How We Decide (11 page)

The game show is entertaining only because the vast majority of contestants don't make decisions based on the math. Take Nondumiso Sainsbury, a typical
Deal or No Deal
contestant. She is a pretty young woman from South Africa who met her husband while she was studying in America. She plans on sending her winnings back home to her poor family in Johannesburg, where her three younger brothers live in a shantytown with her mother. It's hard not to root for her to make the right decision.

Nondumiso starts off rather well. After a few rounds, she still has two big amounts—$500,000 and $400,000—left in play. As is usual for this stage of the game, the Banker makes her a blatantly unfair offer. Although the average amount of money left is $185,000, Nondumiso is offered less than half that. The producers clearly want her to keep playing.

After quickly consulting with her husband—"We still might win half a million dollars!" she shouts—Nondumiso wisely rejects the offer. The suspense builds as she prepares to pick her next briefcase. She randomly chooses a number and winces as the briefcase is slowly opened. Every second of tension is artfully mined. Nondumiso's luck has held: the briefcase contains only $300. The Banker now increases his offer to $143,000, or 75 percent of a perfectly fair offer.

After just a few seconds of deliberation, Nondumiso decides to reject the deal. Once again, the pressure builds as a briefcase is opened. The audience collectively gasps. Once again, Nondumiso has gotten lucky: she has managed to avoid eliminating either of the two big remaining sums of money. She now has a 67 percent chance of winning more than $400,000. Of course, she also has a 33 percent chance of winning $100.

For the first time, the Banker's offer is essentially fair: he is willing to "buy" Nondumiso's sealed briefcase for $286,000. As soon as she hears the number, she breaks into a huge smile and starts to cry. Without even pausing to contemplate the math, Nondumiso begins chanting, "Deal! Deal! I want a deal!" Her loved ones swarm the stage. The host tries to ask Nondumiso a few questions, and she struggles to speak through the tears.

In many respects, Nondumiso made an excellent set of decisions. A computer that meticulously analyzed the data couldn't have done much better. But it's important to note
how
Nondumiso arrived at these decisions. She never took out a calculator or estimated the average amount of money remaining in the briefcases. She never scrutinized her options or contemplated what would happen if she eliminated one of the larger amounts of money. (In that case, the offer probably would have been cut by at least 50 percent.) Instead, her risky choices were entirely impulsive; she trusted her feelings to not lead her astray.

While this instinctive decision-making strategy normally works out just fine—Nondumiso's feelings made her rich—there are certain situations on the game show that reliably fool the emotional brain. In these cases, contestants end up making terrible choices, rejecting deals that they should accept. They lose fortunes because they trust their emotions at the wrong moment.

Look at poor Frank, a contestant on the Dutch version of
Deal or No Deal.
He gets off to an unlucky start by immediately eliminating some of the most lucrative briefcases. After six rounds, Frank has only one valuable briefcase left, worth five hundred thousand euros. The Banker offers him #102,006, about 75 percent of a perfectly fair offer. Frank decides to reject the deal. He's gambling that the next briefcase he picks won't contain the last big monetary amount, thus driving up the offer from the Banker. So far, his emotions are acting in accordance with the arithmetic. They are holding out for a better deal.

But Frank makes a bad choice, eliminating the one briefcase he wanted to keep in play. He braces himself for the bad news from the Banker, who now offers Frank a deal for ???€2,508, or about €100,000 less than he was offered thirty seconds before. The irony is that this offer is utterly fair; Frank would be wise to cut his losses and accept the Banker's proposal. But Frank immediately rejects the deal; he doesn't even pause to consider it. After another unlucky round, the Banker takes pity on Frank and makes him an offer that's about 110 percent of the average of the possible prizes. (Tragedy doesn't make good game-show TV, and the producers are often quite generous in such situations.) But Frank doesn't want pity, and he rejects the offer. After eliminating a briefcase containing €1—Frank's luck is finally starting to turn—he is now faced with a final decision. Only two briefcases remain: €10 and €10,000. The Banker offers him €6,500, which is a 30 percent premium over the average of the money remaining. But Frank spurns this final proposal. He decides to open his own briefcase, in the desperate hope that it contains the bigger amount. Frank has bet wrong: it contains only €10. In fewer than three minutes, Frank has lost more than €100,000.

