Priceless: The Myth of Fair Value (and How to Take Advantage of It) (10 page)

In the actual experiments, a dozen distinct bets were used. They were somewhat more complicated than the examples above, in that the player stood a chance of losing money as well as winning it. (This is more like familiar sports or casino bets: you have to put up some money to play and risk losing it.) The experimental subjects were first shown bets two at a time and asked to choose which they preferred. Then they were shown the same set of bets one at a time and asked to price them. In this part, they were told that they “owned” the bet in question and could sell it back to the house for sure cash. What was the minimum price they would accept?

Out of 173 subjects, 127
always
chose the P bet, yet
always
assigned a higher price to the $ bet. Almost everyone reversed preferences at least some of the time. They weren’t necessarily aware of what they were doing. It would have been hard to remember all one’s responses and enforce a consistency. The volunteers went with their instincts, and those instincts showed a striking pattern.

“These reversals clearly constitute inconsistent behavior and violate every existing theory of decision making,” the psychologists wrote in a 1971 issue of
The Journal of Experimental Psychology
. This time the byline read “Sarah Lichtenstein and Paul Slovic.”

The experiment revealed that most people do not assign prices consistent with their choices. The psychologists’ careful methodology underscored this startling finding. In one set of trials, Lichtenstein and Slovic went all out to make sure their subjects were answering after due reflection. This group of participants played their bets with a roulette wheel and won real money, though not much of it. (Psychologists often have to resort to
penny-pinching in experiments. The subjects played for “points” convertible into dollars, and the maximum winning was $8.) Players were shown each pair of bets three times and reminded of previous choices. They were allowed to change their minds. Only the third choice was binding. With all these safeguards in place, the players
still
assigned higher prices to bets they rejected.

In another set of trials, the instructions for pricing bets were changed. Subjects were asked to pretend that they wanted to
buy
each bet and to state the maximum price they would be willing to pay for it. Logically, there shouldn’t be a difference in buying and selling prices for a simple money bet. The bet is worth whatever it’s worth. But Lichtenstein and Slovic found that people buying bets were less likely to assign high prices to the $ bets. The number of preference reversals greatly diminished.

This was an early description of what’s now known as the
endowment effect
(a name coined by the University of Chicago economist Richard Thaler in 1980). In the absence of market values, selling prices are typically twice as much as buying prices (above and beyond any strategic exaggeration for the sake of bargaining). Lichtenstein and Slovic thus tried three ways of assessing value and found them all potentially contradictory.

In the years since 1971, psychologists and economists alike have tried to explain preference reversal—or explain it away. It was apparent to all that the subjects were using mental shortcuts. Whether pricing gambles or choosing between them, they simplified things.

Here is one of the choices Lichtenstein and Slovic tested:

[P bet]: A 10 in 12 chance of winning $9, otherwise you lose $3
—
or
—

[$ bet]: A 3 in 12 chance of winning $91, otherwise you lose $21.

By design, it is hard to look at this and intuit which bet is “better.” How do you choose, then? One subject in an early experiment explained: “If the odds were . . . heavier in favor of winning . . . I would pay about ¾ of the amount I would expect to win. If the reverse were true, I would ask the experimenter to pay me about . . . ½ of the amount I could lose.”

Any bookmaker would shudder at this. This subject was ignoring much of the information he’d been given. We
all
do that. In splitting a restaurant bill or guessing how much time to buy on a parking meter, everyone rounds mathematical corners. We do it because there’s not much money at stake, and our time and effort may be worth more than the rounding error.

Another factor might be the limits of memory. Short-term memory—roughly, the set of recalled concepts residing in your consciousness
right now
—is said to be limited to around seven elements. Though you may have a great long-term memory for figures, and have gigabytes of financial models on your laptop, these exist only for reference. At the decisive moment (assuming there
is
a “decisive moment”) you can access only about seven numbers or concepts.

The choices in the preference reversal experiments must have brushed against this limit. Participants were given six explicit numbers (a probability of winning, a win amount, and a loss amount, for each of two bets). A conscientious subject might try to calculate additional numbers, like the probabilities of losing or the expectation for each bet. Only so many of these numbers will “fit” in consciousness at once. Thinking about the calculated numbers means forgetting, at least temporarily, some of the original numbers. In Lichtenstein and Slovic’s words, “The strain of amalgamating different types of information into an overall decision may often force an individual to resort to judgmental strategies that do an injustice to his underlying system of values.”

This isn’t true of just some exotic bets cooked up in a psychology lab. Most big price decisions present us with too much information. When setting a price for a used car, a house, or a corporate acquisition, we sift dozens, if not hundreds or thousands, of relevant numbers. Data must be reduced like a fine sauce, to the few most telling numbers and reasons. Doing that means making intuitive judgments about what information may be safely ignored. Anyone who’s ever sat in on a meeting where colleagues justify a new vendor, ad campaign, or vice president hears boiled-down half-truths and heuristics. “I went with the Korean offer because it’s basically a sure thing” . . . “I always offer 75 percent of what I expect to pay—sometimes it works” . . . “This way, we’re guaranteed to make our money back and have a shot at a lot more.” We oversimplify because, simply, there’s no other way of getting by in the world.

