In the field of economics, It’s assumed people act rationally. When it comes to financial decision-making, the individual would make their choices for valid reasons. For many years the Nobel prizes of economics were given to theories based on this deduction. There are two main reasons for this.
1- A part of economists claimed economics wasn’t a social science, it was a natural science that could be explained by mathematics only.
2- This is because the academics suffered from Daniel Kahnemann’s notion of Theory-induced Blindness. Simply put; The economists thought people would act according to the theory of economics because for them it’s obvious.
A nice example for this would be what I’ve read in the book written by Richard H Thaler, “Misbehaving”. In this example, they call random people (about 100 respondents) to ask them questions. Such as; A store has been selling umbrellas for 20 dollars. On a rainy day, the store raised the price to 25 dollars. Is this action acceptable or unfair? 18% answered as acceptable and 82% answered as unfair.
After this experiment, Richard Thaler decides to ask his students who are doing their MBAs in business school. Their responses were 76% acceptable and 24% unfair.
So, why are the results are opposite? Because students think like how economists imagine people would think. Completely in accord with the economic theory, but distant from our reality.
Daniel Kahnemann is a Nobel-winning psychologist, but he won the Nobel prize in the field of economics. He and his colleagues (Amon Tversky and Richard H Thaler) opposed classical economists. According to them, economics was a social science and it couldn’t be approached as natural science.
The foundation of political economy and, in general, of every social science, is evidently psychology. A day may come when we shall be able to deduce the laws of social science from the principles of psychology.
— Vilfredo Pareto
These three men are the pioneers of what we call “Behavioural Economics”. In this approach, people aren’t seen as rational choice makers. They have found so many error types occurring when people make decisions. As mentioned before, Kahnemann and Tversky are psychologists*, who introduced us to the concept of Cognitive Biases.
What are cognitive biases? Why do they occur? I’ll try explaining them and give a couple of examples.
- Cognitive Biases are unconscious errors in thinking. But they can be avoided after training. They affect the individual’s judgment and decision-making.
- The world we live in is complex and our brains tend to simplify things to be able to make quick and automatic decisions. Like some mental shortcuts (these are called Heuristics).
We’ve already seen Theory-induced blindness bias. Let’s check some other popular ones such as The Sunk Cost Bias, Confirmation Bias, and Self-Serving Bias
The Sunk Cost Bias:
One of the most famous cognitive biases is defined as the “tendency to continue an endeavor once an investment in money, effort or time has been made” (Arkes and Blumer, 1985, p. 124).
You bought a new pair of expensive shoes and a shirt to wear for work the next day. Checking yourself in the mirror and seeing your outfit makes you happy. Later that day you realize it’s uncomfortable wearing them. Your heels hurt. So you put them away and never wore them, right?
This is where the sunk cost bias plays its role. You’ll try wearing them a couple of times more because you spent so much money on the shoes. How long will those shoes wait in your closet before you donate them or give them to a friend? I would say that would depend on how much you paid for the shoes.
We all had similar stories to this one, it’s a misjudgment we make. The money we spent is already gone, a thing in the past. We can’t get them back, But we pay too much attention to what we’ve spent, and leaving them in the past makes us feel like we have too much invested to quit.
Confirmation Bias:
This bias happens when we see the new information as a confirmation of our pre-existing opinions. An example of this bias would be the experiment made by Peter Wason. He challenged participants to find out the rule applying to triples of numbers. The numbers were 2–4–6. Participants had to generate triplets of their own, fitting the rule. The rule was simple: Any ascending sequence.
Instead, the participants came up with a different bunch of triples that confirmed their pre-existing opinions. Such as 4–16–36 or 4–8–12…
Besides this rather harmless mathematical one, there could be harmful examples. In modern media confirmation bias is supported by what we call Echo Chambers. It was revealed Facebook had sold user data to third parties and it had an impact on the 2016 elections. Facebook kept feeding us with stories we are likely to agree with and reinforced political polarization further.
Self-Serving Bias:
A bad workman always blames his tools
We all met a sore loser (I’m one as well but luckily aware of it so I can joke about it and get out of this bias when my girlfriend mentions I’m doing it) and they always have plenty of excuses while losing, but they (or i) tend to talk a lot less while winning except self-complimenting.
We can refer to it as the tendency to take responsibility for possible outcomes like “I won the game because I’m too good”. “Damn I worked a lot for this so it’s no surprise I’m this good”. But when it comes to negative outcomes they tend to blame external factors. “I lost because my teammates are dumb”. “Damn my equipment malfunctioned”. “They are just too lucky”. You get the point. This might be happening because our brain tries to protect our self-esteem.
It’s the lag bro you would be dead otherwise
- Any FPS player all the time
So far we’ve explained the difference between the classical deduction on human behavior and the alternative one. Defined and explained Cognitive Biases reviewed some examples. Now it’s time to explain how to avoid making these mistakes according to Daniel Kahnemann. I mentioned earlier it’s possible to train ourselves and stop making these mistakes.
According to Kahnemann, our brains have two operating systems. He named them System 1 and System 2. We could summarize them like:
System 1 (Heuristic)
- Decisions are made FAST
- Automatic, effortless, unconscious
- Independent from IQ
- Heritage of a long evolutionary history, present in our cousin primates and other mammals
- Operate based on associations between concepts, representations (neglect ambiguity)
- More than 90% of our thinking is made by this way
System 2 (Analytic)
- Decisions are made SLOW
- Requires effort and these decisions are made consciously
- Depends on the level of IQ,
- A Much shorter evolutionary history likely appeared in our most recent ancestors (only human ancestors)
- Operates based on logical, probabilistic rules
Now after being aware of this information i guess the lesson here is clear. Think before you act. Try using System 2 more. That was a brief conclusion but I guess it’s enough. Ironically this may lead us to the Dunning-Kruger Syndrome. Where people who lack knowledge and skills in a specific area tend to overestimate their own competence. In the meanwhile, the more experienced people underestimate their competence since they’re aware of the depth of the subject. we’ll focus on it another time.
Thank you for reading if you made it until here. Feel free to ask any questions or share your thoughts with me Yalım Yılmaz . If you liked this post you should check these books.
Thinking fast and slow — Daniel Kahnemann
Misbehaving — Richard H. Thaler
Judgment Under Uncertainty: Heuristics and Biases — Amos Tversky
