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Behavioural Economics Answers

The questions posted in the previous blog were designed to highlight the two systems of thought (the intuitive and the rational) that operate in our brain (see references for confirmation of this outlandish statement!) The degree to which an individual monitors their intuitive thoughts with their rational mind is a profound indicator of other significant personal characteristics.

Question one asked: A bat and a base-ball cost $1.10 together. The bat costs $1.00 more than the base-ball. How much do the bat and the base-ball cost individually? (Did you give it a go?)

Almost everyone who is asked this question reports that the answer that immediately comes to mind is that the bat costs $1.00 and the base-ball costs $0.10. However, if you ‘think’ about the question for more than a moment it becomes clear that this cannot be right as it would result in the bat costing $0.90 more than the base-ball.

Academic Shane Fredericks (2005) found that many intelligent people yield to their first impression and give the wrong result to this question. In one study of Princeton University students 50 per cent gave the wrong answer and in another study of University of Michigan students 56 per cent!

The correct answer is that the bat costs $1.05 and the base-ball costs $0.05.

This question highlights how lax we can be in our conscious monitoring, and how easily we trust a plausible judgement that comes quickly to mind. Generally these intuitive ‘answers’ are based on implicit assumptions. The wide-spread lack of mental monitoring is kinda scary when we move away from questions of base-ball prices and address questions of racism, sexism and the many areas of life where our decisions are guided by implicit assumptions.

The next two questions were in the same theme.

Question two asked: If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?

The answer is 5 minutes, but many people respond by saying 100 minutes. It seems right at an intuitive level.

Question three asked: There is a lake suffering from a blue-green algae bloom. Every day the size of the bloom doubles. If it takes 48 days for the bloom to cover the entire lake, how long would it take for the patch to cover half the lake?

The intuitive answer tends to be 24 days. It is wrong.

The correct answer is 47 days.

Fredericks also found that people’s answers to these questions were highly correlated with certain behavioural traits. For instance, people who answered all three questions right tended to be more patient and more willing to wait to be rewarded. Fredericks’ subjects were asked another question: would you rather $3,400 this month or $3,800 next month?

The students who got all three questions wrong then 65 per cent went for the $3,400 this month. In contrast, of those who got all three answers right, 60 per cent decided to wait a month and take $3,800. The two different amounts equate to an implied discount rate (the interest rate a bank would have to pay you on $3,400 to make it worth $3,800 in a month) of 280 per cent!

How did you go with these simple questions? Should I lend you some money for the month? (You wouldn’t happen to have $3,400 sitting around would you?)

References:

Frederick, S., 2005, Cognitive reflection and decision making, Journal of Economic Perspectives, Volume 19, Number 4.

Epstein, S., 1994, Integration of the cognitive and psychodynamic unconscious, American Psychologist, 49, 709-724.

Chaiken, S., and Trope, Y., (Eds) 1999, Dual-process theories in social psychology, New York: Guilford Press.

Kahneman, D., 8 December 2002, Maps of bounded rationality: A perspective on intuitive judgement and choice, Noble Prize Lecture.

Behavioural Economics Questions

The following simple questions will provide an indication as to how your decision making can be influenced through implicit assumptions. Taking a few minutes to complete the questions as it will provide you with very powerful insights into how easily conscious thinking can be influenced.

1. A bat and a base-ball cost $1.10 together. The bat costs $1.00 more than the base ball. How much do the bat and the base-ball cost individually?

Bat costs:_____________ Base Ball costs: ___________

2. If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets? (A widget is an economic euphemism for ‘product’ or ‘thingie’ – there is a reason that economists are not engineers)

How long?____________

3. There is a lake suffering from a blue-green algae bloom. Every day the size of the bloom doubles. If it takes 48 days for the bloom to cover the entire lake, how long would it take for the patch to cover half the lake?

