Which would you like better? Winning a guaranteed payout of 3,000
dollars or playing a game where you get an 80 percent chance of winning 4,000 and a 20 percent chance of nothing? Most of us would take the 3,000 and run. Now try the same thing in reverse. Choose between a guaranteed loss of 3,000 dollars – or a game giving you a 20% chance of losing nothing and an 80% chance of losing 4,000 dollars.
Most of us choose to play the second game. Unfortunately, according to
classical economic theory, our behavior is irrational. In the first game, we instinctively choose not to play even when that option offers the lower expected amount of money – 3,000dollars instead ofan“average”
outcome of 3,200. In the second, if we were perfectly rational, we would choose to lose 3,000 straight out. But most of us choose to play – and
probably lose more. In short, we are not consistent when faced with risk
– shying away from it when there are gains to protect but embracing
it if we could wipe out a loss.
Renate Schubert, economics professor and Director of the Economic Research Institute of the Federal Institute of Technology in Zurich, laughs: “Thank heavens that economic theorists and researchers have got beyond the stage of merely speculating about how people might behave. We now research their behaviour more accurately – by means of experiments or surveys. Ultimately, economics is about looking at the consequences of human behaviour – and to do that you cannot confine yourself to theoretical
situations. Because economists cannot explain every phenomenon by
referencing traditional theories, we make a point of working with pychologists
and taking their insights into account.”
Indeed,studying psychology and economics as a single discipline earned
psychologist Daniel Kahneman the 2002 Nobel Prize for Economics. His Prospect Theory, developed in the 1970s with Amos Tversky, employs
empirical experiments showing that real people do not assess risk in the same way as homo economicus – that perfectly rational agent invented by traditional economic theory. Still, when it comes to financial decisions, that should never have been much of a surprise, seeing as each choice involves basic human emotions – the need for security or for approval, even one’s
sense of self and independence.
People tend to assess uncertain choices intuitively; they rarely apply the laws of probability. “In the case of researching financial decisions, that is precisely the problem,” explains Renate Schubert, “since the true risk – in other words, the size
and probability of any future loss – is usually unknown. However, laboratory
experiments can be constructed in such a manner that the person running the trial knows the parameters.”
Those experiments show that the risks perceived by the test subjects vary: “Small probabilities of gains or losses tend to be overestimated, while large probabilities tend to be underestimated.” Similarly, gains and losses tend to be perceived differently: “Losses are generally perceived to be larger than they actually
are, while gains are seen as smaller than they are.”
Undue optimism, or «overconfidence» as those who study the phenomenon
say, is one of the other tendencies seen in people making decisions involving significant risk.
“That means that people are apt to overestimate their own knowledge or ability in certain areas. They tend to assess the chances of positive outcomes
as larger than they really are. As a result, decisions are taken quickly, but then just as quickly altered, as overconfident investors frequently reshuffle their portfolios and chop and change the securities they invest in – despite the fact they are incurring transaction costs which lower their net returns. Overconfidence is thus a source of financial market activity – generally, the markets move more than they would without overconfidence.»
These patterns of behaviour are not equally strong in everyone, and vary in
strength and frequency from one group to another. There are, for instance,
variations between men and women.
«Women are less prone to overconfidence, as various studies have shown,» says Renate Schubert. «In one experiment, we also found that women tend to perceive something to be especially risky if they have the feeling they don’t know enough about it. The more information you give them – on the future performance of investments, the likelihood of future gains or losses – the more willing they become to take risks. Among men, information plays a different role – on the contrary: initially, men are more willing to take a gamble than women, but as they become better informed they tend to grow more risk-averse.»
An understanding of what drives investor behaviour and how this influences supply and demand in the markets is just as important to the financial services industry as the analysis of economic fundamentals.
“For example, as part of the advisory process, a bank needs to ask itself:
who is this person sitting in front of me? Only by doing so can advisors give clients the sense of security most appropriate for them – the feeling of being looked after properly. Does the client want to have the right investment recommended to him or her by an expert? Or do they want to bring their own expertise to bear? An investment advisory service which is capable of satisfying clients on a lasting basis can never be a totally standardized product,” explains Renate Schubert.
“One important issue is the result of the advisory process – that, too, needs to be right, and must match the clients’ economic objectives. These objectives are rooted in a client’s particular circumstances, and these in turn influence the degree of security or risk expected of a given investment.”
One important factor affecting the lasting success of an investment decision
is an ability to look at the client’s overall assets or total portfolio. In an interview with the US magazine Forbes, Kahneman stated that people have a tendency to think in terms of gains and losses. The more we do this, the more irrational and short-term our actions become. By contrast, taking the entire portfolio as a frame of reference helps us to gear our decisions to medium
and long-term goals.
That kind of thinking can be extended to include economic policy issues, such as the way private pensions are organized. Renate Schubert: “Women typically have lower incomes and less wealth, while at the same time they tend to live longer. As our population ages, it could present a problem in that women tend to go for lower-risk and therefore lower-yielding asset portfolios. This raises the question of how women can be encouraged to invest their savings in such a manner as to generate higher returns.”
The fact that institutional investors and companies often act very much like private individuals when making decisions under uncertainty does not surprise Schubert: “Ultimately, in these cases, the decisions are being made by human beings.”
Evaluating risks and taking financial decisions are part of the day-today business for a bank. According to Renate Schubert, the most important thing is to have a good risk philosophy. “It is crucial to engage with the whole subject of risk comprehensively, on all levels, and to deal with it openly.” In other words,
transparency, both internally and externally. “Time and again in the scientific literature you come across the short sentence – Risk is an artificial frame. – So somehow you have to model it, identify it and quantify it – it’s not just there for the
taking. Of course, this means there is scope for subjective estimation. It therefore becomes very important to make your underlying assumptions and the decisions based on them transparent.”
In addition, the decisions taken and their consequences have to be analyzed
in retrospect. This helps companies set the right incentives for the future and organize their processes rationally. “To deal properly with potential conflicts of interest, it is important to have clear rules of play, a well-defined code that serves
as a framework for all involved,” Schubert believes.
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