9 July 2015

Why our Judgment Shortcomings about Money Aren’t Irrational

The field of Behavioral Economics / science pointed out how much of human judgment and decision making does not conform to models of economic rationality.

Oversimplifying, we could say that behavioral science gathered mountains of evidence on our own irrational thinking and behavior.

Many introductory materials such as lectures or presentations use a very popular illustration:

We like to think that we are like Mr. Spok, but in reality we are more like Homer Simpson.

This is a very catchy illustration, but it is utterly wrong because in order to understand human judgment and decision making we shouldn’t use fictional characters as references.

In order to deeply understand how Homo Sapiens thinks, we need to look back to our very distant evolutionary ancestors (early Homo Sapiens and pre-Homo Sapiens species).

Simply put, in order to understand how modern humans think, we need to look back at cave-people.

Loss aversion is probably the best known psychological effect (some would call it a judgment bias) when it comes to thinking and decision-making about money.

From a normative economics point of view, the fact that we hate losses roughly twice as much as we enjoy equivalent gains makes no sense – is irrational. We should be willing to put in the same amount of effort for both avoiding a loss of 100 dollars (euros) and gaining 100 dollars (euros). Yet, we know that things do not happen like this… people put in more effort to avoid a loss than they do to achieve an equivalent gain (i.e. 100 dollars).

However, this phenomenon – this way of thinking – made perfect sense for our evolutionary ancestors. In other words, it was (is) evolutionary rational to hate losing what you have more than you enjoy gaining some more.

By evolutionary rational I mean anything that enhances an individual’s chances of survival till reproductive maturity, achieving reproductive success (having offspring) and investing in heirs till they reach reproductive age.

To oversimplify, anything that allows an organism (person) to become a grand-parent can be seen as evolutionary rational.

Just as a note: evolution favors “metabolically cheap” solutions. Anything that brings a cost without providing an advantage in sending one’s genes into future generation(s) will be eliminated in the evolutionary process.

Let’s return to why loss aversion was, in fact, very (evolutionary) rational for our very distant ancestors.

These individuals lived in resource scarce environments. This is not to say that they were starving on a permanent basis, rather it is to say that the available (and accessible) resources were matching the minimal needs of our very distant ancestors.

In such an environment, it is more important to not lose the resources one has than to acquire additional resources. This is from an evolutionary point of view.

Putting things differently, holding on to the few resources one had offered evolutionary benefits (sending one’s genes into future generations) that were higher than the evolutionary benefits of acquiring additional (new) resources.

I am aware that I have simplified things quite a bit, but I guess you get the main idea.

What some call judgment biases such as loss aversion, mental accounting, relativity (contrast effect) etc. might very well be part of what made our generations’ existence possible.

Next week I will present (live) the three major psychological effects on thinking about money and their evolutionary explanations. Most importantly we will explore how Loss aversion, Mental accounting and Relativity influence our decision making about money in real-life situations.

Moreover, I will present some illustrations on how these so called judgment biases can be harnessed for designing better services that improve people’s lives.

The talk we be on July 15th in Washington DC and it is part of the Action Design Meetup events

If you are in the area, join themeetup

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