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Dr. Randy McIntosh , Senior Scientist and Associate Director, Rotman Research Institute and professer at U of T points to scans of brains that are displayed on a computer screen. The different colours represent different cognitive functions of the brain. (FRED LUM/ GLOBE AND MAIL/FRED LUM/ GLOBE AND MAIL)
Dr. Randy McIntosh , Senior Scientist and Associate Director, Rotman Research Institute and professer at U of T points to scans of brains that are displayed on a computer screen. The different colours represent different cognitive functions of the brain. (FRED LUM/ GLOBE AND MAIL/FRED LUM/ GLOBE AND MAIL)

An investor's worst enemy? Their brain Add to ...

On his first day of Economics 101 in university, Barry Ritholtz realized that the discipline itself was missing something fundamental.

The Wall Street veteran says that when his professor began lecturing, “practically the first words out of his mouth were, ‘We’re going to deal with Homo economicus. Humans are rational, profit-maximizing creatures.’ Five minutes into my first economics class, I raise my hand and say, ‘But humans aren’t rational!’” The professor told Ritholtz he should imagine that they were. “Okay,” he thought, “imagine my grandmother had wheels. She’d be a bus.”

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People, Ritholtz knew, tend to do stupid things, like smoking or not wearing seatbelts, despite overwhelming evidence that these behaviours can kill them. He couldn’t accept economics’ central assumption that people are by definition rational, and that they collectively express the order-making invisible hand of the market. Ritholtz went to the registrar the same day, and dropped the class.

Since the time when that contradiction vexed the young Ritholtz, a bridge between economic orthodoxy and human quirk has been erected in the form of behavioural economics, the study of how deeply embedded human traits affect financial decisions. Ritholtz is CEO and director of equity research at Fusion IQ, a research and investment firm with $300 million (U.S.) in assets under management. He is also a prolific writer and blogger—his website, The Big Picture ( www.ritholtz.com), has logged 114 million page views.

Thanks to the bestselling books of academic popularizers such as Dan Ariely, Richard Thaler and Daniel Kahn-eman, the central lesson of behavioural economics—that the brain often misinterprets the information it receives—has been getting a good airing since the 2008 financial crisis. The mistakes include such well-known phenomena as the halo effect (believing that certain leaders can do no wrong) and the sunk-cost fallacy (our aversion to cutting our losses when a project or investment has obviously gone awry).

Behavioural economics’ roots ex-tend to the 1970s, when the Efficient Market Hypothesis—which holds that market prices of traded assets reflect all publicly available information, and thus, because investors are rational, markets are efficient and self-regulating—was in vogue. The EMH became a wrecking ball in the hands of neoconservatives, who used it to justify weakening regulations like the Glass-Steagall Act, a Depression-era law forbidding institutions from combining insurance, investment banking and commercial banking under the same roof. This went on until 2008, when economic carnage—blamed partly on the unregulated repackaging of home mortgage debt—led many people, such as former Fed chairman Paul Volcker, to call into question the omniscience of the market. No rational person with any knowledge of history would believe that house prices would go up ad infinitum, and yet the banks’ profit models depended on that very assumption. So much for Homo economicus.

One of the most fascinating areas of study within behavioural economics is the concept of framing effects. How a question or problem is framed—and, specifically, what future scenarios are presented—affects the kind of solution that our brains will produce. An example chosen by Thaler and Cass Sunstein in their 2008 book, Nudge: Improving Decisions about Health, Wealth and Happiness, is the question of how to encourage people to conserve energy. They write, “Consider the following information campaigns: (a) If you use energy conservation methods, you will save $350 per year; (b) If you do not use energy conservation methods, you will lose $350 per year.”

It’s hardly a surprise that, as Thaler and Sunstein observed, option (b) is a “stronger nudge” and wins more converts to conservation. This behaviour is patently irrational—the outcome is the same, so why should framing the question in terms of a loss or a gain have an effect?—but because of the way our minds instinctively respond to certain scenarios, it works.

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