11. Behavioral Finance and the Role of Psychology

11. Behavioral Finance and the Role of Psychology


PROFESSOR ROBERT SHILLER:
OK, good morning. So, I wanted to talk today about
Behavioral Finance or about Psychology and Finance. This is a longstanding
interest of mine. I’ve been involved with
it for over 20 years. It’s not really emphasized in
your textbook, Fabozzi and his co-authors talk about a lot of
things in the financial world, but not about the underlying
human behavior. Behavioral Finance, or
Behavioral Economics more broadly, is a kind of revolution
that has occurred in finance and economics over
the last 20 or 30 years. And it remains somewhat
controversial. I don’t quite fully understand
why it is that people polarize as much as they do, but some
people don’t like this. We’re coming along to be
the majority, I think. People are now regarding
Behavioral Finance as an important element of finance. But the real problem is that
people are complex and our financial institutions, as I’ve
emphasized, are designed for real people and their
functioning depends on the behavior of real people. And it’s not as simple. You know, another revolution
that’s occurring parallel, of bigger significance, is a
revolution in neuroscience about the human brain. And the human brain is a
very complicated organ. Economists have liked to
invoke the principle of rationality as an underlying
component of their theory, and that has been useful, but it’s
of limited use, because people aren’t rational. They are often rational,
they’re not completely rational. And very often, people
behave stupidly. I’ll put it that way. That includes everyone,
including me, because we’re human and we have limits. One thing about the human
species is that we are aware of other people’s weaknesses
and have an impulse to exploit them. So when you see other people
behaving stupidly, sometimes you think, maybe I can turn
this to my advantage. OK? And that becomes a problem. The history of humankind is a
history of exploitation of one person by another. Not entirely, but I’m saying
it has that as an important element. So, I’m going to talk about
these human failings. It’s not to say that people are
stupid, I’m just saying they’re people, and we’re
all imperfect. We’re smart in some dimensions
and we can be very smart, but we can also make important
mistakes. But before I start, I wanted
to try to put this into a perspective. Maybe, I’ll return to this at
the end of the lecture, but I wanted to start out
on an upbeat note. I’m going to talk about all
kinds of human errors, but I wanted to start on an upbeat
note that the business world generally doesn’t exploit
people terribly. I believe that very
characteristically successful businesses in finance and
elsewhere consider their long-term advantage and the
reputation they have. So, doing something that is
blatantly exploitative of human weaknesses will
work against their long-term advantage. You’ll see a lot of human
failings, but we don’t see people cashing in on them
as often as you’d think. And beyond that, I want to
emphasize also that another aspect of human behavior
is morality. Evolutionary biologists think
that this evolved along with our other traits, that we have
an impulse to be moral. And so, in the long run, you
might not really gain so much satisfaction from exploiting
other people’s mistakes. And so, you don’t necessarily
do that. So, that’s why we have a lot of
weaknesses outlined and we won’t see significant or serious
exploitation of them as characteristic. Now as you know, I have chapters
from my forthcoming book assigned for this course. And I looked back on what I put
up for you to read and I keep thinking, gee, this
really wasn’t ready. So, I had a chapter for this
section of the reading list about Behavioral Finance. And I thought, I didn’t
really get it right. I know what I was trying to
say, but maybe I should — what I start out in that chapter
is talking about Adam Smith and his book The Theory
of Moral Sentiments. Now just to remind you, Adam
Smith was a professor in Scotland in 1759. He was a professor of moral
philosophy, because there were no professors of economics
in those days. And he wrote in 1759 — Maybe I should write some
of this on the board. — He’s probably the most important
figure in the history of economic thought. So, in 1759 he wrote his The
Theory of Moral Sentiments. And in 1776, he wrote the
more famous book, The Wealth of Nations. So, this is The Theory
of Moral Sentiment. The Wealth of Nations is
considered the first real treatise on economics and
it’s a wonderful book. And it’s still very
readable today. His The Theory of Moral
Sentiments is not so widely read. But it’s not really economics,
it’s a book about psychology and morality. I find it very good, even
250 years later. He went through many editions on
this book, because maybe he thought it was his most
important work. But the book starts out about
selfishness and altruism. And the real question, which he
thinks defines economics, is, are people really
completely selfish? Sometimes it seems that way,
that their presumed benevolence is just an artifice for their own benefit. But he wonders, how does an
economy work if everyone is totally selfish? And he ends up concluding
that they’re not. I thought it was very
interesting, the way he put it. The thing he emphasized right
at the beginning of the book is that people inherently
love praise. We crave the approval
of other people. And so, praise is a fundamental
human desire. But then he reflected on it and
he said, do people really want praise itself or is it
something else that they want? Well, think of it this way. Suppose people made a big
mistake and thought that you had accomplished something,
but there was a mix up. You know, it was really
somebody else who did it, not you. And it’s just a complete
mistake. You had nothing to do with it,
but you find lots of people praising you. Would that really
be pleasurable? And suppose you even know that
they’ll never find out that I didn’t do it. Well, Smith said, it
probably isn’t. Think about it. You internally are thinking, I’m
getting all this praise, but I know I don’t deserve it. So, I don’t enjoy it. And then he went on to say that,
especially among people who are more mature, he says
more mature people — not everyone makes this step. But he says, adults, normal,
mature adults, make a transition from a desire for
praise to a desire for praise-worthiness. I want to know that I am the
