Archive for the 'Behavioral Economics' Category
Monday, September 16th, 2013
There always seems to be a new startup involving sending money person-to-person, with the most common demo showing how easy it is to split a restaurant bill with your friends. Is this really a huge problem? Are there many groups of friends where one person orders lobster and four drinks without offering to pay their fair share? Yes it can get weird once in a while, but I would think things would self-regulate quickly. (Okay, maybe not the $47,000 food bill for 6 people on the right!) Also, it’s not very hard to ask for split checks with modern POS cash registers… maybe just tip a bit more for the inconvenience.
The economic argument is that if you know you’ll be splitting the bill evenly, you are incentivized to order more. In a group of six, ordering a $6 cocktail only costs you $1 more. A $12 appetizer is only $2. But you’re also subsidizing other people, so social dynamics come into play. If someone believes others are “freeriding” on them, then they’re more likely to order more, and so on. Do people really spend more when splitting the bill?
According to a study pointed out by Undercover Economist Tim Harford, people just might:
Diners were, at random, offered three different billing rules: split-the-bill, pay-your-share, or on-the-house. They were also asked to order food by writing their choices down, without discussion. This odd request was made less odd by the fact that they were all filling in questionnaires at the time.
Homo economicus immediately emerged: diners ordered, on average, 37 shekels worth of food when paying their own way, 51 shekels when splitting the bill, and 82 shekels when the experimenter picked up the tab for everyone. (A small follow-up experiment hinted that people splitting the bill six ways behave similarly to those paying one-sixth of their own bill.)
The study involved bringing strangers together in an actual restaurant ordering real food, so it’s close but not quite the same as eating with friends. Even with friends, I still tend to think as a group the total bill would be a bit higher, like maybe one more person will order a beer if everyone else is having one.
Thursday, May 3rd, 2012
“Sell in May and go away” is a rhyming market-timing slogan that may never… go away. Here’s a graphic that seems to support the idea that stocks have historically performed much worse between May and October than the rest of the year. Credit to Reuters/Scott Barber via Abnormal Returns. Data set is the MSCI World Index from 1971-2011.
Meanwhile, The Big Picture shares a bunch of graphs from TheChartStore that don’t make it look so clear-cut. Looking at this one, why shouldn’t just bail out every September? Data set is the S&P 500 from 1928-2011.
Larry Swedroe tests the theory out using 30-day Treasury bonds as the alternative investment in this CBS Moneywatch article:
He looked at returns through 2007 from six start dates since 1950. “Sell in May” beat “buy and hold” if you started investing in 1960, 1970 and 2000, but not if you started in 1950, 1980 or 1990. “It’s pure randomness,” Swedroe says. “How would you ever know when to start?”
Throw in the tax implications of all that buying and selling, and I agree. Do you really want to base your investing strategy on a data-mining result that has no logical explanation behind it? Sounds too much like driving a car using only your rearview mirror.
However, Tadas Viskanta of Abnormal Returns has what I think is a reasonable compromise – what if you just decided to rebalance your portfolio at the very end of April and the very end of October? You should rebalance your portfolio regularly anyway, so why not do it twice a year, six months apart. If your target asset allocation is 70% stocks/30% bonds and now you’re at 80/20 due to the recent run-up, why not go back to 70/30. If things end up at 60/40 in November, then again, go back to 70/30.
You could call it “Remember to Rebalance in May and November”. It even rhymes! If “sell in may” really works, you’ll get some benefit from this mean reversion wackiness. If it’s just noise, you portfolio shouldn’t theoretically be hurt any more than picking other months.
Thursday, March 22nd, 2012
Personal finance in theory is simple. Earn more, spend less. We all know that. But what makes it hard is changing our behavior, and much of that behavior is controlled by habits that we can’t stop. A new book called The Power of Habit: Why We Do What We Do in Life and Business by Charles Duhigg tries to explain the science and behavioral psychology of how habits work. You may have already seen some articles based on his work:
- How Companies Learn Your Secrets (NY Times) – Includes how Target figured out that a man’s teenage daughter was pregnant before he did.
- The Power of Habit (Slate) – An excerpt of the book explores the science of cravings and a habit that almost all of us have: brushing our teeth with toothpaste each morning.
- Book Review in Businessweek – About how a new CEO for Alcoa changed the company by changing their routines.
So how do we change our bad habits so that we are more productive, healthier, and wealthier? We have to understand the Habit Loop, which consists of a cue, the routine itself, and a reward. In the case of toothpaste, the cue is feeling a film over your teeth (or just waking up). The routine is brushing your teeth with toothpaste. The reward is the feeling of a clean mouth, but critically also the tingling feeling from the toothpaste. Even though it doesn’t actually help clean your teeth, without the ingredients that cause the tingling, people don’t feel like toothpaste does it’s job and won’t buy it. We crave the tingling.