Frank isn't the only contestant to make this type of mistake. An exhaustive analysis by a team of behavioral economists led by Thierry Post concluded that most contestants in Frank's situation act the exact same way. (As the researchers note,
Deal or No Deal
has "such desirable features that it almost appears to be designed to be an economics experiment rather than a TV show.") After the Banker's offer decreases by a large amount—this is what happened after Frank opened the €500,000 briefcase—a player typically becomes excessively risk-seeking, which means he is much more likely to reject perfectly fair offers. The contestant is so upset by the recent monetary loss that he can't think straight. And so he keeps on opening briefcases, digging himself deeper and deeper into a hole.

These contestants are victims of a very simple flaw rooted in the emotional brain. Alas, this defect isn't limited to greedy game-show contestants, and the same feelings that caused Frank to reject the fair offers can lead even the most rational people to make utterly foolish choices. Consider this scenario:

The United States is preparing for the outbreak of an unusual Asian disease, which is expected to kill six hundred people. Two different programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows: If program A is adopted, two hundred people will be saved. If program B is adopted, there is a one-third probability that six hundred people will be saved and a two-thirds probability that no people will be saved. Which of the two programs would you favor?

When this question was put to a large sample of physicians, 72 percent chose option A, the safe-and-sure strategy, and only 28 percent chose program B, the risky strategy. In other words, physicians would rather save a certain number of people for sure than risk the possibility that everyone might die. But consider this scenario:

The United States is preparing for the outbreak of an unusual Asian disease, which is expected to kill six hundred people. Two different programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows: If program C is adopted, four hundred people will die. If program D is adopted, there is a one-third probability that nobody will die and a two-thirds probability that six hundred people will die. Which of the two programs would you favor?

When the scenario was described in terms of deaths instead of survivors, physicians reversed their previous decisions. Only 22 percent voted for option C, while 78 percent chose option D, the risky strategy. Most doctors were now acting just like Frank: they were rejecting a guaranteed gain in order to participate in a questionable gamble.

Of course, this is a ridiculous shift in preference. The two different questions examine identical dilemmas; saving one-third of the population is the same as losing two-thirds. And yet doctors reacted very differently depending on how the question was framed. When the possible outcomes were stated in terms of deaths—this is called the
loss frame
—physicians were suddenly eager to take chances. They were so determined to avoid any option associated with loss that they were willing to risk losing everything.

This mental defect—it's technical name is
loss aversion
—was first demonstrated in the late 1970s by Daniel Kahneman and Amos Tversky. At the time, they were both psychologists at Hebrew University, best known on campus for talking to each other too loudly in their shared office. But these conversations weren't idle chatter; Kahneman and Tversky (or "kahnemanandtversky," as they were later known) did their best science while talking. Their disarmingly simple experiments—all they did was ask each other hypothetical questions—helped to illuminate many of the brain's hard-wired defects. According to Kahneman and Tversky, when a person is confronted with an uncertain situation—like having to decide whether to accept an offer from the Banker—the individual doesn't carefully evaluate the information, or compute the Bayesian probabilities, or do much thinking at all. Instead, the decision depends on a brief list of emotions, instincts, and mental shortcuts. These shortcuts aren't a faster way of doing the math; they're a way of skipping the math altogether.

