Archive for May 2018

A race between a motorcycle and a wheelbarrow

May 2, 2018

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Behavioral Finance / Behavioral Economics (BF for short) says that in general folks do a poor job of decision-making related to risk and finance.  There is quite a lot of analysis of systematic errors that their experimental subjects have been found to make.

In general, people are found to make IRRATIONAL choices.  RATIONAL choices are defined to be the choices that economists have found to be the best.  (The best in the world specified by the economists – not necessarily in the world that people actually live in.  But that is the subject for a different and long essay.)

This work is highly regarded and widely studied and quoted.  Kahneman and Smith received a Nobel Prize for the original development of BF in 2002 and Thaler received a Nobel prize for his advancements in the field in 2017.

But does it actually make sense?  As they pose the issue, it seems to.  But take a step back.  They are comparing economic decisions made by an economist to decisions made by folks with no training in economics.  If they follow the general protocols of psychology, they would have looked for subjects with the least amount of knowledge of finance and risk.

So should it be a surprise that the studied population did not do well in their study?  That they made systematic errors?

Imagine if you had a group of adults who had never been exposed to multiplication.  And you gave them a simple multiplication test.  Their answers would be compared to a group of math PhDs.  So for the most part, they would have been guessing at the answers to the questions.  If asked, they might well have felt good about their answers to some or all of the questions.  But it is highly likely that they would be wrong.

From this experiment, it would be concluded that people cannot answer multiplication problems.  The study might progress further and start to look at word problems, including word problems that represent everyday situations where multiplication is vital to getting by.  Oh no, people are found to be poor at this as well.

But the solution is not some grand theory about how people are flawed regarding multiplication.  The solution is math education!!!

On risk and finance, our society takes the position that in general we will not instruct people.  That the best way to learn risk is via experience.  And the best way to learn about finance is from a payday lender or a credit card past due debt collector.

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Economists generally have PhDs.  And their course of study includes both risk and finance.  One topic, for example, is the math of finance.  Taught within that topic are many of the approaches to financial decision making that BF has found that people make IRRATIONALLY.  Another course that is generally required of economics PhDs is statistics.  One of the ideas usually covered in statistics is risk.  Even an introductory statistics course provides much more knowledge of risk than is needed to answer the BF questions.  So economists have had systematic instruction that allows them to give the RATIONAL answers to the BF questions.

A side note – the idea of RATIONAL used in BF is consistent with Utility Maximization – an economics theory that was first fully developed in 1947.  So even some economists might have failed the BF questions prior to that.

So instead of the conclusions reached by BF, RISKVIEWS would suggest a very simple alternative:

Teach people about Risk and Finance!

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