Stopping a habit means stopping the habit loop. For example, Duhigg was gaining weight because every afternoon he would go down to the cafeteria and eat a cookie and socialize with friends. After some experimentation, he figured out that the socializing was the reward, and the cookie-eating had just been subconsciously linked. So he started a new habit where he would socialize away from cookies and the craving of snacks went away.
For other bad habits, you may need to avoid the cue, or replace the reward with something that doesn’t harm you as much. I believe this is how nicotine gum and electronic cigarettes work. You can get the nicotine buzz and/or the physical routine of holding a stick and sucking flavored “smoke” out of it.
Starting a new desired habit involves creating a positive reinforcing loop. An example given is to create a cue, like leaving your sneakers and workout clothes beside the bed before going to sleep. The routine is working out, but you need to actively anticipate the reward – a fresh fruit smoothie or maybe the feeling of looking at the scale each day and seeing your weight go down. Replacing bad habits not only requires learning replacement routine or rewards, but also practicing them over and over again.
Is it really that simple? I doubt it. Is this yet another book that distills a complex subject into a overly-simplified but convenient story? Maybe, but I like the questions that it asks. Now which of my many bad habits should I try to change…
Monday, January 30th, 2012
Recently, I came across an investment tip called the Overnight Rule from Carl Richards via the NYT Bucks Blog:
Imagine that all your investment holdings were sold overnight by accident.
You can’t undo the trades, and now all you have is cash.
Would you buy back everything you owned previously again at their current prices? If not, why are you holding them now?
I think this provides a fresh look at your portfolio, as many times we hold investments for irrational reasons. For example, there is the well-documented trait of loss aversion (even though readers of this blog may be immune), where investors really hate selling at a loss, even more than they love selling with a gain.
Perhaps you bought the stock at $20 a share, and it is now at $15 a share. You want to get rid of it “just as soon as it gets back to $20 a share”, so that so you can say you didn’t lose money on it. It’s better to admit the mistake and put your money in something better.
Then there is regret aversion. Perhaps you bought it at $50 a share and now it’s at $400 a share. You get to tell your friends how you bought Apple at $50 a share. You’re afraid it’s overpriced, but you don’t want to miss out if it rises some more. You sit on your gains and choose inaction instead of having to make a hard decision even though your money could be better deployed elsewhere.
Maybe it is company stock from your job, or shares that you inherited from a beloved family member. Whether is it some form of sentimental attachment, inertia, or plain laziness – you may want to consider your reasons for holding them.
There is a small exception to this rule if you are sitting on large capital gains in a taxable account and don’t want to realize them and get hit with the tax bill, especially if the alternative investment is also very similar (ex. mutual funds with similar holdings). However, even in this scenario you want to make sure that you’re not holding a poor investment just to put off a tax bill.
I did not come up with this myself, but read about this rule somewhere online within the last month. I’ve searched for the source but can’t find it, so please let me know if you do. Found it, thanks!
Wednesday, November 16th, 2011
Author and professor Dan Ariely has gained fame from being able to make his behavioral economics research accessible to the general public. We all want to understand better why we do what we do. His newest book is The Upside of Irrationality. You can read sample chapters from his books for free via the eBook Taste of Irrationality.
One of the problems he’s trying to address is saving for retirement. Why do so many people save less than they need to? Here’s what Ariely says, via a recent interview on the Betterment blog:
The world around us (wants) us to spend money now. The incentives (to spend) are always very high. It’s hard to resist that, and sadly, after being tempted towards spending, spending, spending, what we have left for savings is not enough.
Investing is between now and later. It’s about the trade off, and because people are not making these trade offs correctly, we’re basically in the (bad economic) situation that we’re in.
Money is fungible. Any time you spend money on anything, it could be spent on something else. The $10 lunch, the $1,000 TV, the $20,000 car. We all know this is true, but in practice we tend to weigh things differently. Here is a thought experiment taken from a recent talking engagement (paraphrased):
Imagine being presented with the decision to either by a $700 Sony speaker set or a $1000 Pioneer speaker set. Most people go for the better and more expensive Pioneer speakers.
Now, what if the same people were instead presented with the decision between the $700 Sony set + $300 in CDs and DVDs or a $1000 Pioneer speaker set? Ariely found that now most people go for the Sony set and music package.
Why? It’s easier to imagine the value of $300 of CDs as opposed to the diluted value of $300 spread across all the possible things in the world to buy.
Perhaps it would help us to remember a list of things at different price points that are really important to us, so that we can better judge our daily spending. For example, if I really enjoy my daily $3 coffee, then I could think of other small purchases in terms of giving up that coffee. Now, getting everyone to agree to delayed gratification is something for which I don’t think there is a simple solution.
