Economics and psychology are two very different fields. What makes up our culture, emotions, beliefs and political views surely has no effect on our economic outcomes. In fact, the two are not only inextricably linked, there is an entire field that studies the relationship between the two, behavioral economics.
While there has been more work and research done in more recent years Nobel Laureate Richard H. Thaler says that this is not at all a new phenomenon in economics. In fact, before the Second World War, economics was very much a behavioral field.
“After, when economics started to get very mathematical, economists forgot about their behavioral routes,” says Thaler. “The mathematization of economics was important and useful, but then I think economists got a little carried away. The more unrealistic the economic assumptions become, the more problematic.”
The assumption of rationality has deep political implications.
Another Nobel Laureate that has studied behavioral economics is Daniel Kahneman. He says that while people like to think their decisions and views are rational, they’re largely emotional and this has further reaching effects than one may realize.
“Why do people think that they know what they think they know?” asks Kahneman. He says that if you ask someone why they believe in a political movement or even religion, the response is one presented with arguments.
“Subjectively it feels that you believe in that thing because you have the arguments for it. That’s not the way it works,” he says. “It works the other way around. You believe in the conclusion, and then you believe in the arguments that support the conclusion. That’s fundamental.”
“It’s all psychologically coherent, but it’s not coherent in the sense of evidence and conclusions. It’s emotionally coherent. The people you trust, they believe in that. You believe in that. The assumption of rationality has deep political implications.”
The mathematization of economics was important and useful, but then I think economists got a little carried away.
Even institutions people view as strictly mathematical, like financial markets, are impacted by our behaviors. Nobel Laureate Robert J. Shiller was awarded the prize for discovering that stock prices could not only be predicted but be predicted many years in advance, something previously deemed impossible.
“The aggregate stock market I believe is mostly driven by non-economic things, people’s fears, prejudices, reactions to news-stories, reactions to elections and campaigns, things like that,” says Shiller. “The idea that we should leave markets completely alone because they are the best thing that could ever be, computing for our benefit, that’s just wrong.”
Is there ever a way to know you’re making the right choice, especially when it comes to investment decisions? The Nobel Laureates say it’s about having a perfect balance of intuition and regulation, which is not an easy thing.
“We have to allow people to do and to make mistakes,” says Shiller. “There are some people who are just not paying attention and they can be deceived. We need more than nudges. Sometimes we need actual prohibition against deceptive practices.”
People hate losing. And they hate losing much more than they enjoy winning.
Kahneman also warns of ignoring the link between behavior and financial decisions and the discontinuity between gains and losses.
“People don’t react to how wealthy they are or how wealthy they expect to be,” Kahneman says. “They react to changes, they react to gains and to losses. And gains and losses are short-term. They’re immediate, and they’re immediate emotions.”
“People put much more weight at losses than at gains,” he says. “People hate losing. And they hate losing much more than they enjoy winning.”
And therein lays the problem; that intuition feels the same when it’s wrong as when it’s right. If we’re just as likely to make a mistake or take an action that has the potential to hurt us and feel confident about it, how can we know when to trust our intuition?
So how can we become better decision makers? Kahneman share some valuable tips.
“When you’re making an important decision, there are probably two things you should do. One is you should slow down,” advises Kahneman. “The other is you should get advice from a particular kind of person. Somebody who likes you but who doesn’t care too much about your feelings. That person is more likely to give you good advice.”