Money: How are we irrational? Let me count the ways

By MARK FRYER

In recent years "behavioural" economists have found numerous ways in which our financial decision-making is less rational than we might like to think.

Here are just some of the chinks in our logic:

We're not as clever as we think

Ask a group of people if they are better-than-average drivers and most will probably say they are. Unless we're dealing with a roomful of Formula One drivers, they can't all be right.

Behavioural economists say there is plenty of evidence that - in most fields of life, not just driving - most of us are persistently and irrationally over-confident about our ability.

When asked a question, we over-estimate our chance of answering correctly.

And the more information we're given, the more our confidence increases - out of all proportion to our accuracy in getting the right answer.

That optimism makes us prone to the "illusion of control" - to underestimate the role of chance in human affairs, and to see games of chance as games of skill.

Over-confidence often makes investors believe they can "beat the market", despite all the evidence to the contrary.

The short-term rules, OK

When workers are asked if they would prefer a 15-minute break today or 30 minutes tomorrow, they should, in theory, choose the longer break.

In reality, researchers have found the immediate 15 minute break tends to win workers' votes.

This tendency to place too much value on what we have now, and too little on what we could have tomorrow, is obvious in the way we treat saving. Rationally, we know saving makes us better off long term. But the short-term rewards to be gained from spending always seem more compelling.

Short termism also rules many investment decisions. Rationally, we know shares usually go up over the long term, but we often panic when markets suffer a short-term fall (which is why economist Richard Thaler once suggested investors should be banned from seeing their portfolios more than once every five years).

We keep seeing things

If you toss a coin six times, which is the more likely sequence:

a) head, head, head, tail, tail, tail; or b) head, tail, head, tail, tail, head?

Most people pick b), because it looks random, and we all know tossing a coin is meant to produce random results.

In fact, either sequence is just as likely.

Our preference for the second sequence is an example of our tendency to see patterns where none exist.

That same tendency tempts us to put our money into investments which have produced good returns several years in a row - we see those returns as a pattern, when they might be entirely random.

Losing hurts (more than winning feels good)

Most of us are "loss averse" - we experience more pain from a financial loss than pleasure from a similar-sized gain.

Imagine being asked to bet on a coin toss. Guess wrong and you lose $100. How much would the reward for winning have to be for you to accept the bet?

The chances are 50:50, so the "rational" answer would be anything more than $100. In reality though, participants in this experiment typically say a winning toss would have to earn them $200 to $250 before they would be prepared to take on the bet.

In practice, loss aversion means we may avoid taking risks even when accepting those risks will probably make us better off.

It also means we hate to sell losing investments, because doing so makes the loss real, with all the regret that involves.

Thinking happens in compartments

Evidence for this tendency comes from, among other places, the betting habits of US racegoers.

Studies found such gamblers take more long-shot bets later in the race meeting.

Researchers theorise that gamblers open a "mental account" at the start of each meeting, and hate to end a day's betting in the red. A long-shot on the last race is an attempt to recoup earlier losses and end the day in credit.

The gamblers are putting each day's betting in a separate mental compartment, rather than trying to maximise their long-term winnings.

The same "get evenitis" afflicts investors who refuse to sell shares until they get back to their purchase price. The rational approach would be to worry about the return on all their investments, instead of putting one share in a separate compartment.

Compartmentalisation also explains why people who normally watch every penny will happily spend a windfall - they put that "free" money into a compartment of its own.

Hindsight is a wonderful thing

Say something dramatic has just happened - the sharemarket has plunged, the All Blacks have beaten the Wallabies, whatever. Now ask yourself how likely you thought that was before it happened.

Most of us have trouble with that question. We tend to deceive ourselves into thinking we saw the event coming.

Thanks to that "hindsight bias", events which hardly anyone predicted can seem almost inevitable afterwards.

That fosters overconfidence by making the world seem more predictable than it really is.

If we honestly believe we saw the last sharemarket crash coming, and now we don't see any sign of another crash, it can't be very likely. Can it?

Hindsight bias also makes us kick ourselves when we get things wrong - why didn't we buy those Baycorp shares when they were obviously so cheap?

* Contact Personal Finance Editor Mark Fryer at: Business Herald, PO Box 32, Auckland. Phone: (09) 373-6400 ext 8833. Fax: (09) 373-6423. e-mail: mark_fryer@herald.co.nz.