Introduction to behavioral economics

The objective of behavioral economics is to model and quantify psychological factors which affect our financial decisions, such as emotions, misperceptions, and cognitive biases.

Authors: Tiphaine Saltini, CEO at Neuroprofiler and Amélie Clavé, cognitive sciences expert at Neuroprofiler

Are you a rational investor?

Let’s imagine you can gain 50$ or invest in a gamble where you have 50% of chance to win 100$ and 50% of chance to get nothing. What do you choose? Most people choose the safe option to be sure to get 50$ rather than taking the risk to get nothing.

Now, let’s imagine you have the option to pay 50$ or to play a gamble where you have 50% of chance to pay 100$ and 50% of chance to pay nothing. What do you choose? In this case, on the contrary, most people choose the risky option to avoid losing money.

The two gambles have the same level of risk in both cases, though. How to explain these opposite choices?

Such a divergence from mathematical rationality as described above is called a cognitive bias. They are approximations from our brain to help us make faster decisions, basing themselves on situations we have already encountered or heard about, and can therefore lead to mistakes or irrational thinking.

According to Daniel Kahneman, one of the most influential figures of behavioral economics, our brain has two ways of working.

  • A System 1 which is fast, unconscious, effortless, and intuitive. This system relies on mental shortcuts and is prone to most cognitive biases.
  • A System 2 which is slow, logical, effortful, and deliberative. This system is used when we resolve mathematical problems at school or explain complicated concepts to a friend.

To illustrate cognitive biases for instance, we are on average twice more sensitive to losses than to gains. As in our example above, we take risk to avoid losing, but not to win more. We also misperceive probabilities. On average, large probabilities will be underestimated and small probabilities will be overestimated – such as the chance to crash with our plane or to win in casino.

The key innovation of behavioral economics is to incorporate these cognitive biases into classical economic models.

From classical to behavioral economics

We often trace the birth of economics back to the publication of Adam Smith’s book The Wealth of Nations in 1776. From this moment, economists – that would be later called classical economists – tried to create models to understand human’s choice behaviors.

In the 1930s, economists such as Samuelson or Arrow created a mathematical structure aiming at encompassing the way consumers were making their choices. They based their first models on the assumption that investors were rational and self-centered called Homo Oeconomicus.  If we come back to our example in the introduction, the typical Homo Oeconomicus will make the same choice in both cases. Either he is risk tolerant, and he will choose in both cases to gamble, or he is risk averse, and he will choose in both cases the sure option. The fact to choose the sure option in the first case and to gamble in the second case would be viewed as an irrational choice from the perspective of such theories, and Homo Oeconomicus cannot be irrational.

However, in the middle of the 20th century, some scholars, like Allais or Ellsberg started to challenge these classical models and especially this rationality assumption. They proved through experiments that most investors were influenced by cognitive biases and emotions such as loss aversion when making financial decisions.

More recently, in the late 1970s, the psychologists Daniel Kahneman and Amos Tversky launched a new kind of discipline mixing psychology and economics, behavioral economics. They were later in 2002 rewarded for their work by a Nobel Prize in economics, the first to be attributed to psychologists and not economists.

They also developed a new theory mainly aiming at integrating the notion of loss aversion and probability distortion as described above to classical economic models, called the Prospect Theory.