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An Introduction to Behavioral Economics

Citation Tools. Aspects of Investor Psychology. Daniel Kahneman , Mark W. Share This Article: Copy. Tweet Widget Facebook Like. Similar Articles. A Behavioral Finance Explanation. One piece of research suggests that behavioral change could be achieved by helping people connect with their future selves.

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In the study, people who saw an age-progressed avatar of themselves were more likely to accept future financial rewards over immediate ones Hershfield et al. When shopping for multiple future consumption episodes, I may choose the variety pack of cereal, only to realize two weeks later that I would have enjoyed my breakfasts more if I had just stuck to my favorite kind.

5 Psychology Experiments You Couldn't Do Today

This inability to appreciate fully the effect of emotional and physiological states on decision making is known as the hot-cold empathy gap , a term coined by George Loewenstein, one of the founders of the field of behavioral economics. Hot states include a number of visceral factors, ranging from negative emotions associated with high levels of arousal e.

When we make plans for the future, we are often too optimistic. For example, we are subject to committing the planning fallacy by underestimating how long it will take us to complete a task and ignoring past experience Kahneman, The level of happiness that I expect to feel during my next vacation, for example, is likely to be higher than how I will rate it during the actual experience. There are different explanations for this error, including how we remember past events.

Finally, as my vacation days go by, I will simply get used to it and my happiness will level out. Contrary to the homo economicus view of human motivation and decision making, BE does not assume that humans make choices in isolation, or to serve their own interest.

Aside from cognitive and affective emotional dimensions, an important area of BE also considers social forces, in that decisions are made by individuals who are shaped by—and embedded in—social environments. Trust , which is one of the explanations for discrepancies between actual behavior and that predicted by a model of self-interested actors, makes social life possible and permeates economic relationships.

The Stanford Prison Experiment

Although neoclassical economic theory suggests that trust in strangers is irrational, trust and trustworthiness can be widely observed across societies. In fact, reciprocity discussed later exists as a basic element of human relationships and behavior, and this is accounted for in the trust extended to an anonymous counterpart Berg et al. Both trust and trustworthiness increase when individuals are closer socially, but the latter declines when partners come from different social groups, such as nationality or race. Furthermore, high status individuals are found to be able to elicit more trustworthiness in others Glaeser et al.

Trust has been investigated in experimental games. In trust games , participants are asked to split money between themselves and someone else. Player A is asked to determine an initial endowment of zero or a higher value e. The money is then multiplied e. The game is about reciprocity and trust, because Player A must decide how much of the endowment to give to Player B in the hope of receiving at least the same amount in return. In the original experiment Berg et al. This finding confounds the prediction offered by standard economic assumptions. In human relationships, deception is often considered a violation of trust, while in standard economics, dishonesty can be seen as a natural by-product of actors with self-interested motives.

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However, the BE perspective does not consider humans to be more honest; rather, it takes a more social-psychological perspective by showing that dishonesty is not just about tradeoffs between external incentives such as material gain and costs such as punishments. Dishonesty is the product of situations as well as both internal and external reward mechanisms, which often involves self-deception—the reframing of dishonest acts e. People typically value honesty, tend to have strong beliefs in their morality and want to maintain this aspect of their self-concept Mazar et al.

When moral reminders are used, however, this self-deception can be reduced, as demonstrated in laboratory experiments conducted by Mazar and colleagues. Behavioral research on individual decision making in social contexts often relies on experimental games. Along with behavioral decision theory, behavioral game theory is the second major theoretical area found in behavioral economics. Typically, these games endow participants with rewards e.

This occurs over the course of one or more rounds of playing. The outcome of the game is evident in the way rewards are split between players, and the results often show that people have inequity aversion , i. Reciprocity, however, can have positive and negative aspects.

In the real world, charities sometimes use reciprocity to their advantage. Social norms are implicit or explicit behavioral expectations or rules within a society or group of people Dolan et al. Our preferences are not simply a matter of basic tastes; they are also influenced by norms, as manifested in gender roles, for example. Norms vary across cultures and contexts. For example, while market norms would dictate that payment is required for a good or service, social norms are quite different—would you offer to pay a family member for the meal that he has prepared for you Ariely, ?

Sometimes social norms of exchange such as reciprocity and market norms co-exist in the same sphere. For instance, while market exchange norms dictate that I will charge a client for a consulting job, I may also give that client free advice, on some occasions, in the hope that the favor will be reciprocated in the future.

Along with informational feedback e. One study compared contribution levels for a public radio fundraiser in the US. When potential donors were provided with social information signaling norms e. Human susceptibility to feedback about social norms is related to our desire to maintain a positive view of who we are as a person. When the outcome of an action threatens this desire, we may change our behavior, though we often simply change our attitudes or beliefs.

An Introduction to Behavioral Finance

Unlike the rational choice view of human decision making, where preferences guide choices, rationalization implies the opposite: Sometimes preferences can justify actions after the fact March, Cognitive dissonance theory is an illustration of the human need for a continuous and consistent self-image Cialdini, In an effort to align future behavior, being consistent is best achieved by making a commitment , especially if it is done publicly. Thus, pre-committing to a goal is one of the most frequently applied behavioral devices to achieve positive change.

The program gives employees the option of pre-committing to a gradual increase in their savings rate in the future, each time they get a raise. The program avoids the perception of loss that would be felt with a reduction in disposable income, because consumers commit to saving future increases in income. The idea of herding has a long history in philosophy and crowd psychology.

It is particularly relevant in the domain of finance, where it has been discussed in relation to the collective irrationality of investors, including stock market bubbles Banerjee, Economic or asset bubbles form when prices are driven much higher than their intrinsic value. Well-known examples of bubbles include the US Dot-com stock market bubble of the late s and housing bubble of the mids. According to Robert Shiller , who warned of both of these events, speculative bubbles are fueled by contagious investor enthusiasm see also herd behavior and stories that justify price increases.

Doubts about the real value of investment are overpowered by strong emotions, such as envy and excitement. Economic bubbles are usually followed a sudden and sharp decrease in prices, also known as a crash. Behavioral economics BE uses psychological experimentation to develop theories about human decision making and has identified a range of biases as a result of the way people think and feel.

According to BE, people are not always self-interested, benefits maximizing, and costs minimizing individuals with stable preferences—our thinking is subject to insufficient knowledge, feedback, and processing capability, which often involves uncertainty and is affected by the context in which we make decisions. Most of our choices are not the result of careful deliberation. We are influenced by readily available information in memory, automatically generated affect, and salient information in the environment.