Kahneman and Tversky stumbled upon the concept of loss aversion after giving their students a simple survey that asked if they would accept various bets. The psychologists noticed that when a person was offered a gamble on the toss of a coin and was told that losing would cost him twenty dollars, the player demanded, on average, around forty dollars for winning. The pain of a loss was approximately twice as potent as the pleasure generated by a gain. Furthermore, decisions seemed to be determined by these feelings. As Kahneman and Tversky put it, "In human decision making,
losses loom larger than gains.
"

Loss aversion is now recognized as a powerful mental habit with widespread implications. The desire to avoid anything that smacks of loss often shapes our behavior, leading us to do foolish things. Look, for example, at the stock market. Economists have long been perplexed by a phenomenon known as the premium equity puzzle. The puzzle itself is easy to explain: over the last century, stocks have outperformed bonds by a surprisingly large margin. Since 1926, the annual return on stocks after inflation has been 6.4 percent, while the return on Treasury bills has been less than 0.5 percent. When the Stanford economists John Shoven and Thomas MaCurdy compared randomly generated financial portfolios composed of either stocks or bonds, they discovered that, over the long term, stock portfolios
always
generated higher returns than bond portfolios. In fact, stocks typically earned more than seven times as much as bonds. MaCurdy and Shoven concluded that people who invest in bonds must be "confused about the relative safety of different investments over long horizons." In other words, investors are just as irrational as game-show contestants. They, too, have a distorted sense of risk.

Classical economic theory can't explain the premium equity puzzle. After all, if investors are such rational agents, why don't all of them invest in stocks? Why are low-yield bonds so popular? In 1995, the behavioral economists Richard Thaler and Shlomo Benartzi realized that the key to solving the premium equity puzzle was loss aversion. Investors buy bonds because they hate losing money, and bonds are a safe bet. Instead of making financial decisions that reflect all the relevant statistical information, they depend on their emotional instincts and seek the certain safety of bonds. These are well-intentioned instincts—they prevent people from gambling away their retirement savings—but they are also misguided. The fear of losses makes investors more willing to accept a measly rate of return.

Even experts are vulnerable to these irrational feelings. Take Harry Markowitz, a Nobel Prize-winning economist who practically invented the field of investment-portfolio theory. In the early 1950s, while working at the RAND Corporation, Markowitz became intrigued by a practical financial question: how much of his savings should he invest in the stock market? Markowitz derived a complicated mathematical equation that could be used to calculate the optimal mix of assets. He had come up with a rational solution to the old problem of risk versus reward.

But Markowitz couldn't bring himself to use his own equation. When he divided up his investment portfolio, he ignored the investment advice that had won him the Nobel Prize; instead of relying on the math, he fell into the familiar trap of loss aversion and split his portfolio equally between stocks and bonds. Markowitz was so worried about the possibility of losing his savings that he failed to optimize his own retirement account.

Loss aversion also explains one of the most common investing mistakes: investors evaluating their stock portfolios are most likely to sell stocks that have
increased
in value. Unfortunately, this means that they end up holding on to their depreciating stocks. Over the long term, this strategy is exceedingly foolish, since ultimately it leads to a portfolio composed entirely of shares that are losing money. (A study by Terrance Odean, an economist at UC Berkeley, found that the stocks investors sold outperformed the stocks they didn't sell by 3.4 percent.) Even professional money managers are vulnerable to this bias and tend to hold losing stocks twice as long as winning stocks. Why does an investor do this? Because he is afraid to take a loss—it feels bad—and selling shares that have decreased in value makes the loss tangible. We try to postpone the pain for as long as possible; the result is more losses.

The only people who are immune to this mistake are neurologically impaired patients who can't feel any emotion at all. In most situations, these people have very damaged decision-making abilities. And yet, because they don't feel the extra sting of loss, they are able to avoid the costly emotional errors brought on by loss aversion.

Consider this experiment, led by Antonio Damasio and George Loewenstein. The scientists invented a simple investing game. In each round, the experimental subject had to decide between two options: invest $1 or invest nothing. If the participant decided not to invest, he kept the dollar, and the game advanced to the next round. If the participant decided to invest, he would hand a dollar bill to the experimenter, who would then toss a coin. Heads meant that the participant lost the $1 that was invested; tails meant that $2.50 was added to the participant's account. The game stopped after twenty rounds.