How many days? ________________

Looking Up And Seeing Stars

Just over a week ago Dianne Odell, at the age of 61, died because of a power failure to her home in Jackson, Tennessee. While family members frantically tried to start an emergency generator, her father said, “We did everything we could do but we couldn’t keep her breathing. Dianne had gotten a lot weaker over the past several months and she just didn’t have the strength to keep going.”

Dianne Odell had spent the previous 58 years with a two meter machine completely enveloping her body to keep her alive. This machine, a 340-kilogram iron lung, was a cylindrical chamber with a seal at the neck that completely enveloped her body with only her head exposed. At the age of three, Dianne was struck down with the debilitating disease polio. Her life was dependent on a machine developed in 1928 that produced positive and negative pressure on her lungs to induce breathing. Because of a spinal deformity from the polio that made it impossible for Odell to wear a more modern, portable, breathing apparatus she had to use the older machine.

Her unique deformity meant that she had to spend her life lying on her back, looking up at the ceiling. She was believed to be one of the last, if not the last, survivor of polio to live with the support of an iron lung. She lived with the support and care of her family, with her mother and father, who were over eighty years old, refusing to have her institutionalised.

In many ways Dianne Odell was unlucky. Just three years after she contracted polio a vaccine was developed that effectively wiped out the crippling disease. She was also unlucky because a spinal deformity arising from the polio made it impossible for Odell to wear more modern, portable breathing apparatus that generally replaced the iron lungs in the 1950s. She was also unlucky because so few people suffered from her condition that little attention was paid to alleviating it.

In one crucial way, however, Dianne Odell was very lucky. Dianne did not have the distractions and clutter perspective that occlude my and many others understanding of the world. Nor did she have any illusions as to her circumstances. She was in a stark position and confronted with conditions that many of us, and most definitely I, would find intolerable.

Dianne Odell was lucky because her life was stripped back to a simple decision, how to respond to her circumstances and create the most meaningful life possible. The life she made is one worthy of respect.

The ability to take challenging circumstances and transform them into positive life experiences is a unique one. However, almost every day you and I are confronted with decisions and situations where we can choose to react or respond creatively and consciously. The Naked Ape is dedicated to exploring and celebrating our collective achievements despite our very, very human limitations.

Dianne Odell was one of the unique individuals who, despite tremendous challenges, was determined to rise above them and live a full-life. Dr. Walton Harrison, Odell’s paediatrician just after she was diagnosed with polio, said that she had beaten the odds to live as long as she had. “I didn’t think she would last through puberty because her lung capacity was so limited,” he said. She earned a diploma from Jackson High School and an honorary degree from Freed-Hardeman College.

Dianne loved to talk with people and had a mirror installed so that she could make eye contact with visitors who entered her room. She loved having visitors, and particularly enjoyed encouraging younger children with disabilities to go for their dreams. In a 2001 interview with the Associated Press, she said she wanted to show children, especially those with physical disabilities, that they should never give up. “It’s amazing what you can accomplish if you see someone do the same thing,” she said.

She also wrote a book, the work of years. In an interview with the STAR Centre, Dianne said, “I have had two dreams in my life. The ability to “write without the help of others” and “to write my own letters and perhaps books.” She continues, “My dream of writing a book without help has come true. I had started a children’s book over 12 years ago. The computer I had then gave me nothing but frustration. It must have been three years before I realized that the method of voice recognition that I was using would never work for my voice. It broke my heart to think of all the wasted money people had contributed for my benefit.”

It would not be until another decade before Dianne could purchase a voice activated computer of suitable quality to write her children’s book, “Blinky Less Light”. The story goes:

“Not so long ago, in a distant corner of the heavens, there was a tiny, almost invisible star. His name was Blinky. His parents loved him very much, although they knew Blinky was different. He was very small and gave off only a dim light, almost like that of a firefly,”

Eventually, the small star manages to become a wishing star, despite tremendous obstacles, and eventually grants a wish that saves a young child’s life.