Wednesday, August 24th, 2011
I’m currently reading the book Cheap: The High Cost of Discount Culture by Ellen Ruppel Shell, which is very well researched and a good read so far. One of the major themes of the book is how our culture is losing the ability to discern quality for ourselves. As a result, we use brand names and prices as shortcut indicators of quality.
First, take brand names. In general, we love brand names, because each of them allows a mental shortcut as to what to expect. Mercedez Benz. Rolex. Nike. This is why outlet malls are so popular. Since brands = quality, and outlet = low prices, we get insanely excited. Outlet malls are greater tourist attraction draws than national monuments.
As for prices, how often do you see a huge number on a shirt price tag, but with a slash through it? Retail Price: $80. Your Price: Only $19.99. Even better, make it one-day only like Groupon or Woot.com. The Manufacturers Suggested Retail Price (MSRP) is often purely a marketing scheme to make you feel like you’re getting a deal. This is called the reference price. You may not know anything about fabrics or stitching, but hey, this shirt used to cost $80, so it must be pretty good quality. I’m saving over 75% off the original price, how can I lose?
Coach is given as a great example of a well-recognized brand name that uses these tendencies to its advantage. Starting out in 1941 as a small leather workshop in New York, Coach is a maker of “affordable luxury” leather purses and other accessories complete with trademarked logos. Most manufacturing is now done in China and other cheap-labor countries. In fact, the gross margins across the company are now a huge 70-75%. (Gross margin is the difference between selling price and the cost to produce.)
Traditionally, outlet and factory stores sold slightly damaged or defective examples of their regular products at a steep discount. However, it may surprise you that now many brands make goods designed specifically for their outlet stores. At a Coach Factory Store, 80% of the stuff inside is sold exclusively in those stores. These are lower-quality versions, intended to be sold only at outlets for a lower price. You can’t return outlet purchases at a regular store, because they aren’t the same thing and are subtly marked as such (also because they want to make it harder to return).
Would it surprise you further to know that Coach makes more profit from its factory stores than its full retail stores? Per this article, Coach had 347 retail stores and 129 factory stores in North America. In a way, you could say that the main purpose of the full-price Coach stores in upscale shopping centers is to keep up the facade of quality. Meanwhile, the Coach Factory Outlets provide all the profit. The glitzy stores create that critical reference price ($800 purse!), so you think the Factory Store price is a good one. A $149 Coach? What a deal. If you own Coach bags or know people who do, think about it. How many did you buy at a “real” store vs. a Factory store?
Over time, this practice should dilute Coach’s brand equity. However, if we are indeed unable to judge quality and are just interested in brand names anyway, then it will take a while.
Tuesday, September 28th, 2010
Thanks to the discovery of free eBook rentals at the library, I finally read Blink: The Power of Thinking Without Thinking by Malcolm Gladwell over the weekend. It’s a short book and an easy read, which probably helped create its great popularity.
The book is primarily about the power of your “adaptive unconscious” to make quick and often-accurate decisions. By doing what Gladwell terms “thin-slicing”, the mind extracts the pertinent information out of a ton of available data. An expert on antiques spotting a fake within seconds, a researcher who has seen hundreds of couples being able to predict divorce, a veteran military commander winning a war game against a sophisticated algorithm overwhelmed with data, or someone who has studied facial expressions for years being able to spot hidden emotions. While interesting, I viewed much of this as an expected result of experts being experts.
However, in the end it also exposes how the unconscious can make bad decisions, full of prejudices and tendencies that you aren’t even aware of. Even if you think you are making decisions completely objectively, unless you truly strip out all the other variables then you can’t be sure. Although there is little mention of personal finance topics here, I would say this cautious side is where the book applies to money.
Other books like Your Money and Your Brain and Predictably Irrational have shown that a lot of our instinctual and/or unconscious tendencies towards money actually hurt us financially. We repeatedly find ourselves in speculative bubbles, our mind does quick relative calculations when it shouldn’t and we get used to a better lifestyle too quickly. Being aware of these hidden tendencies can help us become more successful.
Friday, August 13th, 2010
After two days of polling for my Frugality and Decision Making question, here are the results of my casual survey. As with my monkey poll question, each visitor was randomly given one of two different poll questions. I really love that you all put so much thought into your decision, but in fact the point I was trying to get across was a bit different.
As you can see, the only difference between two questions is the original price of the item being purchased. In both cases, you are deciding whether you want to save $7 by spending 15 minutes of your time. $7 is $7. Or is it? The vast majority of readers would take the 15 minutes for a $25 pen, but the vast majority would also not spend the 15 minutes for a $455 suit.
