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The basics of behavioral finance is that people deviate from the rational and self-interested agent who supports theories of classical economics. Homo sapiens is not Homo oeconomicus. Our decisions are strongly influenced by emotions, social pressure, logical or memory fallacies. Such cognitive biases are often presented as ”bad things” which prevent us from making the right decision. However, cognitive biases are a very wide and ambiguous term which covers many different cognitive mechanisms. Even what we mean by rationality is not always clear. Is it a deviation from individual profit maximization? From mathematical verity? From wisdom? From reality? From evolutionary optimum?
Let’s consider the question of risk-taking. As described in another article, risk-taking behavior depends on loss aversion, greediness and overoptimism. In other words, it depends on how much risk we are willing to take to win more, to loose less and on how we perceive the probabilities of such outcomes. If our decision is totally neutral, we behave equally in case of low/high and positive/negative outcomes with high/low probabilities. Is such a behavior ”better” than the other ones? If we are traders, we’d better be greedy to increase our profit while a medical doctor should be loss averse if losses represent lives. This is rather a question of personal preferences, and thus eventually of wisdom and morality, than a deviation from rationality. For optimism, the question is trickier. We do not choose really to overweight small probabilities and underweight large probabilities of winning. The process is unconscious. We just feel that we can win in a lottery with a 1% of chance of success and that we need to pay for insurance against extreme weather conditions while there is 99,0% that such an event will not happen. Are we a irrational if we do so? Again, the answer is not straightforward. Yes we are, as we misperceive the reality. Even if we are totally aware of our 1% of chance of winning the lottery, we keep gambling as we unconsciously overweight this probability. However, in some cases, they can have a positive impact on our decisions. If we are entrepreneurs or politicians, we’d rather be a bit overoptimist to motivate teams and electors.
What about memory or causality fallacies and social biases? Is it irrational to remember more the first and last event of a series, to make generalities from our limited past personal experiences, to be more afraid by men than women, to prefer collaborate with people like us, to punish free-riders even if it is costly…? Such biases often make sense from an evolutionary perspective. Focusing on last and past events enables to reconstruct quickly a story. Integrating our past experiences helps us make decisions in uncertainty. Similarly, on average, women are indeed less strong than men and strangers are more dangerous than people from the tribe. Many cognitive biases are heuristics or intuitions which can be very effective in making quick and result-oriented decisions in a complex environment.
So, I’m biased, is it serious, doctor? As we have seen, some cognitive biases, like loss aversion or greediness, are related to our personality or personal preferences. They thus cannot be really classified as good or bad. We deliberatively invest in risky assets because we like risk as we prefer to go back to the same place for holidays as we are rather conservative. Other biases, like most cognitive fallacies and social biases, make us misperceive the world and are often unconscious. We think that this person has performed the best during the interview while in fact this is because she was from your hometown or because she was the last to be interviewed. Such biases can be useful heuristics to make quick decisions in complex environments. In this sense, they are optimal under constraints. However, they have better to be avoided if time allows. Finally, logical fallacies such as base rate fallacy (ignoring when calculating conditional probabilities) or syllogism fallacies are just errors that are false, and, this time, are irrational, whatever the situation!
Thinking fast and slow, D.Kahneman
Picture: Le déséspéré, by Gustave Courbet