For her 60th birthday a celebratory gala was held to raise funds for her healthcare. More than 1,100 people attended, including the actor David Keith and former Vice President Al Gore. Odell was rolled onto an ambulance for her ride to the gala wearing a sequined gown designed by a local seamstress with a tiara adorning her head. When she was wheeled into the room, with an American flag draped over the machine, she received a standing ovation. Some of the people who attended knew her well, but others had heard about her determination and spirit and wanted to meet her.

As Francis Bacon remarked, quoting from a speech by the Stoic philosopher Seneca, “The good things which belong to prosperity are to be wished, but the good things that belong to adversity are to be admired.”

On hearing of Dianne’s response to life’s adversity, it is impossible not to admire her spirit and character and marvel at the love she gave and received.

References

Csikszentmihalyi, M., 1991, “Flow: The psychology of optimal experience”, page 200.
Photographs used in this post are from http://66.78.165.185/index.php?option=com_content&task=view&id=63&Itemid=108

More valuable links:
http://www.onlineathens.com/stories/022002/hea_0220020028.shtml
http://orig.jacksonsun.com/photogallery/20070217odellbday/pages/A-DianneOdellSociety-km.htm
http://66.78.165.185/index.php?option=com_content&task=view&id=63&Itemid=108

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Monkey Business and Narrative

Humans are amazingly bad at predicting probabilities. We fail at it in a number of systemic ways. One of the most critical, and one of the easiest to manipulate, is how we unconsciously predict probabilities within the context of a narrative.

Consider the case of the feminist Linda and her job at the bank. Why do so many people get this question wrong? It is because people are driven by the narrative of the description rather than by the logic of the analysis. The narrative subverts the conscious mind, leaving the brain to say, “But surely Linda is more likely to be involved in the feminist movement in her part time?”

When there is a seeming internal logic to events, people innately try and link them. The trait seems to be a relic from the dark nights when we would huddle around fires and hear stories that explained the world. Having nothing else (like the empirical standards of science) to guide themselves by, our forbearers were reduced to assessing reality through the internal logic of stories.

“This trait can be seen in the success of Hollywood. Incredible amounts of energy and creativity are spent to transform someone’s imagination into electronic dreams that we can all share. Then we huddle together in dark rooms and watch the flickering frames transport us into other worlds.

Economically, these narratives are incredibly important. They determine the way that the vast majority of us determine the risks and probabilities associated with investments of all kinds. Only those who have mastered the arcane arts are immune from being influenced by the power of the narrative.

Stock markets are ruled by Bulls and Bears. The bulls think prices are going up, and they always have a really good reason for it – think of the ‘new economy’ of the dot com era or the ‘enhanced risk management’ story that underpinned the sub prime expansion.

At the moment, financial markets are ruled by the Bears – those who think that recession is just around the corner and that the entire financial market may collapse. Hence the HUGE falls in prices around the world’s stock markets.

To be successful in the stock market you must rise above the narrative that is being played in the stock market and use your rational capacities to assess what is going on. This may mean taking advice from a number of people, or it may mean really researching conditions for yourself rather than relying on catch phrases (the ‘China story’, the ‘Greater Depression’, etc) to determine your decisions.

Monkey Business and Two Systems of Thought – Part B

It becomes more difficult to think things through when they are emotionally charged.

As we said before, our mind has evolved to assist our survival. As a consequence, it tends to get triggered more often (and with more ‘validity’) in highly stressful situations. This is particularly true when we are dealing with a situation that is unfamiliar to us. How hard it is to use your bigger brain will depend on how well you know it. When you master a topic or issue, you tend to have greater access to your cognitive abilities.

This is very important when dealing with highly charged situations about which we are unfamiliar. The more raw emotion involved, the more likelihood that people will be thinking with their little brain rather than their big one.

There is no issue more pressing right now than the global financial crisis. With the stock market up and then down by record amounts every other day, anyone with financial assets must be worried.

