Oh, That Irrational Aversion

GLOBAL GURU/DANIEL KAHNEMAN

Why does losing a dollar feel so much worse than gaining a dollar? For a good answer, and related insights into stock market behaviour, we have Daniel Kahneman to thank

You know them. Market participants who talk incessantly about the market. Who speak of this entity, the market, in the hushed tones of demure respect. Who think of this behaviour as entirely rational, largely because the market is entirely rational.

You know them. Which is why you also know that they're rational, but mostly as measured on their own terms of rationality. And when a psychologist gets into the act to put this rationality to the test, things begin to look different.

Professor Daniel Kahneman, the Eugene Higgins Professor of Psychology at Princeton, didn't just get into the act. He got himself plenty of glory, and from eggheads too. He won himself a Nobel prize "" in Economics, not Psychology "" in 2002, doing so. This makes him one of the first cross-disciplinary academic celebs on planet Earth.

As the Royal Swedish Academy of Sciences phrases it, he won for "Integrating insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty." Kahneman's research partner, Amos Tversky, passed away in 1996 and thus could not be jointly awarded the Nobel.

So what contribution did Kahneman make to 'the dismal science?'

The good professor did the unthinkable. He questioned Economic Theory. Or, to be specific, its starting assumption of the rationality of decision making agents in perfectly competitive markets.

Psychological reality, he hypothesized, was not so easily adaptable to the squeaky clean world of rational economic behaviour.

Yeah, so people do weird things every now and then. So what?

Well, Kahneman turned this insight useful. Specifically, useful to the analysis of decisions made under conditions of "uncertainty" (when you don't know what will happen next, for example). Instead of the regular "prescriptive" approach, which was about what ought to be done, he gave us a "descriptive" approach by investigating patterns of observable behaviour.

In other words, Kahneman brought the analysis off paper and into the real world. Prospect Theory, unveiled in 1979, was about "decision making under risk can be viewed as a choice between 'prospects' and 'gambles'" as Kahneman & Tversky saw it. Decoded, what this statement means is that individuals are less willing to gamble with profits than with losses.

The duo used clinical experiments to show that individuals care about changes in their financial wealth, rather than the total absolute value of their wealth. Moreover, people are irrationally loss-averse. A loss is painful, whatever the magnitude. A pain they go to unreasonable lengths to avoid. In a gamble, people do not calculate probabilities to see what they stand to gain versus what they could lose. Emotions enter the picture.

But isn't that common sense? Not in economic theory all this while. A gain of one dollar ought to compensate for a loss of one dollar. But that's not how people respond.

Here's what happens in Kahneman's own words: "You have two people, both of whom get their quarterly returns on their stock portfolios. One of them (Person A) learns his wealth has gone from $1 million to $1.2 million, and the other one (Person B) learns his wealth has gone down from $4 million to $3.5 million. Traditional economic theory, based on Bernoulli's analysis would consider the second person better off, since in the end , he still has more in absolute terms. But when people think of the outcomes of their decisions, their outlook is much short-term. So, in reality, we would find that person A is actually happier than person B. Individuals just don't think in absolute financial terms. They think in terms of relative financial terms and in terms of gains and losses."

What makes people behave the way they do? Some of it is on account of common human flaws, according to Kahneman. These, if understood properly, can be anticipated so that economic models are crafted accordingly. The point is to understand what goes on in the strange recesses of the mind. Individuals may become overconfident, for example, deluding themselves into possession of knowledge that is illusory. They may also end up focusing too much on immediate outcomes, acting to avoid regrets rather than making the most of opportunity.

All this has resulted in a subfield of economics known as "Behavioural Economics" which attempts to explain how cognitive errors and human emotions affect the decision making process. Together with the work of others, this has put the so-called "Efficient Market Hypothesis" to the test of the human mind.

Most of all, it is stock market participants (who talk incessantly about the stock market) who should pay attention to Behavioural Economics.

Already, the discipline has identified two common investor mistakes. The first is excessive trading (caused by the human flaw of over-confidence). The second is the tendency to hold on to investments making losses while selling those which are making profits (caused by the human desire to avoid regrets).

Cognitive failures resulting from irrational behaviour can explain several stock market anomalies, be it manias, panics, asset price bubbles, herd-behaviour and noise amplification.

The important thing to remember is that the market, alas, is all too human. It is like you.

Now does that worry you?