimately improving individual welfare. “If we ignore identity,” Donkor concludes, “we miss the bigger picture in decision-making.”…
Understanding the choices that we, and those around us, make: “What Soccer Fans Can Teach Us About Making Irrational Decisions,” from @SIEPR.
* Aldous Huxley
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As we ponder the price (and as a reminder that there are other kinds of irrational decisions and that sometimes returns do matter to investors), we might recall that it was on this date in 2008 that Bernard “Bernie” Madoff was arrested and charged with defrauding investment clients of as much as $65 billion. A pioneer in electronic trading and chairman of the Nasdaq stock exchange in the early 1990s, he had turned to money management. By 2008, Madoff was running a huge and growing fund that promised its investors high and stable returns… the problem: it was a Ponzi scheme, the largest known Ponzi scheme in history.
“Criticism may not be agreeable, but it is necessary. It fulfills the same function as pain in the human body. It calls attention to an unhealthy state of things.”*…
The estimable Henry Farrell on why, on average, we’re better at criticizing others than thinking originally ourselves…
… our individual reasoning processes are biased in ways that are really hard for us (individually) to correct. We have a strong tendency to believe our own bullshit. The upside is that if we are far better at detecting bullshit in others than in ourselves, and if we have some minimal good faith commitment to making good criticisms, and entertaining good criticisms when we get them, we can harness our individual cognitive biases through appropriate group processes to produce socially beneficial ends. Our ability to see the motes in others’ eyes while ignoring the beams in our own can be put to good work, when we criticize others and force them to improve their arguments. There are strong benefits to collective institutions that underpin a cognitive division of labor.
This superficially looks to resemble the ‘overcoming bias’/’not wrong’ approaches to self-improvement that are popular on the Internet. But it ends up going in a very different direction: collective processes of improvement rather than individual efforts to remedy the irremediable. The ideal of the individual seeking to eliminate all sources of bias so that he (it is, usually, a he) can calmly consider everything from a neutral and dispassionate perspective is replaced by a Humean recognition that reason cannot readily be separated from the desires of the reasoner. We need negative criticisms from others, since they lead us to understand weaknesses in our arguments that we are incapable of coming at ourselves, unless they are pointed out to us…
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… It’s not about a radical individual virtuosity, but a radical individual humility. Your most truthful contributions to collective reasoning are unlikely to be your own individual arguments, but your useful criticisms of others’ rationales. Even more pungently, you are on average best able to contribute to collective understanding through your criticisms of those whose perspectives are most different to your own, and hence very likely those you most strongly disagree with. The very best thing that you may do in your life is create a speck of intense irritation for someone whose views you vigorously dispute, around which a pearl of new intelligence may then accrete…
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… One of my favourite passages from anywhere is the closing of Middlemarch, where Eliot says of Dorothea:
“Her full nature, like that river of which Cyrus broke the strength, spent itself in channels which had no great name on the earth. But the effect of her being on those around her was incalculably diffusive: for the growing good of the world is partly dependent on unhistoric acts; and that things are not so ill with you and me as they might have been, is half owing to the number who lived faithfully a hidden life, and rest in unvisited tombs.”
Striving to be a Dorothea is a noble vocation, and likely the best we can hope for in any event; sooner or later, we will all be forgotten. In the long course of time, all of our arguments and ideas will be broken down and decomposed. At best we may hope, if we are very lucky, that they will contribute in some minute way to a rich humus, from which plants that we will never see or understand might spring.
Eminently worth reading in full: “In praise of negativity,” from @henryfarrell.
* Winston Churchill
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As we contemplate the constructive, we might recall that it was on this date in 1871 that a discipline wholly dependent on incorporating corrective critique into its methods was founded: Cleveland Abbe became the founding chief scientist– effectively the head– of the newly formed U.S. Weather Service (later named the Weather Bureau; later still, the National Weather Service).
Abbe had started the first private weather reporting and warning service (in Cincinnati) and had been issuing weather reports or bulletins since 1869 and was the only person in the country at the time who was experienced in drawing weather maps from telegraphic reports and forecasting from them. The first U.S. meteorologist, he is known as the “father of the U.S. Weather Bureau,” where he systemized observation, trained personnel, and established scientific methods. He went on to become one of the 33 founders of the National Geographic Society.
“Wouldn’t economics make a lot more sense if it were based on how people actually behave, instead of how they should behave?”*…
Behavioral economics aims to accomplish exactly that. Its approach has been to catalogue the dozens of cognitive biases that stop us from acting “rationally.” Jason Collins argues that instead of building up a messier and messier picture of human behavior, we need a new model…
From the time of Aristotle through to the 1500s, the dominant model of the universe had the sun, planets, and stars orbiting around the Earth.
This simple model, however, did not match what could be seen in the skies. Venus appears in the evening or morning. It never crosses the night sky as we would expect if it were orbiting the Earth. Jupiter moves across the night sky but will abruptly turn around and go back the other way.
To deal with these ‘anomalies’, Greek astronomers developed a model with planets orbiting around two spheres. A large sphere called the deferent is centered on the Earth, providing the classic geocentric orbit. The smaller spheres, called epicycles, are centered on the rim of the larger sphere. The planets orbit those epicycles on the rim. This combination of two orbits allowed planets to shift back and forth across the sky.
But epicycles were still not enough to describe what could be observed. Earth needed to be offset from the center of the deferent to generate the uneven length of seasons. The deferent had to rotate at varying speeds to capture the observed planetary orbits. And so on. The result was a complicated pattern of deviations and fixes to this model of the sun, planets, and stars orbiting around the Earth.
Instead of this model of deviations and epicycles, what about an alternative model? What about a model where the Earth and the planets travel in elliptical orbits around the sun?
By adopting this new model of the solar system, a large collection of deviations was shaped into a coherent model. The retrograde movements of the planets were given a simple explanation. The act of prediction became easier as a model that otherwise allowed astronomers to muddle through became more closely linked to the reality it was trying to describe.
Behavioral economics today is famous for its increasingly large collection of deviations from rationality, or, as they are often called, “biases.” While useful in applied work, it is time to shift our focus from collecting deviations from a model of rationality that we know is not true. Rather, we need to develop new theories of human decision to progress behavioral economics as a science. We need heliocentrism…
For a thoughtful critique of current thinking and a set of four “features” that might inform a new approach: “We don’t have a hundred biases, we have the wrong model,” from @jasonacollins.
* Dan Ariely, Predictably Irrational: The Hidden Forces That Shape Our Decisions
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As we dwell on decisions, we might spare a thought for someone who would probably have had little patience for ideas like these, Rose Friedman; she died on this date in 2009. A free-market economist, she was the wife and intellectual partner of Milton Friedman– a father of the “Chicago School” of neoclassical economic thought that underlies the neoliberlism so dominant of late [see here], of which behavioral economics is a corrective/critique– with whom she co-wrote papers and books (e.g., Free to Choose and Capitalism and Freedom) and co-founded EdChoice (formerly the Milton and Rose D. Friedman Foundation), with the aim of promoting the use of school vouchers and “freedom of choice” in education.
When her husband received his Medal of Freedom in 1988, President Ronald Reagan joked that Rose was known for being the only person to ever have won an argument against Milton.
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