By Prateek Ghoshal

In my opinion, the behavioral side of finance and economics is by far one of the most intriguing concepts that I’ve encountered in my small time with the subject. Relatively new to the field, it combines behavioral and cognitive psychological theories with conventional economics and finance in analyzing irrational decision-making. The assumption of ‘rationality’ that we perennially experience in our economics textbooks has always been hotly contested. Psychology provides an apt analysis for the ‘irrational’ decisions that people tend to make unknowingly. In this present article, I do not dwell into the theory behind the subject but provide a few applications from business and finance that will surely get you thinking!

Dominating alternatives

Let’s talk about business-strategy!

Does the introduction of a third decoy option, make you more likely to chose the option, which a particular person wants you to chose?
To explain this, I’ll give an example from psychologist and behavioral economist Dan Ariely’s TedX lecture.

Consider the different subscription packages offered by The Economist. Initially potential consumers were given two options: $56 for an ‘only-online’ subscription and $125 for ‘online-print’ subscription. A large proportion of consumers chose the first option while a few publishers preferred the second. However things changed dramatically when a third decoy option was introduced. A third option of $125 for ‘only-print’ subscription was added to the existing two options. As expected consumers did not prefer the third option, but what was perplexing, was that now a majority of the consumers went for the second option ($125 for online-print).
The mere introduction of the third option made the second option look extremely attractive. As and when consumers were given an option to compare, they went for the more lucrative offer, in this case: $125 for both online and print rather than $125 for print only. However amidst this transformation, they contradicted their initial choice of $56 for ‘only-online’ subscription. End Result: Higher sales for The Economist!

Belief Manipulation

The concept of belief manipulation implies that individuals manipulate their thoughts to take on actions, which they would have earlier considered to be immoral. The reason behind this involves another concept in psychology called ‘cognitive dissonance’. Cognitive dissonance is the discomfort one feels when an individual takes on an action that is in conflict with their typically positive self-image.

A very interesting example was provided by Nicholas Barberis in his paper ‘Psychology and the Financial Crisis’. It is a well-known fact that one of the major factors behind the crisis of 2008 was the surge in sub-prime securities and mortgage loans. However, the question that most individuals failed to understand was that, in spite of the risk involved in these loans, why did banks take on such large exposures?

Plausible Reason: Belief manipulation!
Bankers were well aware that their model was highly risky but giving up their jobs would be financially costly.  Instead, they manipulated their beliefs telling themselves that their actions were in fact not risky.
Even though this particular application lacks research but ‘belief manipulation’ can form the basis for various financial and economic problems.

Decision Paralysis:
Can reducing the number of options to consumers increase Sales?

In a study to prove this point, researchers sat down in a supermarket with bottles of Jam on display. The expectation was some users would stop by, fewer would taste, and yet fewer would purchase. One group sat with 6 varieties on display, and the other with 24 varieties on display. While more people stopped by in case of the 24-jar display, the number that bought was 10-times less than the 6-jar scenario (3% vs. 30%).

What was expected is that consumers prefer more choices. However it turns out the opposite! When faced with too many options, individuals are unable to evaluate them all, and end up deciding not to buy at all. End result: Lower Sales!

Loss aversion

Demonstrated first by the founding fathers of behavioral economics, Amos Tversky and Daniel Kahneman, Loss aversion refers to the tendency of individuals to strongly prefer avoiding losses to acquiring gains. Based on ‘The Prospect Theory’ developed by the same, it is believed that the pain people experience from a loss is twice as much as the pleasure they tend to experience when they achieve an equivalent type of gain.
Stock markets in particular provide numerous evidences of Loss aversion. Investors evaluating their stock portfolio are most likely to sell stocks that have increased in value or have gone down the least amount. Why? Because individuals are afraid to take a loss. Unfortunately, this means that people end up holding on to their depreciating stocks. Over the long term, this strategy ultimately leads to a portfolio composed entirely of shares that are losing money.

Conclusion:

Understanding the consumer psyche and the irrationality of the human decision-making process is key to developing efficient financial outcomes and product features in the market. The examples above provide an extremely superficial insight to behavioral economics and finance. However, it reinforces the argument there is a dire need to internalize the irrational decisions that people to tend to make.

Posted by The Indian Economist | For the Curious Mind