Bear with me – I’m about to cite a fictional, 1960’s period cable drama and yes, it has something to do with how you manage your finances.
In an episode of the AMC show Mad Men,1 the protagonist and presumptive advertising wizard Don Draper addresses a room full of American Cancer Society board members, as they ponder an anti-smoking ad campaign. It’s important to note that the show is set at the height of Big Tobacco’s supremacy; long before the Federal Trade Commission had added health warnings to cigarettes, much less prohibited television ads. On the show, characters smoke profusely indoors and out, in business meetings in offices, and during working lunches and fancy dinners.
Draper tells the board that they need to change the nature of the conversation about smoking. As ad agencies—both in this fictional world and our very real one—scrapped for the business of industry giants like Phillip Morris in the ‘60s, cool-hunting teenagers and young adults were bombarded by glamorous and glorified images of people—many celebrities—smoking on television, in magazines, and on billboards. Draper proposes a campaign based on parents and children, and how cigarettes come between them.
No, Draper wasn’t arguing that these young adults would give up cigarettes from a fear of losing their parents to disease or incapacity. Rather, he grasped at their sentimentality; that they would mourn their own mortality, and perhaps regret not being around for their hypothetical future children.
The Mad Men pitch is an example of behavioral economics in action, and more specifically, what we encounter in our daily and professional lives every time we make a purchase at the grocery store, study the stock ticker, or save money for some future event. We are irrational, emotional beings on a micro-level, and the decisions we make reflect that.
Yet these behaviors converge into macro displays: We see widespread speculation, “experts” trying to time the market, and emotional, herky-jerky responses to normal fluctuations.
We’ve already addressed how “noise” affects consumer decisions, in this case specifically from the financial media. Just take a look back at the coverage of the fiscal cliff crisis, the presidential election and debates before that, and the debt ceiling crisis of 2011 for perspective. Do 2012’s market results align with what we experienced as financial decision-makers the last year?
The hypothetical self-lamenter from the Mad Men smoking anecdote reflects what some economists have called the “Economic Man,” a person whose behavior is rational only in the pursuit of the maximal achievement of specific goals while minimizing the costs necessary to achieve those goals. The most important thing to note in this definition is that this person’s rationality does not consider the moral basis for his or her individual goals.
Think of the teenagers whom Don Draper’s ad campaign would reach: Per his theory, they wouldn’t take their habits’ effects on other people into consideration (secondhand smoke), or weigh the ethics of addiction for profit. They would worry about their ability to provide in the future. The costs they would be minimizing would be the illnesses keeping them home from work, literal costs of doctor visits, and the loss of time (time is money!) inherent in an early death.
A recurring problem is that our decisions are clouded by dozens of cognitive biases:
- A preference for the status quo
- Being unrealistically optimistic or overconfident
- Being loss-averse
- Picking the likeliest outcome only from those available
- Searching for information that confirms our beliefs
- Claiming responsibility for successes but not failures
- Agreeing with the herd even when you believe otherwise, groupthink
We are sometimes not the best judges of the long-term consequences of our decisions for these very reasons and many more. These biases and rules-of-thumb accumulate into what one author calls our “inner Homer Simpson,” or our reptilian brain (versus our conscious one).2
Understanding and adjusting for these decision-making features is the subject of Cass R. Sunstein and Richard H. Thaler’s book, Nudge: Improving Decisions About Health, Wealth, and Happiness. It’s an interesting take on how public policy makers and those that aid decisions can help us (irrational, emotional actors) make better choices. What are some notable examples?
- Automatic enrollment in 401(k) plans.
- Opting-out of organ donor in some states.
The problem the authors address is our (sometimes) dumb decision-making and inability to be clear about our interests. They argue that behavioral economists should “highlight the best option, while still leaving all the bad ones open.”3 They expand on this by tackling specific policy changes, the studies backing them, and their respective implementations. The premise of their work solicits two key criticisms4:
1) Should we entrust that much decision-making power to our institutions? Additionally, how would freedom of choice be affected?
2) “If the ‘nudgee’ can’t be depended on to recognize his own best interests, why stop at a nudge? Why not offer a ‘push,’ or perhaps even a ‘shove’?”
Here’s the problem, Sunstein and Thaler published Nudge before the 2008 economic collapse. Thinking and even proposing public policy changes, especially in the financial sector, has taken on a completely new understanding since then. What aided the collapse in a behavioral economic sense?
- Generally risk-averse individuals bet increasingly large amounts of money on risky hedges. Credit rating agencies bypassed industry standards with subprime mortgages(Groupthink);
- Institutional negligence (policy and product) by banks, financial establishments, etc. (e.g., executive bonuses via availability bias, status quo bias);
- Political overconfidence that AIG collapse, for example, would not create an avalanche effect (2009 recession).
It’s unclear how these issues have been addressed since then. Before we put too much confidence in institutions to help us become better financial decision-makers, let’s recap how the fiscal cliff negotiations reflect some of these very same issues:
- Preference for the status quo: Both Democrats and Republicans pushed for extension of Bush tax cuts;
- Being loss-averse: House Speaker John Boehner’s (R-OH) first offer was to extend tax cuts up to $1 million household income;
- Claiming responsibility for successes but not failures: Disappointing jobs numbers reports vs. overall market growth.
We could go on. The point is, sometimes those in charge of the nudge, push or shove are as clouded by decision-making shortcomings as we are as individual actors. In fact, one of the FCC’s first responses to the Surgeon General’s conclusive link of cigarette smoking to lung disease was to revert to the “Fairness Doctrine.”5 An FCC public policy from 1949, the doctrine required broadcasters to air both sides of controversial issues to their audiences6 , i.e. smoking is so cool, desirable, etc. vs. Surgeon General warning: smoking causes cancer. The actual ban on radio and television cigarette advertising wasn’t implemented until 1971, 22 years after the doctrine was introduced. That’s availability bias in action.7
It’s time to be a more aware decision-maker. Fallacies and biases affect the choices you make. Check back in Tuesday, January 22nd for Part 2 of Mad World: Smoke and Mirrors. We’ll take a look at how virtual reality and long-term thinking can help our brains address our shortcomings in response to our environment.