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Caveman Economics: How ancient history stymies good decisions — Pop Economics

Caveman Economics: How ancient history stymies good decisions

by Pop on August 14, 2010

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We’ve feared losses for 40 million years.

How hard is it to learn to be a good investor? I’ve written a lot about the behavioral quirks that cause us to make major mistakes when we put our money in stocks and bonds, even though we know that we’d do a lot better to make different decisions. Losses hurt more than gains feel good. Walking inside your boss’s office for a review actually triggers an adrenal response—you’re ready to sock your boss in the face or fly out the door as he tells you how well you’re filling out Excel spreadsheets.

Of course, none of these emotional and hormonal responses actually help you do anything. You know that having cold, sweaty hands isn’t going to help you explain your position to your boss effectively, in the same way you know that getting a free ice cream cone should make you just as happy as dropping one on the floor makes you sad. So why do we do it?

Monkeys fear losses too.

One of the unique traits of the human species is our use of money. If you’re a cattle rancher, you don’t have to drive 100 heads of steer to your Realtor’s office to buy a house. We’ve created a fungible, easily divisible medium of exchange that makes it much more convenient.

That old invention makes it that much harder to run economic or scientific tests to understand why we treat money the way we do. Animal testing—putting aside ethical issues—is much easier with medicines. The guinea pig was cured or it wasn’t. And after studying side effects for a while, we can move on to human testing.

But what if you could teach a monkey to value and use money? Then you could run all sorts of experiments to see how deep our ridiculously unprofitable predilections run.

M. Keith Chen, a behavioral economist at the Yale School of Management, has done just this. His community of Capuchin monkeys has learned to value coins. They can exchange coins for orange peels or apple slices. Chen can change the prices of the prizes every so often to see how the monkeys react.

In 2006, Chen ran experiments to see just how mad a monkey gets when prices go up versus how happy he gets when they drop. To do this, he faced the monkeys with two trainers, with different colored clothing. The first trainer would show a monkey two apple slices, but when the monkey traded in his token, he would either pay the monkey the promised two slices or just one—averaging out to 1.5 slices per payment.

The second trainer would show a monkey one slice. But when the monkey paid a token, he would either give the monkey the one, promised slice or would unexpectedly deliver two slices—again averaging out to 1.5 slices.

Rationally, the choice between the two trainers should have been a wash. But the monkeys preferred the trainer who gave them unexpected gains two-and-a-half times more than the one that gave them unexpected losses.

So, think you can get over loss aversion? Our ancestors might have felt this way for 40 million years. Good luck!

Monkeys also treat risk the same way we do.

Another fun monkey experiment: The capuchins were presented with two sets of trainers. In the first set, both trainers promised the monkeys one piece of food (by showing it to them).

But in fact, the first trainer always paid out two pieces, and the second trainer would pay out one piece half the time and three pieces half the time. Again, statistically, the trainers were a wash, but the monkeys preferred the one with the guaranteed, two-piece payment more than the risky guy.

In the second set, monkeys were always promised three pieces of food. But the first trainer would consistently pay out two pieces and the second trainer either paid out one piece or three pieces. In other words, the monkeys could take a guaranteed, one-piece loss or roll the dice (and risk losing two pieces). This time, the monkeys preferred to take the risk.

What do those experiments show? That when we have a choice between guaranteed gains or taking a risk for an even larger gain, we’d prefer the bird in the hand. But when we might take a guaranteed loss or can take a risk to possibly lose nothing, we’re willing to take the risk.

Monkeys overvalue what they own.

Why is it so hard to get a trade going in Monopoly? I noticed this especially when I was younger. After the board was bought up, the players would start to offer trades. Thing is, the offers would always be ridiculously lopsided. “I’ll trade you Boardwalk for North Carolina, Atlantic, Ventnor, and St. Charles.” And the response: “No way, I’ll give you Atlantic and $100 for Boardwalk.” And so on.

Economists calls this the “endowment effect.” We value things more if we own them. In one famous experiment, humans were asked to buy and sell coffee mugs. In each and every case, they wanted more for the mug than they, themselves, would be willing to pay for it.

Sadly, it doesn’t look like evolution has gotten us over this one either. Chen gave one group of his monkeys one kind of good and the other group another kind.

The monkeys preferred each type of good equally. So you would expect the monkeys to end up trading about half of the food with each other. Instead, almost no trades were conducted at all. “Yeah, I like apple slices as much as I like orange peels. But this is my orange peel.”

So next time you find yourself thinking you can overcome the behavioral biases that cause us to handle money so irrationally, think back to the monkeys. We’ve been fighting this for 40 million years. Think you’re going to be the one to overcome it?

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{ 2 comments… read them below or add one }

Rob Bennett August 16, 2010 at 9:32 am

We’ve been fighting this for 40 million years. Think you’re going to be the one to overcome it?

The point is well-taken. But it is too cynical/pessimistic/gloomy doomy for my tastes.

I agree 100 percent that emotion is what ruins our investing dreams. And I agree 100 percent that it is hard to conquer our negative investing emotions. Where we go on different paths, Pop, is with the idea that there is nothing constructive we can do to help ourselves to do better in the past than we have done in the future.

What if we didn’t count the “gains” that the market experiences solely as the product of emotion/overvaluation (the two are the same thing — rational investors would obviously price the market reasonably)? The market was priced at three times fair value in 2000. What if we told investors on their portfolio statements that the real lasting value of their portfolios was only one-third of the nominal number (that each $300,000 portfolio had a long-term value of only $100,000, and so on)?

This would greatly diminish the emotion experienced by investors. If we had done this, investors would not have been shocked to see the losses they have experienced over the past 10 years. In fact, those using the valuation-adjusted numbers for purposes of financial planning would not even be seeing any losses! All that has happened is that the cotton-candy gains we were pretending existed in 2000 have been blown away in the wind with time, as always happens and as always must happen.

It is by pretending that bull market gains are real that we set ourselves up for bear market losses. We need a more realistic approach to stock investing, one that impresses on investors that the word “overvaluation” means just what it suggests — gains that are the product of overvaluation are not real.

Yes, it will be a continuing battle to impress this on investors. But we are not even trying when we tell investors that it is okay to remain at the same stock allocation at all valuation levels. If we announced the valuation-adjusted level of the DOW each time we announced the nominal value, that would make a big difference. People need to hear the realities as often as they hear the imaginary, non-valuation-adjusted numbers. That would help us all try to ground ourselves in reality. It would be an important first step.

Rob

Jeff @ sustainablelifeblog August 16, 2010 at 10:10 am

Interesting thoughts about how similar we (still) are to monkeys. I think you can witness people overvaluing what they own every weekend in your city by going to a garage sale. On occasion, you can find good deals on fairly hard-to-find or otherwise odd purchases, but in general, the sellers want too much money for the stuff they are trying to sell.

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