kind of person who will be praised and I don’t need
to get the praise. And he said, it’s that tendency
ultimately, which makes an economy work,
that people don’t care just about praise. He gives an example
of mathematicians. And he said he’s known many
mathematicians in his life and he finds that they’re
almost all obscure. The public doesn’t know
about mathematicians. They couldn’t explain to the
public what they do. And they don’t seem to care at
all, because they know the public doesn’t appreciate
mathematics. And so, there’s a few
mathematician friends who understand what they do
and may praise them. But ultimately, a mathematician
can sometimes do the work completely unknown. And it’s the praise-worthiness
that drives these people. You may think I’m being too
idealistic, when I say this, but I think that the finance
profession — this is what I was trying
to say in that chapter. That the finance profession,
like other mature professions, is really dominated — although there’s a lot of funny
things that happen. It is really dominated by people
who have reached this desire for praise-worthiness. And so, you’re not going to
exploit people extravagantly. Just because, why
would I do that? This is not a good thing. I wouldn’t feel good about it. Well, some people will. Now, I wanted to also mention,
not everyone reaches this mature state that Adam
Smith describes. And that’s one of the
complexities of human society. And I think that the finance
profession has a problem with other kinds of people. Now there’s a whole branch of
psychology called Personality Psychology that categorizes
people by their personality. And we’re not all the same. And in our society, we have
many different kinds of personalities. A successful society promotes
people up who have the praise-worthiness desire. We try to recognize them and
we try to put people of character into important
positions, with not complete success. But I wanted to just briefly
talk about — this is a lecture
on psychology. I wanted to talk about other
personality types. And I was going to use a book
called The Diagnostic and Statistical Manual Edition IV
published by the American Psychiatric Association. They’re coming out with a
fifth edition in 2014. DSM-IV is kind of a household
word around my house, because my wife is a psychologist.
DSM-IV is actually controversial among
psychiatrists, because it’s too cut and dry for
some of them. What it tries to do is, identify
mental illnesses and personality types in a
quantifiable, reproducible way, so that we can define who
has this mental illness or who has this personality type. And so, it gives you checklists
and it says, the patient must have exhibited at
least three of the following five behaviors. And then, there will be another
checklist. And so, you keep score and you can actually diagnosis personality disorders. I’m just going to mention
one of the many personality disorders. One of them is called
APD, called Antisocial Personality Disorder. And so they have checklists,
but just to give you a sense — oh, and the Antisocial
Personality Disorder is called psychopathy, or one kind
of APD is psychopathy. Another one is called
sociopathy and — I don’t know. There’s a huge literature
on these. But according to DSM-IV, 3% of
the male population in the world is APD, and 1% of
the female population. A simple definition
for APD is a jerk. There are more male jerks than
female jerks, apparently, according to their — this is all quantifiable
and done. But what is an Antisocial
Personality Disorder? It has the following
characteristics: lack of remorse, frequent lying, lack of
empathy, superficial charm, shallow emotions, distorted
sense of self, constant search for new sensations. Have you met someone
like that? You probably have, because
that’s 3% of the population. I’m not anti-male, when I point
out there are three times as many jerks among
males as females. Females have characteristically
different personality disorders. And you can look down the list.
It’s much more than 3% of the population that
would be diagnosed with one or the other. So, you know, an APD person
is manipulative, feigns affectionate or warm feelings,
but doesn’t feel them, and is trying to deceive you. Once a student came to my office
and asked to sign up as my research assistant. I was talking and I thought,
well, maybe. I said come back
and talk to me. Later on, I read about him
in the Yale Daily News. He was an impostor student. He was not a Yale student. And he had been around to other
university campuses. He was an impostor at like
three different campuses. There was something wrong
with this person. Kind of made me feel — then he
came later and asked me for a recommendation letter. I couldn’t believe it after I
read about him in the Yale Daily News. This is extreme. And so, incidentally, someone
did a study of APD by going to a prison and categorizing
the inmates using DSM-IV standards. And they found that 40% of
the prisoners had APD. Also, neuroscience people have
found that there are differences in the prefrontal
cortex that are correlated with APD. So it seems to be — it’s a problem we have in our
society that some people have a brain structure that’s
a little different. And it may make it difficult
for them to behave in a good way. We’re learning more and more
about neuroscience. It’s interesting to me that Adam
Smith’s book still rings true though after — There’s some basic common
sense that we all learn. You have to judge people
and you have to learn their character. And you have to be a person of
character for, in the long run, that’s what you want. It gives you what you
want in life. Oh, another thing I wanted
to say is that people are manipulable. Unfortunately, true. And unfortunately, we live in
a world where it’s hard to avoid manipulating people at
all, because we have a free enterprise system that
encourages competition. And if the competition is
manipulating people, how do you completely stay
clear of that? I think, this is one of the
contradictions of our society. A very simple and obvious
manipulation is, they’ll put a price on some item they’re
selling, like $9.99. So you’re like, well, why didn’t
they just say $10.00? Well, you know why
they didn’t. It’s called ”pricing points”
in marketing. Because $9.99 sounds
a lot less, psychologically, than $10.00. So, everyone does it, almost
everyone does it. But is that bad? Well, it’s bad in a way. It’s manipulative, isn’t it? I mean I’m annoyed by it. Maybe you are, too. But if you were in business,
