Posted tagged ‘Behavioral Economics’

Risk Intelligence IV

March 20, 2019

Overcoming Biases

In a recent post, RISKVIEWS proposed that Risk Intelligence would overcome biases.  Here are some specifics…

Biases

  • Anchoring – too much reliance on first experience
  • Availability – overestimate likelihood of events that readily come to mind
  • Confirmation Bias – look for information that confirms bias
  • Endowment effect – overvalue what you already have
  • Framing effect – conclusion depends on how the question is phrased
  • Gambler’s Fallacy – Belief that future probabilities are impacted by past experience – reversion to mean
  • Hindsight bias – things seem to be predictable after they happen
  • Illusion of control – overestimate degree of control over events
  • Overconfidence – believe own answers are more correct
  • Status Quo bias – Expect things to stay the same
  • Survivorship bias – only look at the people who finished a process, not all who started
  • Ostrich Effect – Ignore negative information

Each of Education, Experience and Analysis should reduce all of these.

Experience should provide the feedback that most of these ideas are simply wrong.  The original work that started to identify these biases followed the standard psychology approach of excluding anyone with experience and would also prohibit anyone from trying any of the questions a second time.  So learning to identify and avoid these biases through experience has had limited testing.

Education for a risk manager should simply mention all of these biases directly and their adverse consequences.  Many risk managers receiving that education will ever after seek to avoid making those mistakes.

But some will be blinded by the perceptual biases and therefore resist abandoning their gut feel that actually follows the biases.

Analysis may provide the information to convince  some of these remaining holdouts.  Analysis, if done correctly, will follow the logic of economic rationality which is the metric that we used to identify the wrong decisions that were eventually aggregated as biases.

So there may still be some people who even in the face of:

  • Experience of less than optimal outcomes
  • Education that provides discussion and examples of the adverse impact of decision-making based upon the biases.
  • Analysis that provides numerical back-up for unbiased decision making

Will still want to trust their own gut to make decisions regarding risk.

You can probably weed out those folks in hiring.

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Risk Intelligence II

February 28, 2019

Somehow it worked.

Several psychologists stated that economists were rational and those who didn’t know what economists knew were irrational.

They collected data on how irrational folks are and analyzed that data and grouped it and gave cute names to various groups.

But I think that you could do the same thing with long division. Certainly with calculus. Compare answers of rubes on the sidewalk to math PhD s on a bunch of math questions and how well do you think the rubes would do?

Some of the questions that the psychologists asked were about risk. They proved that folks who rely solely on their gut to make decisions about risk were not very good at it.

I am sure that no-one with any Risk Intelligence would have bet against that finding.

Because Risk Intelligence consists of more than just trusting your gut. It also requires education regarding the best practices for risk management and risk assessment along with stories of how well (and sometimes ill) intentioned business managers went wrong with risk. It also requires careful analysis. Often statistical analysis. Analysis that is usually not particularly intuitive even with experience.

But Risk Intelligence still needs a well developed gut. Because history doesn’t repeat, analysis always requires simplification and assumptions to fill out a model where data is insufficient.

Only with all of Education, Experience and Analysis is Risk Intelligence achievable and even then it is not guaranteed.

And in addition, Education, Experience and Analysis are the cure for the irrational biases found by the psychologists. I would bet that the psychologists systematically excluded any responses from a person with Risk Intelligence. That would have invalidated their investigation.

Their conclusion could have been that many of us need basic financial and risk education, better understanding of how to accumulate helpful experiences and some basic analytical skills. Not as much fun as a long list of cutely names biases, but much more helpful.

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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