Experience, Rare Events and Risky Choice

Choice, Education and Experience

Decision making, the challenge of choice, is often discussed as though it’s a single, invariant type of event.  Perhaps this is most strongly presented in the idea of stable preferences, the idea that if we choose to eat the fish at a restaurant one day then we should choose it the next day as well, always assuming we liked it.  People don’t actually behave like this, and decision making is much more complex than economics often makes out.

However, we can roughly divide our choice processes into two – decisions we make from personal experience and decisions we make from education.  We may invest in banks because we've had a good experience doing so, but we may choose to limit our investments based on third-party knowledge that financial institutions are inherently risky.  But how we decide which model to follow can change the course of our lives; and certainly determine the health of our wealth.

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Eat Your Stocks

Much Ado About Nothing?

Scientists study stuff which exist: physicists the physical laws of nature, biologists the nature of life and psychologists the human mind. Economists, on the other hand, study money: which is surely a figment of the human imagination.

Given the ephemeral nature of the subject it’s a wonder that there’s any mileage in spending any effort on the subject at all, but huge amounts of time and money are expended in doing so. So if money is fundamentally unreal, what the hell is economics all about?

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A Brief History of Behavioural Finance

The Nobel Prize for Psychology

Noble Prize winning committees aren’t renowned for consistency. Giving Barack Obama the Peace Prize for not being George W. Bush is a triumph of hope, but hardly based on rational analysis. We might also wonder if the selection panel got its wires crossed when it awarded the Economics prize to a psychologist.

But it wasn’t just any old shrink who got the bauble. It was Daniel Kahneman, half of the dynamic duo that invented the whole topic of behavioural finance. The other half, Amos Tversky, died in 1996. Between them, Tversky and Kahneman pump primed a change in the way we expect stocks to behave. Outside credit rating agencies, it’s no longer enough to assume we can predict market movements on the basis of number crunching on a grand scale. Now we need to take our own mental confusion into account.

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Investor Decisions – Experience is Not Enough

Economic Paradoxes

At the heart of Prospect Theory, the seminal approach behind behavioural finance, lies a puzzling paradox. Although the theory argues that people overweight the chances of unlikely events occurring – so, of instance, we worry much more than we ought to that our children will be kidnapped – the evidence from the field suggests exactly the opposite.

So, it seems we have a dilemma at the centre of the behavioural universe. Either way traditional economics gets it wrong but so, it seems, does the newfangled psychological kind. Given that we start the analysis with only three choices – that people correctly weight rare events, underweight them or overweight them – then it’s a bit disappointing that the two main branches of economics manage to slightly miss the correct answer.

That’s “slightly” in the sense of “completely and utterly”, of course.

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The Death of Homo economicus

Active Stockmarket Investment is not for the Inexperienced

Economists and political philosophers from Adam Smith to John Stuart Mill long held fast to the idea of the human being as a rational creature, one wishing to maximise their own self-interest at least effort and risk to themselves. This creature – dubbed Homo economicus by its opponents – is some kind of perfect calculating machine, weighing up risks and rewards and making logical choices in its own self-interest.

Basically it’s what an economist imagines themselves to be. Like Mr. Spock without the ears, green blood, mind melding and curious eyebrows.

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