The Answer is Relativity.
Humans are trained to base our decisions in a relative manner, and compare them to whatever is available. We hate making decisions in a void. In this case, your mind may have trouble deciding if a $7 savings is worth it, so it goes straight for the price. In this case, $7 is savings of nearly 30% for the pen, and less than 2% for the suit. The decision is now easier, even though it may not make rational sense. We should think about money in a more absolute manner, but we tend not to.
More Examples of Relativity
- Think about how happy you are with your current salary. Now, imagine your co-worker who is junior to you gets paid $5,000 more a year. Much less happy now, right? H.L. Mencken noted that a man’s satisfaction with his salary depends on whether he makes more than his wife’s sister’s husband.
- Rome or Paris? Let’s say you love Paris and Rome equally, but have to decide between a Paris trip with hotel/airfare/free breakfast, a Rome trip with hotel/airfare/free breakfast, or a Rome trip with hotel/air but no free breakfast. Most people will proceed to pick Rome with free breakfast, because in that case you can make a comparison where you are making a clearly “superior” choice.
Given three choices, A, B (distinct, but equally as attractive as A), and A- (similar to A, but inferior), we will almost always choose A, because it is clearly superior to A-.
When Williams-Sonoma started selling a bread machine, sales initially were slow. But after they added a new “deluxe” version that was 50% more expensive, they started selling a lot. People now saw the first bread machine as a bargain.
- Have you ever rationalized an additional purchase because you’re already spending so much? When catering a large event that costs $5,000, a person may not think twice about adding a soup entree for an additional $200. The same person may get really excited when saving 50 cents on a can of soup.
- Which dot is bigger?
Often, simply acknowledging our tendencies and trying to think more broadly can help up make better decisions in the future.
As some of you have figured out, the idea for this week’s poll question and many of the examples above came from a book called Predictably Irrational by Dan Ariely, which explains how humans don’t always respond perfectly logically. (The actual poll question is from a study by well-known researchers Amos Tversky and Daniel Kahnemann.) I hope to put up more poll questions from this book (so don’t spoil them please ), as I find it much more fun and interactive than a book review.
Wednesday, August 11th, 2010
Here’s another poll to test your frugality behaviors and decision-making processes. There is no right or wrong answer, I promise. Just answer the poll honestly before reading further. It’ll just take a second.
(Due to some technical hurdles, please click on the “Read the rest of this entry…” link below to vote. Thanks!)
Read the rest of this entry…
Saturday, August 7th, 2010
After two days of polling for my Are You Smarter Than a Monkey question, here are the results. As I revealed after voting, visitors were each served up one of two different poll questions randomly, with an equal chance of getting either one. This worked out pretty well, with 49%/51% split of voters.
If you compare the questions side-by-side, you realize that they actually ask the exact same thing. Your two choices are essentially:
- $1,500 guaranteed, or a
- 50/50 chance at either $1,000 or $2,000
In statistics and gambling, there is a concept called expected value which is the probability-weighted sum of the possible values. In this case, the expected value for both options is $1,500. In other words, over many coin flips, the average person will get $1,500. So there is no “right” answer really, it’s more about how much risk you wish to take on. In general, you all would rather take the sure thing. I would be in this camp as well, but I’d probably take the risk if the expected value was a bit higher (remnants of blackjack self-training).
So if both polls are asking the same thing, a rational human being would answer both questions the same. However, psychologists have found that how the question is posed changes the answer. In the top poll, you start with $1,000 and are faced with either a sure gain or a bigger gain/nothing. In the bottom poll, you start with $2,000 and are faced with a sure loss or a bigger lose/nothing.
This small difference tries to test the phenomenon of loss aversion, which is the human tendency to strongly prefer avoiding losses rather than making gains. In this case, studies found humans hated the idea of losing $500 guaranteed so much that they’d take the risk in order to possibly avoid a loss, even though as we showed above the two choices are the same. Research with monkeys found that capuchin monkeys would also rather avoid the sure loss, indicating that this may be a genetic flaw rather than caused by our environment.
However, you guys were the complete opposite.
More people (38% versus 33%) went for the risky option when they had the $1,000. I don’t have any solid explanation for this, but here are some theories:
- Readers of this blog are exceptional and don’t have loss aversion, they are of the “nothing to lose anyway, let’s go for it” mindset.
- My testing was flawed. In the official studies, I am not sure if the same person was asked both questions, one after another. In retrospect, perhaps it would be better to present it in this manner.
- Readers were already aware of the loss aversion theory, and compensated when answering the poll.
- People either voted on both polls or multiple times on either poll, perhaps after reading the rest of the post explanation.
Either way, this was fun, and with nearly 1,500 voters, I’ll definitely try another experiment soon.