would you do that too? You might feel that you have to
and it’s a harmless sort of manipulation. It’s not hurting
anyone really. They’re maybe buying a little
bit more than they want. See, that’s the kind of
thing that comes in. So, in looking at financial
institutions, they’re often manipulative in that sense. It’s similar to a politician. If you want to be a member of
Congress or whatever, you can’t say what you
really believe. Because you won’t get elected. You’ve got to kind of
doctor your opinions to the public opinion. But you might have a moral
purpose underlying it all, because you want to
get elected so you can do good things. So, you do end up
saying things. So, it’s hard to judge
people, good or bad. It’s an overall sense you get
of someone’s character. That people are doing things
that appear somewhat manipulative and somewhat bad,
but you get an overall sense of the person through time. And ultimately, our society,
within limits, rewards people that show character through
all the confusing details. Now I wanted to move — that
was my introduction. I wanted to move now to
discussing some particular aspects of Behavioral
Finance, or more broadly Behavioral Economics. And about human failings that
are exploitable by somebody and are somewhat exploited,
but remain. I wanted to start out with
what’s probably the most famous element of Behavioral
Economics. It’s Prospect Theory and
it was invented by two psychologists, Daniel Kahneman
and Amos Tversky, in the late 20th century. They called it Prospect Theory
because it was a theory of how people form decisions
about prospects. And a prospect is a gamble. It’s about people’s decisions
under uncertainty. And in very simple terms, the
Prospect Theory says — now there’s a huge literature on
this, so I’m trying to give you a very quick description
of it. That there’s something called
a value function, which represents how people
value things. And there’s a weighting
function, which shows how people infer or how they deal
with probabilities. And I just wrote simply what
Kahneman and Tversky say. I’ll draw a picture of the
value function and the weighting function. And this will be very quick and
you’d have to read more, but the way people value
gains or losses — let me see. I better draw the line
in the middle. OK, and we’re talking about
financial gains, so these are gains, and this is zero,
and this is losses. Well, negative. What I have on the horizontal
axis is wealth or money or something like that. Zero in the middle. And then, we have on this
axis value, which is something like utility. I’ll erase my zero, so it
doesn’t get in the way. What they find is,
that people’s value has a funny shape. We don’t weigh gains and
losses linearly. In the positive quadrant, when
we have positive gains, there’s diminishing
value like that. It doesn’t ever slope down. It’s concave down like
diminishing marginal utility in economic theory. But for losses, it looks
something like this. It’s concave up. I’m exaggerating a little bit,
but this is a diagram that Kahneman and Tversky wrote in
their famous Econometrica article 30 years ago. So, there’s diminishing marginal
utility for gains, but there’s the opposite — well, we have concave up. And there’s a kink. Note that the value function
has a kink at the origin. So, what does this mean? OK, first of all, this
origin is a — from what point do I estimate
gains and losses? That’s called the reference
point and it’s psychological. And it’s subject to
manipulation. The reference point
is the zero, from which I measure things. So, first of all, the reference
point is probably today’s wealth. But it can be something else if
people are manipulated by the way something is
presented to them. Framing, according to Kahneman
and Tversky, is presentation. So, I can give the same prospect
to people, but word it in different ways
that suggests a different reference point. And that will change
people’s behavior. So, you can manipulate people
by describing something in different terms, by suggesting
a different reference point. But typically, the reference
point is today’s wealth. The kink means that people are
very conscious of little changes in their wealth and
they’re spooked by them. I’m really afraid, because my
value drops very rapidly, even for a small loss. So, if you were to say,
lose $5 this morning. You had it in your pocket and
you lost it on the way to this lecture, you would feel
exaggeratedly bad about that. You should really regard $5 as
just nothing, because the present value of your lifetime
income is in the millions, so what’s $5? But you don’t think that way. So, you’re spooked and deterred
by small losses, and less encouraged by
small gains. So, this kind of thing allows
businesspeople to exploit people if they want to. If people are so focused on
these little changes, then you are encouraged in business to
try to pick things out the people are paying attention
to, like small things, and sell insurance policies
on just those things. Insurance should be concentrated
on the really big things, like life insurance. You know the fact that one of
your parents could die and the children’s family would be
out of money for the rest of their lives. That’s a big thing. But it may not work to sell
that kind of insurance. You can do something that is
more focused on what people are watching and make it
something little so that it doesn’t require them to
spend so much money. The classic example of that
is funeral insurance. You go around telling people
— and for some reason this sales pitch works, and it’s
worked for thousands of years. They sold this in
Ancient Rome. You tell people, if someone in
your family dies, you can have an expense of getting a proper
burial for this person. It costs money. And so, they would insure
that one thing. And it was a little thing, but
it works to sell that. Another example of it is airline
flight insurance. You’re insured for this flight
on the airplane. I heard an ad for funeral
insurance recently. They’re still doing this after
2,000 years, because it still works and it’s manipulative. That’s not what you should
do for people. You should not pick out
some little thing. Or they also have diamond
ring insurance. After an engagement, some women
will want to buy an insurance policy on the diamond,
because it can actually fall out of your
ring and you lose it. But that’s like, what is it?