The New York Times summed up the dominance of emotions effecting peoples decisions at the moment by saying:

“Fear can be seen at every turn — in headlines raising questions about another Great Depression, and in the crowds gathered around office televisions to track stocks or to parse the latest pronouncements from the Federal Reserve chairman, Ben S. Bernanke, or the Treasury secretary, Henry M. Paulson Jr.”

When the emotion is up, people start thinking with their little brain. This leads to poor decisions. It is also why Warren Buffet said, “When the markets are greedy, I am fearful. When the markets are fearful, I am greedy.”

Warren Buffet is someone who has spent his life buying businesses. He has mastered the art of understanding business value. He is someone who knows how to use his big brain when it comes to investing. It has made him one of the richest men in the world.

Which brain is driving you?

Monkey Business and Two Systems of Thought – Part A

The single largest hurdle to making rational decisions (and avoiding global financial crises!) is that humans have more than one system of thinking.

Our brain has evolved two systems of thought (at least!) that focus on very different things and that arrive at conclusions in very different ways. The first is a survival system and is centered in our amygdale. This reactive system constantly scans the external environment and prompts the brain to react to it. It can reach conclusions very quickly, and if there is a sense of personal survival involved, then your thoughts will be highly emotive.

In terms of mass, the grey matter of the reactive system is broadly equivalent to that of a Labrador.

Our second system of thought is very different. It is more developed and represents our species’ greatest asset – the ability to think rationally and intelligently. This is our big brain.

Unfortunately our little brain is very quick at processing. This is hardly surprising since it evolved, in part, to keep us out of danger. It wouldn’t really do for our survival reflexes to kick in after we’ve had time to sit down and think about it.

When we are confronted with a situation that challenges our survival, our small brain says, “Crap, that’s an enraged grizzly bear, I’m out of here!” Then, without conscious thought, it pumps our bodies full of adrenaline and sets our heart and our feet racing. Meanwhile, our big brain is saying, “Hmmm, I wonder what the optimal response to this emerging challenge may be?” Then, a short conflict with an enraged bear later, it says, “ARGHHHH.”

The challenge is that we, as humans, do a fairly poor job of differentiating the two systems of thought. In fact, people frequently completely fail to realize that their initial judgment of a situation is completely wrong.

Review Question 1. (See previous blog Are You A Monkey?) When most people see this question their little brain prompts them, “The answer is $1.00 for the bat and $0.10 for the ball.” This is an intuitive response that arrives in our brain.

It is also wrong!

Those who got the question right would have had a slightly different experience. Their brain would have registered the immediate thoughts of the little brain, but they would have said, “Hang on a minute, that doesn’t make sense! If the ball is is $0.10 and the bat is $1.00 more than that then the bat alone would be $1.10 and combined they would be $1.20. I need to think this through a bit.”

Question 1 was a trivial example of a very profound human experience. It is scary how many people do not stop to think things through. It is particularly scary if you come to realize how often you don’t stop to think things through. I sure know I found it scary.

Monkey Business and the Current Economic Crisis

It is official. The value of businesses in Australia is half what it was just one year ago. This is one of the worst falls in equity values since the Great Depression. What has happened to make the value of companies decline by half? What has so fundamentally altered perceptions that governments all over the world are calling for a new global financial order and are pumping money into the economy as soon as they can print it?

Theoretically, a company’s stock price represents all the expected future cash flows from the business discounted for its associated risks. So if people were rational decision makers, then it would be quite extraordinary to find that expectations have so fundamentally altered over the course of a year without some major catastrophe fundamentally altering the risks or profitability of all businesses.

Unfortunately, neither you nor I make particularly rational decisions. In particular, our perceptions and judgments of risk and of probabilities are highly flawed.

