Thursday, 15 March 2007

Listening to Kahneman

Regular readers of the shared articles on my coffee table (that would be one of you, including myself) would notice that I often find myself fascinated by articles on cognitive biases, particularly from this collaborative site, Overcoming Bias. I did not read behavioural economics back in university, preferring instead to focus on game theory and econometrics (perhaps I should have taken an extra paper… in fact, I have a strong feeling that I should have…), so I am relatively new to the subject.

cognitive bias is a broad term for all distortions in the human mind that are hard to avoid and that lead to a perception, judgement, or reliability that deviates systematically, involuntarily, and rather distinct from the “reality”. Decisions made influenced by cognitive biases are not easily reconcilable with rationality, and thus could potentially lead to sub-optimal outcomes. Some familiar examples include overconfidence, gambler’s fallacy and self-deception.

In this post, I will try to introduce, informally, three relevant biases.

1. Paternalism

Not sure if it has been formally articulated, but paternalism is a form of bias. It relates to policy that is intended to benefit some people by limiting their choices, that is, the interference of a state or an individual with another person, against their will, and justified by a claim that the person interfered with will be better off or protected from harm, like a parent who stops a kid from playing in the street.

Basically, a paternalistic individual believes that he/she has superior rationality and reasoning, and that others are helpless in doing for what is good for them, and thus decisions are best left not to these helpless people.

For example, when one decides that a movie should be banned without really watching the show at all, because he knows better. Or when one decides that the populace is too stupid to understand matter pertaining to planning of transportation infrastructure.

2. Hyperbolic Discounting

The second interesting bias refers to the empirical finding that people generally prefer smaller, sooner payoffs to larger, later payoffs when the smaller payoffs would be imminent; when the same payoffs are distant in time, people tend to prefer the larger, even though the time lag from the smaller to the larger would be the same as before.

For example, when given a choice of getting RM 100 on say, September 1st, 2009 or RM200 3 years later (September 1st, 2012), you choose the latter option - that is, equivalent interest rate of about 26% per year (!). But when given a choice of RM 100 right now, and RM 200 three years from now - essentially the same scenario but with different time-frame - you choose to get RM 100 now.

Or similarly, when you decide to formulate a long term policy which is intended to ultimately enrich a portion of the population and lead to more equality amongst all in the long run, and that the potential long term gain from this policy should outweigh all the competing short term gains. But when the policy goes from formulation to implementation, most affected rather choose quick gains rather than potentially larger long term benefits.

3. Confirmation Bias

Sometimes known as myside bias, confirmation bias is a tendency to search for or interpret information in a way that confirms one's preconceptions and to avoid "counter-attitudinal" new information. It refers to the tendency for people to extend critical scrutiny to information which contradicts their prior beliefs and uncritically accept information that is congruent with their prior beliefs. An important consequence of the bias is that many incorrect beliefs are slow to change and often become stronger even when evidence is presented which should weaken the belief. Generally, such irrational belief persistence results from according too much weight to evidence that accords with one's belief, and too little weight to evidence that does not.

For example, after making the decision of buying a Toyota Vios, one tends to be especially receptive towards advertisements, positive reviews and comments for Toyota Vios, and choose not to heed reliable information that the Honda City is actually a better car overall.

Or when one choose not to believe that a policy has done little to achieve its objectives after many years, and decides – against evidence and well-accepted scholarly and empirical understanding that it would not work, to extend the policy forever. Or the conviction that one has for the future of an automotive company he helped create, despite blatant signs that it is a failure.

It is crucial to acknowledge that cognitive biases exist and to appreciate that they could lead to sub-optimal decisions and outcomes in the daily happenings of our lives, from simple trivial matters to over-arching policy decisions that have repercussions lasting multiple decades and affecting welfare of the entire nation.

Have you noticed your cognitive bias today?



Anonymous said...

Econometrics not my thing... I'm not really good in math


Anonymous said...

Or cogintive abilities for that matter. Blogger seems to think I am a bot.. and I failed the word verification about 3 times


Hi&Lo said...

Very interesting and tons of truth how minds are manipulated to accept propaganda.

zcer said...

Cognitive biases are manifestations of our mind's fuzzy (fuzzy logic) nature in contemplating the world. Most were adaptive in our ancestral environment, but have come to be more of a nuisance in these modern times. However, some still make sense, to certain extents. The "hyperbolic discounting" bias. I don't think i remember much economics, but isn't there an equation or something based on how money at present is worth more than money in the future? However, i think such sentiments when taken too far, do become biases. When it comes into conflict with long-term policy, as you have stated. And when people overcompensate for a perceived bias.

I used to find such cognitive biases interesting too. It makes much more sense though (and perhaps less frustrating), when interpreted within a framework of evolutionary psychology. Which although still young, is an exciting new science making much progress and gaining respect in it's explanation of human nature.

Oh, and i want to thank you for all your very good and interesting posts . I've been eagerly following them, and will continue doing so. Keep it going!

Elanor said...

thanks all for commenting :)

zcer, you are absolutely right - money now worth more than money later. So if you are given RM1000 now, or RM1000 a year from now, because with a current FD rate of 3.8 or so, RM1000 now is worth RM1038 a year later.

However, with regards to hyperbolic discounting, what happen is that if a scenario is given sometime in the future, say, whether you rather accept RM1000 in 2010 or RM1200 in 2011. Rationally, given that 20% returns for a year is pretty good, you most will take RM1200 because it is more... rational.

However, if this scenario is changed to RM1000 right here, right now, or RM1200 a year from now, empirically a large portion of people actually prefer the quick-gain option of RM1000 even when given the same scenario as above, they prefer RM1200. This decision is somewhat, erm, temporally inconsistent.

Also, say you have chosen RM1200 for the first scenario, when it is 2010 and are asked to choose again, you might choose RM1000 instead.

I.e., ppl seems to prefer quick smaller gains rather then wait for longer bigger gains if the choice is imminent (even when adjusted to returns and risks), but if it is not imminent, most are more 'rational' and prefer the bigger gain.

oh, if you are interested in evolutionary psychology, you might find evolutionary game theory interesting too! Google it.

zcer said...

Oh, i get what you mean by the temporal inconsistency. I was just thinking, perhaps it might not just be simply that. Maybe instead of being temporally inconsistent. It could be temporally non-linear.

The standard assumption is that bigger gains are always better. But as a certain amount of money may be worth more now than in the future. Perhaps also a certain amount of monetary gain now, is better than the same amount of gain later in the future?

I didn't know game theory adopted evolutionary insights. I'll be looking into that now. Thanks.

Elanor said...

zcer: wow, your grasp on the matter is amazing - you are absolutely right about the non-linearity bit, hence the name 'hyperbolic-discounting'.

you sure you are not thinking of doing economics? you are definitely thinking marginal.

zcer said...

oh... *smacks forehead*

sorry, i should have read the wikipedia article you linked to. Now the name makes sense.

My point is basically that in certain cases, it might not be a fallacy (or something negative as such). Thats all. :)

I started econs with much enthusiasm after reading some capitalist propaganda from the 1960s (my father's) lol. So i took econs when i studied the IB at my college. Unfortunately, I failed to meet criteria. For homework assignments i get the sole remark: "Hmm...interesting" And at exams i fail miserably. I dropped out of college actually.

I'm studying math now. I think some rigor is good for me. Then i'll perhaps look at econs from an applied math perspective.

Anonymous said...

This post is interesting Elanor, for it reminds me that it is a good mental habit to be cautious in drawing conclusions and not let the mind be influenced by too one-sided preconceptions or preferences :)