$5,000 or something? It’s not big, it’s
not essential. And if you’re insuring that and
not other things, you’re making a mistake. Fortunately, the insurance
industry is not too — it has come around to do
things that are more — they are doing things that
matter and are big. And that’s because this Kahneman
and Tversky value function is — it represents an error that
people are prone to be making. But it’s not total
and not complete. And so ultimately, people
don’t go to insurance companies that manipulate
them. It gets around and eventually
people come around in wanting something better. So, while there is some
manipulation, it’s limited. The other aspect of Kahneman
and Tversky is the weighting function. I’m going to draw again
a picture of it. This time it’s how people
psychologically think about probabilities. This again is Kahneman
and Tversky. A probability is a number
between 0 and 1 or 0 and 100%. I’ll put 0 here and 1 here. We can tell someone the
probability of something, but they can’t accept it
psychologically. The errors that people
make are described by the weighting function. What the waiting function is,
it’s the psychological impact. You are behaving as if you
just don’t understand the probability. So, what Kahneman and Tversky
say is, that for very low probabilities people may
round them to zero. And for very high probabilities,
they may round them to one. But if they decide not to round
them to zero or one, they exaggerate the difference
between zero and one. You just can’t think in terms of
a continuum of probability. So, this is what the weighting
function — this is the weight as a function
of the probability. For low probabilities
it’s zero. I’m going to maybe exaggerate
it here. Then it jumps up. It’s something like this, and
as it gets close to one, it jumps up to one again. So you see, it’s like a
broken line segment. And there’s been various
versions of this theory, but this is the simplest
version of it. So that means, if you’re getting
on an airplane, you think, well, what’s
the probability of this airplane crashing? Well it’s probably something
like 1 in 10 million or, what is it? Even less than that. So most of us, in our
mind, just say, it’s zero and I’m done. I’m not going to think about. I’m not going to
worry about it. So, we’re down here. We’ve rounded it to zero. But some people don’t
round it to zero. And for them, they just blow
it out of all proportion in their minds, and it becomes
exaggerated. So, I have it here, so it
looks like it’s a half. This would be one here and
this is about 0.4. And then ultimately, if the
probability gets really high, then I’m not even going to
think about it, it’s one. In some of the most primitive
languages in the world, there’s only a couple
of numbers. There’s zero. There’s one. Maybe there’s two or
three, and then there’s no more numbers. Well, our minds are still very
primitive in dealing with probability. So it’s like there’s only
three probabilities. Can’t happen, may be,
and will happen. So, I think airline flight
insurance is an example of trying to manipulate this
personality characteristic. So, it means that they’ll
catch all the people who exaggerate it. They used to have vending
machines outside of airlines. The vending machines would
encourage you to buy just for this flight. They put it right there when
you’re getting on the flight. And so that’s when you’re
most nervous. If you’re one of these
people who’s up here. And of course, most people don’t
buy it, but they don’t have to sell it to everybody. They just sell it to these
people and they charge an outrageous price. But I haven’t seen these vending
machines anymore. This is interesting. Economists wrote about them 30
or 40 years ago and they used to be everywhere. And they just kind
of disappeared — Do you ever see one of these? I think they’re gone. Why is that? Well, somehow we get past
things like that. It’s not like Kahneman and
Tversky are representing immutable errors. These are errors that
naturally happen. But you can get past it. And you end up wanting to deal
with people you trust. So, you see some vending machine at
the airport and you think, well, my insurance agent isn’t
recommending I get this. I’ve got some kind
of insurance. So, you walk past it. There’s a professor in Germany
at the Max Planck Institute in Berlin, Gerd Gigerenzer, who
has been taking on Kahneman and Tversky in saying that
they’re right that people show these tendencies for errors. But I can train people out
of them with no problem. I just tell them this is an
error, and teach them then, and they don’t do it anymore. Gary Gorton just did a seminar
here on errors that people make in financial — No, Nick Barberis here at SOM,
and he was using Caltech students and found that — and tested their ability
to prevent certain kind of errors like this. And he found that even the
Caltech students made these errors just horribly. We’re wondering, aren’t they
supposed to be bright? Those are young math geniuses. But about a third of them
got everything right. So I’m thinking, you know,
they’re only undergraduates. By the time they get along, if
they go — they’ll eventually be trained out of
these errors. But right now, they’re behaving
just like Behavioral Finance says they will. So anyway, I think that you will
find that Prospect Theory explains a lot of things that
go on in finance, but it doesn’t explain everything. And let me move on. So, we want to talk about — let me see. I have got so many things
to tell you about here. And I’m thinking
about my time. It’s a huge field, Behavioral
Finance. Let me mention a few
other things. Regret Theory is a
theory that — it’s kind of related to
Kahneman and Tversky. It says that people fear
the pain of regret. There’s an old expression. “I was kicking myself,”
because I made some bad decision. Well, that’s a painful
experience when you did something wrong. This is represented somewhat
in the kink in the Prospect Theory value function. But Regret Theory says that
there’s actually a painful emotion, that you’re
wired not to like to have made a mistake. And so then, you end up
designing your life around that and trying to avoid
doing anything that you might regret later. And it can create problems. You