•   •   •

After the experiment, Lichtenstein debriefed the preference reversal subjects. In each case, she tried to convince them that they had been “wrong” in order to see whether they would stand their ground or recant. ORI made audio recordings of these conversations. In them, Lichtenstein’s tart delivery is as perfect as an Elaine May routine. I will give a few excerpts from a 1968 debriefing (and encourage you to listen to the full audio on the Web):

S
ARAH
L
ICHTENSTEIN
: I see. Well, how about the bid for Bet A? Do you have any further feelings about it now that you know you are choosing one but bidding more for the other one?

S
UBJECT
(male college student): It’s kind of strange, but no, I don’t have any feelings at all whatsoever really about it. It’s just one of those things. It shows my reasoning process isn’t so good, but, other than that, I . . . no qualms.

L
ICHTENSTEIN
: No qualms. Okay. Some people would say that that pattern of responses is not a reasonable pattern.

S
UBJECT
: Yeah, I could see that.

L
ICHTENSTEIN
: Well, supposing I asked you to make it reasonable. Would you say, well, it’s reasonable now, or would you change something?

S
UBJECT
: Actually, it is reasonable.

L
ICHTENSTEIN
: Can I persuade you that that is an irrational pattern?

S
UBJECT
: No, I don’t think you probably could . . .

You may be wondering whether we should cut those poor preference-reversal subjects a little slack. (“A foolish consistency is the hobgoblin of little minds,” Ralph Waldo Emerson wrote, endearing him to the inconsistent ever since.) There are a few things to be said for the quaint virtue of self-consistency, though. Inconsistency in
prices
is different from inconsistency in music tastes. Behind every corner stands a sharp character ready to profit from prices gone askew. That practically everyone’s normal, thoughtful pattern of price setting presents an ongoing arbitrage opportunity was a shock. Consider an amusing confidence game called the money pump:

L
ICHTENSTEIN
: Well, now let me suggest what has been called a money-pump game and try this out on you and see how you like it.

S
UBJECT
(same as above): Okay.

L
ICHTENSTEIN
: If you think Bet A is worth 550 points, you ought to be willing to give me 550 points if I give you the bet. Does that sound reasonable?

S
UBJECT
: If I were to give you . . . yeah, that would be reasonable.

L
ICHTENSTEIN
: So first you have Bet A.

S
UBJECT
: Okay.

L
ICHTENSTEIN
: And I have Bet B, and I also have your 550 points. That was reasonable, wasn’t it?

S
UBJECT
: Yeah.

L
ICHTENSTEIN
: That I should take your 550 points?

[Both say “Okay.”]

L
ICHTENSTEIN
: So, you have Bet A and I say, “Oh, you’d rather have Bet B, wouldn’t you?”

S
UBJECT
: Yeah, it’s a sure thing.

L
ICHTENSTEIN
: Okay, so I’ll trade Bet B. Now . . .

S
UBJECT
: I’m losing money.

L
ICHTENSTEIN
: I’ll buy Bet B from you. I’ll be generous; I’ll pay you more than 400 points. I’ll pay you 401 points. Are you willing to sell me Bet B for 401 points?

S
UBJECT
: Well, certainly.

L
ICHTENSTEIN
: Certainly. Okay, so you give me Bet B.

S
UBJECT
: Uh-huh.

L
ICHTENSTEIN
: I give you 401 points, and you’ll notice that I kept your 550 and . . .

S
UBJECT
: That’s right.

L
ICHTENSTEIN
: I gave you 401 . . . I’m now ahead 149 points.

S
UBJECT
: That’s good reasoning on my part. [laughs] How many times are we going to go through this?

L
ICHTENSTEIN
: Well, . . .

S
UBJECT
: Okay, I see your point you’re making.

L
ICHTENSTEIN
: You see, you see the point, I can go through it indefinitely if I simply stick to the pattern of responses you have told me. Now that you see that in that money-pump sense that pattern of responses just doesn’t . . .

S
UBJECT
: Doesn’t fit.

L
ICHTENSTEIN
: Doesn’t fit.

S
UBJECT
: It ain’t so good.

L
ICHTENSTEIN
: . . . Do you still feel that you would not want to change any of your three responses here?

S
UBJECT
: I’d have to think a lot more time on it.

The money-pump game can indeed be repeated ad infinitum. Lichtenstein and the “mark” keep swapping A and B, and with every cycle, Lichtenstein picks up 149 points. Talk about taking candy from a baby! There’s one difference between this “con” and the ones pulled on street corners: here there’s no deception. Each step of the way, the victim understands what’s going on and makes a choice grounded in his so-called values.

Lichtenstein’s inquisition failed to budge this subject. At one point, he toyed with recanting “just to make myself look rational,” but he couldn’t bring himself to do it. To be “rational” would be to deny what he felt inside. Like a perverse Galileo, he knew his valuations still moved.

“Roulette Bet May Decide Man’s Fate,” ran a curious headline in the March 2, 1969,
Las Vegas Review-Journal
. A photo showed the avuncular Ward Edwards playing a game “designed by scientists to probe what makes man tick.”

A 25-cent bet on a Las Vegas roulette table could be a factor in the greatest decision ever to confront mankind.

That would be the unimaginably catastrophic decision to plunge the world into nuclear war. Some place, at some time, as long as a human being is able to poise his finger over a nuclear button, that is a possibility.