Lessons From The New Science Of Behavioral Economics

Gary Belsky, Thomas Gilovich

For this book, I decided to hand-write (and later digitize) notes. These are not very detailed but enough for my personal reference. This is an experiment and I may or may not continue taking notes for other books.

Read my review of the book on Goodreads.

Economics assumptions

  • humans = rational
  • humans = efficient with money

Counterexample - tipping. (we do it because of social heuristics and rules of thumb)

Statistical regression = As n increases, sample measure moves closer to average

Mental accounting

Study by Epler: “rebate” (people don’t spend) vs “bonus” (easy to spend)

Bigger bonus = harder to spend

  • Credit cards - makes us spend $ we otherwise won’t, and often spend more.

Getting around:

  • Ditch credit card
  • Every dollar is the same
  • Wait before spending the bonus (weeks or months)
  • “All income is earned income”

Prospect theory

  • When decision is to make a preference, people look at the positive qualities
  • Conversely, when decision is to choose worse option, people look at the negative qualities

In finance:

  • We assign value to gains or losses in absolute terms and not as a % of net worth. Losing $500 for someone with $1,000 vs someone worth $100,000. Remember, every dollar is the same.
  • We feel more strongly about losses than gains = loss aversion.

Disposition effect - Sell winners early, hold losers too long.

Sunk-cost fallacy

  • Drive in snow to attend a game for which we bought the ticket even if it means risking life
  • Don’t want to appear wasteful

Decision paralysis

  • 1 good choice = easy decision
  • 2 good choices = no decision
    • decision under conflict

2 types of people:

  • Maximisers: find out everything about all choices before making a decision
  • Satisficers: find out enough about the choices + use gut instinct + “trusted screeners”

In finance:

  • Too many choices when it comes to investing; causes high level of bank deposits
  • The longer we defer a decision, the less likely we make it ever (tight deadlines are helpful)

“Trade-off conttast” - Choices are enhanced or hindered by the trade-offs between choices.

  • If A is better than B => A.
  • If B is better than C (in ways different from what makes it worse than A) => N
    • B’s appearance is enhanced
  • “extremeness aversion” - people are more likely to choose an intermediate choice.

Status quo bias: Resistance to change.

  • People tend to overvalue what they have
    • “endowment effect”
    • another manifestation of loss aversion

Regret aversion: people want to avoid the pain of regret and responsibility for negative outcomes.

Examples

  • Keeping money in checking/savings and not investing
  • Keeping low-paying job rather than make the switch
  • Net selling a losing investment

Solutions

  • Narrow the choices down to fewer
  • Deciding not to decide is a decision
  • Put decisions on autopilot. Write and follow rules = make less decisions.
  • Set deadlines for decisions.
  • Pretend like you are deciding from a neutral position. Or flip the perspective (“should I sell this stock” becomes “am I comfortable buying this stock today”)

Money illusion

Nominal change (actual dollars) vs real change (in buying power)

When home prices rise, so do other prices.

“Neglecting the base rate” - disregard or discount the overall odds (lottery).

  • Insurance (wedding, flight etc)

  • Play the averages because change plays a greater role

Confirmation bias

  • View and seek information in a way that supports our existing beliefs.
  • First impressions matter. Eg advertising.
  • Anchoring: Latching onto an idea or fact as a reference point
    • Particularly prone to anchoring when swimming in unfamiliar waters
    • Useful (don’t eat random berries - could be poison)

Solutions

  • Have a person board of directors and seek a second opinion
  • If you have less knowledge about something, seek more information
  • Be humble and know when you’re wrong

Ego

Overconfidence

  • Over rate one’s abilities.
  • Helps in some cases. For example, when people start businesses, overconfidence that you can beat the competition is useful.
  • Different from conscious arrogance.

Financial consequences:

  • Underpreparedness
  • Buying expensive things without research
  • FSBO (fizzbo) = For Sale By Owner (For Sale By Overconfidence)

Also:

  • People tend to remember successes, and repress failures.
  • “Heads I win, tails it’s chance”
    • People think they caused success, but something else caused failure.

Herding

  • Following the trend often doesn’t work (plenty of research)
  • Causes bubbles and crashes

Information cascade:

  • How fads begin
  • Ignore private information and focus on others’ actions.

Solutions:

  • Avoid hot stocks
  • Tune out the noise
  • Set and follow your own rules

Emotions

Neuroeconomics - How brain affects financial decisions

  • Reflexive system: Fear, disgust, greed
  • Reflective system: Reasoned, analytical

Financials: People tend to use reflexive and not enough reflective when investing.

Solutions:

  • Voice your reasons
  • Have checklists
  • Make a pros and cons list

Conclusion

  • Every dollar spends the same
  • Losses hurt more than gains please
  • Spent money doesn’t matter (sunk-cost)
  • Too many choices are bad

Steps to take:

  • Raise insurance deductible (playing the averages)
  • Self-insure and cover the cost of small losses
  • Pay off credit card debt with emergency fund (interest rate high enough to justify)
  • Buy index funds
  • Diversify investments
  • Keep track (budgeting)