may make bad decisions, because you’re overly worried
about regret. Gambling behavior. Anthropologists have reported
that gambling occurs in every human society. And so, it’s one of the
human universals. Not that everyone does it, but
in every society you’ll find people that do it. I have a 1974 study. It found that 61% of U.S. adults
actually gambled at least once for money
in that year. I bet, it has gone up. There’s more opportunities for
gambling and it’s gone up. 1.1% of men are compulsive
gamblers and 0.5% of women. This is another male trait. Somehow men are more vulnerable
to compulsive gambling than women. But it’s only a factor
of 2-to-1. But it’s an addiction
that happens that distorts people’s thinking. And it’s such an addiction that
we have an organization called Gamblers Anonymous that
helps people with this. It ruins people’s lives. People end up getting a divorce,
because you can’t stay with someone, married to
someone, who is squandering the family money. They do it. They end up sneaking around to
gamble, like drinkers sneak around for the next drink. Gambling behavior, it seems to
be associated psychologically with a self-image, a sense of
who I am and why I’m an important and good person. A sense of competence. Most gamblers do things that
they think are revealing of their competence. And they tend to pick a certain
form of gambling that they become psychologically
identified with. And they avoid any other
form of gambling. Gambling behavior is part
of what goes on in the stock market. Certain people who have a
personality, which makes them particularly interested in
gambling, find that a life in finance can give them the
kind of stimulation. Gambling behavior, by the way,
is almost like a drug addiction in a sense. People who are depressed may go
to a gambling casino as a way of getting themselves
out of the depression. And they say that when they walk
into the casino, suddenly my troubles are gone. I feel invigorated and alive. It’s almost like it creates a
hormonal difference that they seek, and it’s almost like
injecting yourself with something, so it’s a very
hard thing to conquer. I mentioned before, when the New
York state in 1811 created the first corporate law that
produced a lot of questionable companies, people then said,
this is just gambling. It’s bad. But the other side of it is
that this same gambling behavior, it’s not usually
a pathology. It’s an aspect of human
sensation-seeking of various aspects of our psychology
that drive us. What the stock market is, in
some sense, is a way of channeling this kind of behavior
into something productive instead
of just a game. And so, they make it very clear
in the stock markets of the world, this is about
business and this is productive. The same emotional patterns that
created gambling behavior as a human universal
underlie some — this is not abnormal,
it’s most people. Underlie traits that
work out well. OK, the next major thing I
wanted to talk about is overconfidence. And psychologists have found
that there’s a human tendency to overestimate one’s
own abilities. We all think — not all of us, most of us think
we’re above average. Some of us think, we’re
way above average. And this tendency has been
revealed in a number of experiments. I thought I would
try one on you. I don’t know if it will work. I’ll try it on this class, if
you will participate in this experiment by a show of hands. I’m going to ask you — I have three questions here. And I want to ask you
to write down a 90% confidence interval. Do you have a pencil
to write this down? And then afterwards, I’m going
to tell you the answer and see if it fell in your confidence
interval. OK, so this is what it is. What is a 90% confidence
interval? It’s a range of values, so that
you are 90% sure that the true value lies in this range. So, if I asked you, what is the
population of New Haven? You might say, 90% confidence
interval that’s between 50,000 and 150,000. That means, you’re 90% sure that
the population falls in that range. And so, you should be right
90% of the time. If I ask you to give 90%
confidence intervals, you should be right 9
times out of 10. If I ask for a 99% confidence
interval, you have to widen the interval so that you
should be right 99 times out of 100. So, what I’m going to ask you
to do, if you will cooperate with me, is give 90% confidence
intervals for — I have three questions I’m
going to give you. But I have to ask you to be
honest, otherwise this thing won’t work. You could game me by just
giving excessively wide confidence intervals, right? From the ”zero-to-infinity”
type. Then you’ll always
be right, but you’re not playing honestly. So, I have to appeal to your
character to do this honestly. So, I have three
questions here. I just changed the questions. The first is — now what you have to write
down on your notepaper somewhere is your honest
estimate of a 90% confidence interval. And so, the first question is,
the world population — how many people are alive
in the world? As of, I think it
was 8:00 a.m. this morning
[addition: February 21, 2011]. The U.S. Census has something
called the World Population Clock and just go — don’t cheat. I know, some of you
have laptops. Don’t do it. But after this you can search
Google on World Population Clock and it shows you
minute-by-minute how many people there are in the world. Every birth and death. It’s not actually recorded,
it’s a fake. But I mean it’s supposed
to be an estimate. So, I got the world
population. So, what I want you to do, can
you write down a lower bound and an upper bound for the world
population this morning as measured by the
U.S. Census? OK, can you write that down? But I don’t want you to
make it too wide. Remember, I only want
you to be 90% sure. And I don’t want you to make
it too narrow, because then you’re more likely to fail. So, you’ve written that down,
the world population? OK, my next question is — 2. The world, what does it weigh? Well, actually, it’s the mass,
in kilograms, of the world. Can you write that down? This is astronomy. Let me say, I’m asking for it
in kilograms. But you can do it in metric tons. That just knocks off
three zeros. A metric ton is 1,000 kilograms.
