Behavioral Economics - We're only human!

I'm alaya a question for you listening right now. What
are you more scared of shocks or tiny mosquitoes?
People are often terrified of sharks, you know. They think
of the movie Jaws and not scary music starts playing
in their head, or they just can't shake that story
they read about a swimmer who got bit by a shark.
But even in the US, you're more likely to die
from a mosquito than a shark.
People overestimate the danger of sharks, even though mosquitoes are
much deadlier. Personally, I'm terrified of Tripoli and West Nile.
Those are mosquito born illnesses that can kill you with
just one massie bite.
And yet people who avoid swimming in the sea due
to fear of sharks go outside at dusk without mosquito repellent.
Risky doesn't make any sense.
This comparison of sharks and mosquitoes illustrates a much broader problem.
Many of us make mistakes in assessing risks, and they
make misguided decisions as a result of that misassessment.
This sharks versus Mozzi's comparison, It's just one of the
systematic ways in which people make mistakes. Psychologists have worked
with economists develop behavioral economics. All of economics consider human
decision making, but behavioral economics focus on the ways in
which we humans get tripped up pretty regularly by our brains.
Behavioral economics is what we'll be exploring on this week's
Think Like an Economist with me Betsy Stevenson and.
I'm Justin Wolfs. This is the podcast where we teach
you the tools from economics and maybe psychology that will
change your life, such as knowing how psychology affect your
decision making. Journalist and former economic student, as to Antapacholi,
far is with us.
So people sometimes joke that economists base their models on
Homo economicus. This is a humorous term of a wholy
rational person. Many of us also think we are very
rational when we're assessing our risks.
Yes, and one of the main problems is about relying
on snap judgments rather than taking time to analyze the
situation more thoroughly. Psychologists distinguished between two styles of thinking,
your intuitive thoughts and a more methodical style of thinking
that uses your more deliberate, logical self.
Denny Carnaman is a psychologist who actually won a Nobel
Prize in economics and he won it for getting economists
to think harder about how our brains think about and
sometimes distort the decisions we make. He calls that first
style of snap judgment the intuitive style of thinking thinking fast,
and that second style of judgment, the more deliberate thinking
that uses more cognitive effort. He calls that thinking slow.
We actually need to use thinking fast in our life
because life is short and we can't do slow thinking
on every small choice. So what we really need to
do is figure out when we need to think slow
and when we can get away with thinking fast.
That's why it's so important to learn about the types
of mistakes that thinking fast might lead you to make.
One example of the way we make mistakes is that
we tend to be over confident. I read once that
most people think that they are better than average drivers,
but obviously that can't be true.
One way I demonstrate to my students, and I've done
this with executives about how overconfident they are, is I
asked them a bunch of random questions and ask them
to give me their ninety nine percent confidence interval. So
what that means is they have to give me a
range within which they're ninety nine percent sure that the
answer lies. So, for instance, Naz, what's your ninety nine
percent confidence interval about how many sheep there are in
New Zealand.
I don't know anything about a New Zealand sheep, but
I feel with ninety nine percent confidence there are at
least ten thousand sheep and probably not more than ten
millions sheep.
Nos is why as that confidence in it all is,
the true answer is not in it In fact, in
New Zealand there are nearly thirty million sheep.
Wow, one question doesn't show this concept very well. But
if we repeated that with ninety nine more questions, so
we gave you one hundred questions, then you should only
get one of them where the right answer is going
to lie outside the interval. But now as you got
one question and you didn't have your right answer in
the interval, it makes me think maybe you shouldn't have
been ninety nine percent confident.
What I play this game with my students, they tend
to get about seventy percent right, even when they think
they should be ninety nine percent confident.
What overconfidence means in our everyday life is that entrepreneurs
tend to be overconfident in assessing their company's chances for success,
and people picking stocks tend to be overconfident that they're
picking winners.
The danger is that overconfidence can lead you to underestimate
risks and therefore make really bad decisions. Also, if you're
over confident, that might lead you to not reach out
to get advice from experts, even when that's advice that
could really help you.
When you're making decisions where the stakes are significant, it's
worth slowing down and remembering that there are other outcomes
than the ones you're seeing and hoping for, and that
it's worth it to assess things slowly and with more information.
So now I know to be careful about my own overconfidence.
What are some other psychological errors that we tend to make.
A key part of making good choices in the face
of uncertainty is quantifying that uncertainty, or the probability of
each outcome properly. Unfortunately, the mind is not a very
good probability calculator.
