Behavioral Economics and Human ‘mis-behavior’

Daniel Kahneman, fondly known as the Grandfather of Behavioral Economics, passed away earlier this year. His groundbreaking work in this field revolutionized the way we understand finance and economics. Before behavioral economics, it was widely believed that humans acted rationally when it comes to finance and economics. Kahneman’s work, however, highlighted that human behavior is often far from rational. He was awarded the Nobel Prize for his 'Prospect Theory,' which delves into the everyday behavioral biases that lead people to make poor financial decisions.

Understanding Prospect Theory: Risk Aversion and Risk Seeking

The Certainty of Profit

Consider this scenario:

You have two choices: a 100% chance to gain 500 rupees or a 50% chance to gain 1000 rupees.

Both options are profitable, but most people would choose the guaranteed 500 rupees. This is because we tend to be risk-averse when it comes to securing a profit. The thought process is, "Why take a risk when I can have a sure gain?" Prospect Theory explains that in profitable situations, we prefer certainty and avoid risk.

The Uncertainty of Loss

Now, let’s look at a different scenario:

You have a choice between a 100% chance to lose 500 rupees or a 50% chance to lose 1000 rupees.

This situation is trickier. When faced with a potential loss, we often become risk-seekers. We think, "Why accept a certain loss of 500 rupees? There’s a chance I might not lose anything if I take the risk." This tendency to gamble in the face of certain loss is something we see in many aspects of life—whether in investments, relationships, or other decisions where the fear of loss drives us to take risks.

Conclusion: Embracing Rational Thinking for Better Decisions

Traditional economics would argue differently than behavioral economics. It suggests that it’s more logical to take a risk for a potential gain rather than to risk further loss. If humans were truly rational, we would prioritize maximizing profit over avoiding loss. However, our emotional responses often cloud our judgment. By delaying gratification, you might increase your chances of achieving greater profits. Similarly, when facing a loss, it might be wiser to accept it now rather than gamble and risk deeper losses.

Next time you’re tempted to lock in a quick profit, consider whether waiting could increase your gains. Or when confronted with a loss, think carefully about whether it’s worth taking a risk to avoid it or if it’s better to accept the loss and move on. By striving to think rationally, we can make better decisions as investors—and in life.

Some more real life examples:

1. You bought a ticket to a movie. 10 minutes gone and you realize, it's a bad movie. Do you suffer through it or book your lost time?
2. People stuck in a bad relationship, anyone?
3. Anyone knows a friend who didn't join that first job they had, instead went on to become a successful actor or changed career to take a chance? Or do you regret not taking a chance because there was a profit in sight?
4. What is your behavior when choosing term insurance? Premium is a certain loss. Most choose a mediocre LIC policy for a certain profit and avoid term insurance because they see premium as a certain loss.
5. Companies offer CTC. It's a cost to company and employees love it. If they were to instead say, income to employee, may be they would know the reality, but love it less?
6. McD sells you that burger combo to make it look profitable for you. Consumers love small profit. There is another bias here at play. Will talk about it some other day!!

It's a very powerful tool used all around us for marketing, product pricing.