And just so you’ll know for sure, that’s not the
same thing as a long ton, which is U.K. The United Kingdom
uses the long ton, which is 2,240 pounds. I just looked this up. And is 1.1 metric ton. And it’s not exactly the same
as a short ton, which we use in the United States, which is
2,000 pounds, which is 0.98 metric tons. Just tell me, how many tons. That’s not going to
affect your 90% confidence interval, right? Just tell me how many tons
does the earth weigh. And then that’s the second and
I have one more question. How many languages are
there in the world? Now, I know you might complain,
this is a matter of definition, because sometimes
two dialects might be considered a separate
language. Well, I’m asking you to
give me the number — the World Authority on languages
is an organization that has a website called
ethnologue.com. And if you go to that website,
they’re always discovering new languages. They keep track of it. New languages keep getting
discovered, because some guy is hiking out in Siberia and
they go to this little village, and say, hey, these
people are speaking a language that has never been
documented before. So, it’s this process of
learning languages. They also keep dying out,
because there’s just elderly people in this village, and when
they die you know this language is going to
die with them. So anyway, the question is,
I want your 90% confidence interval for the number of
languages, as defined by ethnologue.com. You have to guess how they
define a language. But you have an idea more or
less what a language is. It’s more than a dialect,
because they can still understand each other if they
speak different dialects. We’re talking about really
different languages. OK, have you written down three
confidence intervals? OK, so I’m going to write
down the answers and I hope this works. I’m trusting to your honestly
in getting these things, because you good game me
and make this not work. But give me your honest count. So, I’m going to write down
the correct answer. So, the world population
as of 8:00 a.m. this morning
[addition: February 21, 2011] was 6,901,330,581. Now, can I get a show of hands,
how many peoples’ confidence interval includes
that number? OK, can someone tell me
what percent that is? That is not 90%. You’re doing pretty
well, though. What do you think, Oliver? STUDENT: About 80. PROFESSOR ROBERT SHILLER:
You think it’s 80? Let me see them up again. Maybe it is 80, all right. You’re doing really well. Some honest people here didn’t
put their hands up. All right, well, that’s one. So, we did 80 instead of 90. What about the weight
of the earth? In kilograms. Well, it’s 5.974
times 10 to 24th power. And I’ll give you
that in tons. It’s 5,974 billion
billion tons. You got that? You might have to do
some calculation. It’d be 5.9734 times 10
to the 18th power. [correction: 5,974 times
10 to the 18th power is the weight in tons.] OK, can we do a show of hands? How many people had
a number in — how many people are in the
confidence interval there. All right, Oliver, what
do you think? What’s the fraction? STUDENT: 5%, maybe 10. PROFESSOR ROBERT SHILLER: 10%. OK. So this one, we did really
well on world population. 80, 10. The last one, how many languages
are in the world? Well, according to
ethnologue.com there are 6,909 languages this morning
[addition: February 21, 2011]. How many people got that within their confidence interval? OK, what do you think, Oliver? STUDENT: About the same, 10%. PROFESSOR ROBERT SHILLER:
10%, OK. Why did you do so much better
on world population? Well, thank you for being
honest with me. I think it worked once again. The overconfidence. So, why is it that people are
overconfident like this? And psychologists have tried to
describe, what it is that goes on in people’s minds that
produces answers like this. One of them is, that people seem
to have a sense that they understand the world more
than they really do. It’s an illusion. Actually, the world is just
infinitely complicated and there are so many surprises. When you think about a question
like this, there’s many different perspectives
that you can take. And if you thought more about
it, your imagination might help you to widen your
confidence interval. But you can’t think of all
the perspectives at once. And so, you tend to gravitate to
the first one that comes to mind and it gives you an
underestimate of the confidence. So, that is overconfidence. By the way, I think it’s a
little bit higher in males than females. I didn’t do a separate
male/female count. But females [correction: males] are definitely overconfident. That’s the so-called macho
personality that’s supremely overconfident, which is —
that’s not in DSM-IV. I don’t think it is, but it is more
common among males. But it’s really, everyone
is overconfident. There’s no important sex
difference here. Incidentally, I think that
overconfidence, and this is an important phenomenon, it
goes beyond yourself. It extends to your friends. And you exaggerate — there’s a tendency for people
to think that I have very smart friends. I was reflecting
the other day. When I was an undergraduate at
University of Michigan, I was in the honors program and we
thought we were pretty smart. And I had a number of young
people that I just imagined were heading toward really
great careers. There was one student that we
called Young Jack Kennedy. You know, this was
some years ago. Jack Kennedy was president
of the United States. We thought he was a genius. That was probably wrong, too. None of these people
are geniuses. I was thinking that most of my
friends ended up in very good careers, but nothing that you
would think was spectacular. I had one friend as an
undergrad, who I thought was a genius, and his name was
Bruce Wasserstein. Anyone ever heard of him? Maybe not. Well see, that’s it. But he founded his own
investment bank called Wasserstein Perella, became
really rich and then he bought interest in Lazard Freres, the
French investment bank. He was a real big shot
on Wall Street. I met him again about 10 years
ago and then he died. God. He had a heart attack
