The Case Against Behavioral Economics

Behavioral economics exists because we fail to act “rationally.” Recently, an increasing amount of people are publishing findings in this field. 

Consider prize-linked savings accounts. Created as a way to alter the spending habits of consumers, this savings account distributes some of the interest payments in a lottery format. You’re at no risk of losing the principal, and you can “win” additional interest. 

Why do they work? For one, we’re terrible at dealing with probability. We have no idea how to differentiate between events that have 1 in 100,000 odds vs 1 in 1,000,000 odds. Hence why so many people play the lottery.

Dan Ariely’s Predictably Irrational is another fascinating read.

However, we must maintain perspective. Behavioral economics has serious shortcomings.

For example, the actions of each individual actor on a micro level do not scale to a macro level. This contrasts sharply with reductionism, where the belief is that large-scale events can be broken down into small component parts. Then changes can be made that would, in theory, alter macro outcomes. 

Reductionism leads us to believe that we can prevent future financial disasters.

Nassim Taleb wrote an excellent criticism of behavioral economics and why we can’t “nudge” our way to desired outcomes.

I want to highlight two sections.

The first concerns loss aversion, which is “an individual’s tendency to prefer avoiding losses to acquiring equivalent gains. Simply put, it’s better not to lose $20, than to find $20.”

I initially thought this was a huge mental bias. Surely we should enjoy gaining $20 as much as we dislike losing $20. That changed after learning about ergodicity.

Taleb writes, “‘Loss aversion’ is a mathematical property for any item that is conditioned on survival, not a psychological preference. The concavity/convexity stems from distance from ruin (fragility) and whether it addresses the individual or the collective.” In other words, we’re correctly focusing on having skin in the game. A $20 loss puts us closer to ruin.

His description of mental accounting further illuminates this concept. He writes, “Mental accounting is a defense mechanism for ergodicity… If you don’t play with the ‘house money’ differently from the initial endowment, you will go bust in the presence of the slightest absorbing barrier. Playing with the house money restores ergodicity.” Everything is about survival and maintaining skin in the game. 

Here’s a recent example of loss aversion and absorbing barriers: play calling in football. 

People have been shouting from the rooftops for years that NFL teams make suboptimal decisions. Is it the result of a principal-agent problem? 

There is a plethora of reading material already, but let’s try framing it differently. If a coach begins making aggressive play calls, are they running a higher chance of hitting the absorbing barrier of being fired?

Until all this is settled, behavior economics will continue to make waves. Especially when investing fundamentals go out the window and decisions are made based on nominal share price.