The science of our biases & choices

Economists used to theorise that human beings are rational creatures who process available information and act in such a way as to optimise expected returns. But in the 1970s, two Israeli- Americans proved (cynics would say it is hardly necessary to prove humans are irrational!) that this was often demonstrably untrue.Risk aversion | They ran some simple thought experiments. Try one. Suppose you are given Rs1,000, and offered two choices. Either, you can play a game where you have a 50% chance to win another Rs1,000, or you lose nothing. Or, you can accept an extra Rs450, with no obligations. What would you choose to do?Most people grab the extra Rs 450. But the math indicates you would come out ahead if you played the game. Play the game, and you will emerge with Rs 2,000, half the time, and with Rs 1,000 in the other cases. Put it together and you’re likely to get a return of Rs 1500 – the extra Rs500 is Rs 50 more than just taking the Rs 450. That’s a specific cognitive bias – risk aversion. Daniel Kahneman (1934-2024), who passed away this week, won the Economics Nobel in 2002 for the work he had done in this area, in collaboration with Amos Tversky (1937-1996). These two cognitive scientists (and their followers) transformed economic theory, creating a new branch, even though neither of them had studied economics.Loss aversion | This was another powerful bias they documented. Most people feel the hurt of a financial loss more acutely than they feel the joy of a commensurate gain. Indeed, if an average human is offered the chance to play a game, where they toss a fair coin with the prospect of winning Rs 60, or losing Rs 50, many will decline because they fear the loss of Rs50 more strongly than they welcome the prospect of winning Rs 60. Some behavioural scientists even theorise the pain of a loss is felt twice as acutely as the joy from a gain.Disposition effect | Those two did a series of experiments asking such “playful” questions and analysing the empirical data they generated, to tease out the cognitive biases we carry. They discovered many and some of those discoveries were revelatory. The disposition effect for example is why investors frequently sell profits in stocks that are going up, while hanging onto stocks that are going down.Cognitive biases have effects that go well beyond having an impact on individual net worth. Biases carried by individuals can reinforce each other and lead to powerful network effects, if multiple members of a group have the same, or similar biases.Individuals to institutions | One of the interesting implications is that cognitive biases embedded within us as individuals end up influencing institutional decisions, and thus have massive financial and geopolitical effects. Be it investing, making consumption choices, crafting corporate strategy, mapping a political or military campaign, or negotiating an economic treaty, humans taking critical decisions have biases, which feed into decisions. Even in areas like trading where AI is taking over and making decisions, algorithms are likely to have biases of programmers and of the training data baked in.Prospect theory | This is what the associated branch of behavioural science is called. It is one of the few areas of economics where experimental results can be replicated to some degree. Human beings tend to behave in the same, often irrational ways, over and over again. Indeed, iconoclastic trader and best-selling author, Nassim Nicholas Taleb, once pointed out that Kahneman may be the only economics Nobel winner whose results can be replicated.Kahneman himself, rather surprisingly, also ended up being a bestselling author. His book Thinking, Fast and Slow became a cult classic, discussed in circles well outside the ambit of nerds who trade stocks, or play poker. He called fast intuitive thinking “System 1”, and slow, logical step-by-step thinking “System 2” and showed there’s a place for both systems in decision-making. However, when we use the inappropriate system (usually the fast intuitive System 1 when we need to use the slow System 2), we make mistakes.Deep insight | Kahneman’s early years saw his family move from Israel (then Palestine) where he was born, to France where he lived as a child during WWII. His father survived a Nazi concentration camp, before they went to Israel again. Kahneman related an incident where he, a Jewish 8-year-old, was caught on the street after curfew by an SS infantryman. Instead of sending him to a concentration camp, the trooper showed him a picture of his own son who was about the same age, and gave him some money and sent him home. That’s when he realised people are complicated. Later, during his military service in the Israeli army, he was supposed to evaluate other soldiers for courage, leadership qualities etc. He discovered that standardised tests were nonsense and started looking for more insights.His lifelong fascination with deciphering thought processes led to a series of deep insights explaining many types of individual and collective behaviour. More than that, he actually changed the ways in which people think, and made us more self-aware as a species.