and died. So, I know his whole life. I saw him when he was 18 and
I’ve watched his whole life, and it’s now history. It’s kind of scary. But I remember thinking he was
a genius as an undergrad. I was wondering, what was
wrong with my judgment? Why did I see so many
other geniuses? Now that I think back on it,
he had a sort of real world common sense that amazed me. He just knew things that —
it wasn’t fake knowledge. He seemed to know how
things worked. So, I guess I was right
about one of them. But not enough that none of you
have heard of him right? He has an investment bank
named after him. You should have heard of
him, but maybe not. But anyway, this thing affects
peoples’ thinking, too. I think that we tend to think
that the head of state who is running, the head of our central
bank is a genius. And this really clouds
our thinking. It’s like our ego extends to
the other people that we associate with ourselves. Now, the head of a central bank
in another country we have no respect for. It’s only in our own country,
because it’s part of our ego involvement that produces
this overconfidence. This tendency for overconfidence
produces a lot of anomalies and opportunities
for manipulation. So, for example, Rakesh Khurana,
who is a professor at the Harvard Business School,
has written a book called Search for the Charismatic
CEO. He claims that there’s a
tendency for people to think that CEOs are geniuses. Or at least the one that
we found is a genius. And companies then seek out a
genius CEO to put in charge of the company as a kind
of manipulation of the stock market. They think if we get — you
know, if we got some guy who’s run other companies successfully
in the past, he must be a genius. Put him in our company, our
stock price will go up, then we can sell our executive — we can exercise our options
and make a lot of money by putting in this fake genius. And Khurana says, well, there
are some people who are maybe geniuses at management,
but most of the time they’re just lucky. And we tend to develop
overconfidence. And then what happens, according
to Khurana, is, you put in some guy who turned
around some company spectacularly, supposedly. You bring him in to run a new
company and he doesn’t know anything about this
new company. But he has to justify himself,
so he lays off a lot of people and shuffles things around, and
just destroys everything in the company, and
ruins things. This is related to another
author that I recommend. I’ve mentioned him
before, I think. Nassim Taleb wrote a book called
Fooled by Randomness. He’s Lebanese, but now in the
U.S. Nassim Taleb, Fooled by Randomness, that says that most
of the things that happen in life are just chance. We tend to ascribe them. If they happen to us,
we conclude — we’re very quick to conclude
that it’s a sign of our own genius. And if it happens to someone
that is a friend of us, then you think, well, I have genius
friends, isn’t that nice? And so, it leads to mistakes. OK, let me go to another — how much time do I have — cognitive dissonance. This is another psychological
principle. The term was coined by
sociologist Leon Festinger in the 1950s, I believe. I actually met this guy. That’s the nice thing about
being in academia, you meet all these great names if
you’re in long enough, eventually. But what is cognitive
dissonance? It’s a judgmental bias that
people tend to make, because they don’t want to admit
they’re wrong. Maybe I’m oversimplifying
this mistake. It’s painful to think, that I
believe something and it was wrong, so people will cling to
old beliefs and try to find evidence that supports their
beliefs, because they have an ego involvement with
the belief. And so, I will be biased. The famous experiment
indicating cognitive dissonance, done by some
psychologist, had the following form. They got a list of people who
had just bought a car and they knew what make of car. They got the list from car
dealers, so they knew exactly what car they had just bought. And they called these people
up and asked them to participate in a psych
experiment. Or I think they said a
marketing experiment. They didn’t let them know that
they knew what car they had just bought. And then, the experiment
was the following. Let’s go through a number of —
what magazines do you read? And they said, let’s
get these out. They got all the magazines that
were on the newsstand. And they said, let’s look
through page by page and tell us which ads you remember
reading. What they found is, that people
read the ads for the car they just bought. And they avoided especially the
car that they thought they might buy, but decided
not to buy. So, after you buy a car,
you want to confirm your belief in it. So, you selectively get
information that confirms your belief. And so, this cognitive
dissonance is another factor. It’s been demonstrated. It’s an error that
people make. It doesn’t mean that people — again, none of these
errors is unviable. People will make the error and
then they’ll learn from their mistakes and they’ll correct. They’re not totally cognitive
dissonant, but it’s just a kind of error that
keeps coming up. So, I give you a couple of
examples of cognitive dissonance and its effects
on finance. So, Will Goetzmann, who is a
professor here at the Yale School of Management, and a
couple of his co-authors found that mutual fund investors — when a mutual fund does very
badly in its investment performance, many or most
investors sell the stock and get out of it. But some of them hang on. And they thought that that was
due, perhaps, to cognitive dissonance. Because I bought this fund,
I don’t want to sell because I was right. So, what they did is, they
interviewed these people and they found that these people
didn’t even know how badly the fund has done. They had blocked it out and
they had an exaggerated impression. An exaggerated impression of
this, which is characteristic of cognitive dissonance. You just forget the evidence
that’s contrary to your theory and you keep assembling
evidence that supports your theory. I have another example of