Last weekend I had the pleasure of delivering a presentation on the systematic ways in which people, as frail humans, fail to make rational decisions. The seven ‘deadly sins’ of human decision making (I presented on three of them) are:

  1. Having two systems of thought;
  2. Narrative evaluation of risk and probability;
  3. Being influenced by how decisions are framed;
  4. That the availability of an event in memory will influence its relevance;
  5. A bias to the status quo;
  6. We are loss adverse; and
  7. That we have a bias towards information that confirms our preconceived ideas.

The presentation also touched on how these thinking flaws contributed to the current economic malaise.

Knowing how mistakes are made allows you to make better decisions. If you can make good decisions while all about you people are making poor ones, then you will be well positioned to make money and be successful.

Over the next couple of blogs I will outline the basis elements of the presentation, Monkey Business: Evolutions Taint and the Current Economic Crisis.

But before beginning, I want to ask you a question: What kind of investor are you?

The Great and Mighty Mo

This blog will discuss the powerful forces the great ‘Mo’ exerts on decision making. Not, in this particular case, the Mo of Movember (a time when the whole of Australia pauses to appreciate the linkages between facial hair, Helen Clarke, depression and prostate cancer). Rather the Mo of Momentum.

They say that 60 per cent of the effort involved in walking is spent on the first step – overcoming inertia. Thereafter, it takes a fraction of the effort to maintain existing momentum.

The same is true in our professional and personal lives. We can tell our future by the momentum of decisions that determine where we are right now. If we were to ‘stop’ taking action, we would continue to drift along in the same direction (your sales would continue for a while, your friendships would last for a while, you’d keep putting on weight) until you started to take concerted action.

Nowhere is the power of the great Mo more pronounced than in social decision making. Mo is important because we tend to extract ‘information’ from the perceived decisions of others. If everyone is doing it, then how bad/dangerous can it be? Something must be right!

That is how property bubbles develop. Two guys get together and talk about how a third made a killing in selling his house. Before you know it, house prices have trebled all across the Western world.

While that is mildly facetious, it does help to explain the huge build up in housing starts (people building new homes) that occurred in the US. There, housing starts rose by 47.5 per cent from 2001 until the beginning of 2006. Then people started to clue into actual risks involved in buying houses and since then the number of new starts dropped by over 150 per cent.

We call this dawning awareness the sub prime crisis – and the momentum of that crisis is fundamentally altering economic activity throughout the world today.

It’s Grand Final Time

It is the end of September and the beginning of a great Ozzie tradition: the footy grand finals.

What is obvious to anyone who has ever passionately supported a sporting team is that your emotional state can be significantly altered by their success.

Our ‘social identity’ is frequently linked to the sporting teams we support. What code of football do you support? Rugby, Aussie Rules, Soccer or Rugby League? Your answer may well say a great deal about your socio economic background.

Interestingly, sport is a fantastically civilized form of tribalism, with its own dress, and code of appropriate behaviour. We also have tribal chants, a pantheon of minor deities to worship and follow and an overweening sense of our own moral superiority when compared with our competitors.

I remember watching Australia play New Zealand in the third and deciding game of an international series. I stayed glued to the television for what felt like ages as the lead see-sawed back and forth until finally I won.

It was the first, and last, time I ever watched woman’s netball, yet it made me incredibly excited at the time.

Scientists may be able to explain why I felt so good because Australia’s netballers beat those pathetic and morally reprobate New Zealanders. Scientists have found that the levels of testosterone (the male sex hormone associated with virility and aggression) increased by over 25 per cent in those men whose sporting team won. Those men who suffered the ignominy of associating with the losing team suffered an equally significant decline in testosterone.

Researchers, from Georgia State University, took saliva samples from men in Brazil and Italy when both countries were competing in the finals of the soccer World Cup. They found that: “Testosterone, and the feeling of power associated with it, increases as subjects bask in reflected glory and decreases as they experience vicarious defeat.”

The researchers noted subtle differences in behaviour as well: “Some Brazilians were arrested for riotous celebration in the streets.” While, “the Italian men looked depressed and apathetic. They were disheartened by the loss.”

Oh those silly foreigners!