There are three kinds of biases we all tend to
have that can get in the way of us doing
a good job assessing probability. The first of these is
called availability.
Bias, so whenever there's a plane crash, it's all over
the news, even though in reality planes are so much
safe for the driving that you're better off flying than
driving if you want to reduce the rate of accidents
per mile.
So here's the thing about availability bias. It's that tendency
to overestimate the frequency of the kinds of events that
are going to be easily recalled, and then to underestimate
the frequency of less memorable events.
Danny Carnaman would tell us to stop a moment and
think more deliberately about these risks.
Slow deliberate thinking has made me much more afraid of
mosquitos than I am of sharks or planes.
The second kind of bias that can get in the
way of doing good job assessing probabilities what we call
anchoring bias.
Anchoring bias is when we make an initial prediction about
something and then adjust our estimation from there.
And the problem arises because we rarely adjust enough. So, nas,
I've got a coin here, what do you think the
probability is? If I flip it once, it'll come.
Up heads fifty percent?
Okay? And as if I flip it eight times in
a row, what do you think the chances are I
get eight heads in a row?
I don't know one now.
In fact, the answer is zero point four percent. So
instead of one in one hundred, it's one in two
hundred and fifty. There was an example of anchoring bias.
Because you started with the anchor of fifty percent. You
knew you had to adjust it because getting eight heads
is harder than getting one, but you didn't adjust far enough.
The third way in which we're bad at assessing probabilities
is the representativeness bias, which is about making assumptions about
probabilities based on how similar something is to others in
that category.
For example, investors tend to favor companies started by men.
Most investors are white men, and they've seen all those
success stories of all those male CEOs, and so they're
more likely to assume that the probability of business will
succeed by a white man is going to be high
because they fit their stereotype of what a successful CEO
looks like.
Representativeness bias is a big problem when it comes to discrimination,
and it's often done unconsciously.
A general rule of thumb is that if you judge
probabilities based on how similar things are, then it's time
to start thinking slow and allow your more deliberate and
logical side to start doing a more thorough analysis and
hopefully leads you to a better assessment.
These are all the biases that impact our ability to
assess probabilities. But I bet that we have biases when
it comes to evaluating payoffs too, And since figuring out
how to handle risk involves evaluating probabilities and payoffs, these
biases can get in the way of making good decisions too.
That's right, and there are two really big ones I
want to help think about today. One is focusing illusion,
which is the tendency to mispredict your utility by focusing
on a few factors at the expense of others.
In The second bias is called loss aversion. People tend
to be about twice as sensitive to losses as they
are agains.
Basically, it means that you can be tricked by framing
something as a gain or a loss, and how it's
framed will end up impacting your judgment.
So when I tell my student they get a b
if I told them the day before to expect to see,
they feel pretty good.
They feel like now they've earned something back instead of
having lost something.
This can really matter in the real world. There's good
evidence that say doctors make different decisions if you tell
them that a treatment will help ninety percent of people,
then if you tell them that it won't help ten percent.
Last version means that if I give you fifty dollars,
the joy you get from it is smaller than the
pain you'd feel if they took it away. So giving
you something and then taking it back makes you worse
off than if you'd never had it in the first place.
And the big mistake that loss a version can cause
when it comes to making decisions is it can cause
you to pay attention to sunk costs. Remember you should
always ignore sunk costs. They're sunk. Your decision needs to
reflect the marginal costs and benefits that you face now right.
For example, homeowners often get fixated on the price they
paid for their house and won't sell their house for
less than they paid for it. The problem is loss
of version can cause them to hold onto a house
that they really don't want, where they'd be better off
accepting the best offer on it and moving on.
Given so many of us trip up when we're trying
to assess our risks. What can we do so we
can make better decisions around risk taking.
The most important thing to do is know when you
need to slow down and think more methodically about a decision.
Sometimes you really do need to pull out the sheet
of paper and tally up the pros and cons of a.
Choice, or, as economists would say, we're telling the marginal
benefits and marginal costs. It's also important to realize that
we have to think fast some of the time, so
try to set yourself up for success. Just knowing that
you're likely to be over confident should tell you to
be a little more cautious than your first instinct, says.
Being aware of our biases is an important step in
overcoming them. That's true for all the biases we mentioned today,
and it's at some point you too, may shudder at
the sight of a mosquito and look at a shark
with wonder rather than fear
Look on and enjoy the rationality