cognitive dissonance and this one was produced by Professor
Sendhil Mullainathan at the Harvard Economics Department. And Mullainathan looked at
financial advisors — and his co-authors. What they did in this study — that’s a whole big profession. I remember at the beginning I
pointed out how many hundreds of thousands of financial
advisors there are. What they did, it’s an
interesting experiment. They hired actors to go to
financial advisors and ask for their help. And the experiment was
the following. They would say the same thing to
each financial advisor, but the different actors would
present their existing portfolio differently. In other words, you’d go to the
advisor and you’d say, I have a portfolio of investments
and I’m almost entirely in money
market funds. That’s all. You’d just say that. You wouldn’t express
any opinion at all. Another actor would go and
say, I’ve got all of my portfolio in tech stocks. Or I’ve got all of my portfolio
in options. Now, what should advisors
tell people? Well, if they were acting really
professionally, they should question the assumptions
that made the actor supposedly put all their
money in one kind of investment. And many of the financial
advisors did, but usually they didn’t. They didn’t question
the actor. They assumed that the actor, who
had put, supposedly, all of the investments in money
market funds, was someone who was very risk averse, or thought
that was the right thing to do. And they didn’t want to
challenge them, so they would walk out of there with maybe
a slightly different mix of money market funds. And somebody else who was in a
very risky portfolio, they didn’t challenge them. And they even sent actors in
with almost all of their portfolio in their own
company’s stock. Now if you work for Ford
Motor Company — I noticed my uncle — I had conversations with
him about this — who worked for Ford Motor
Company and put all of his life savings in Ford
Motor Company. I said, Uncle Ralph, you
shouldn’t do that. Because it’s your job and all
of your life savings. What if something happened
to Ford Motor Company? Fortunately, he didn’t
work for GM, which became worthless recently. But it can happen. You know, Ford could be
completely wiped out. That’s your life savings. And you know what
he said to me? He said, you know, I’ve worked
at Ford all my life. They treat me well, I
believe in them, I’m not going to sell. So, there’s lots of
people like that. So, when they show up at a
financial advisor, the first thing that they should do, the
financial advisor should tell them, get out of your
Ford stock. That’s just too risky. But only 40% of the financial
advisors did that. The 60% left them mostly in
their own company stock. Why did they do that? Well, Mullainathan thought, it’s
because the advisors know there’s cognitive dissonance,
and they’re afraid to drive away a new client. Maybe they’ll gradually do it
over a while, but you just don’t challenge their
deep beliefs, whatever they say is true. And so, they’re kind
of yes-men. Not all of them, and maybe
they’ll come around. It relates then, again,
to a moral dilemma. If you are a financial advisor
working in private practice, what do you do with people who
come to you, if you know from experience that challenging
their deep-seated beliefs will drive them away? So, in the real world,
this is again — I’m not sure that these
financial advisors are doing the wrong thing. If they would eventually tilt
them toward a more responsible portfolio, they can’t
drive them away. I have a lot of — so many. Let me list some of the
others and move on. What else should I talk about? Anchoring. Anchoring refers to a tendency
to anchor your opinions on something that captures
your attention. The famous anchoring experiment
by, it was again, Kahneman and Tversky — I could almost do this
experiment here in class with you if I had a wheel
of fortune. A wheel of fortune is
like on a game show. You spin the wheel and it comes
up with a number between zero and a hundred in this
particular wheel of fortune. So, this is the experiment. They asked their subjects,
how many people — it had to be something
that had an answer from zero to a hundred. One of their questions was, how
many nations in the world [addition: in percent] belong to the United Nations? So, they asked the question. They said, don’t answer
me just yet. Think about that question. What percent of nations
in the world belong to the United Nations. Then, they spun the wheel, and
it came up and it showed a random number. And then, they asked people
for the answer. Well, it turns out that people
tended to give an answer close to the number that just
came up on the wheel. This is totally irrational,
right? That wheel has nothing to
do with the answer. And yet people were
influenced by it. So then, they would follow-up
and ask them, hey, that number you gave is the same as the one
that just came up on the wheel, or it’s close to it. Why did you do that? The guy would say,
just coincidence. I wasn’t influenced
by the wheel. Of course not. But you know they were, because
statistically they proved that they were. So, anchoring means that people
are attracted to — they’re affected by subconscious
things. I shouldn’t say subconscious. They didn’t make a logical
connection. When you face real ambiguity and
you don’t know the answer and you’ve got to come up with
a decision, you are swayed by the most silly and
random things. There’s a representativeness
heuristic. This is also Kahneman
and Tversky. And that is, that people
overemphasize certain patterns that they think are
representative of what they’ve seen before. So for example, certain patterns
in the stock market that may be very rare
and unusual. If they remember it, if it
somehow attracted their attention, they begin
to look for that pattern again and again. And they see it too often. So for example, Head
and Shoulders, we talked about that. McGee, the technical analyst, he
saw the Head and Shoulders pattern in the stock market. And he saw that it crashed
after that. But actually, it’s pretty
hard to find those, they’re kind of rare. And it’s not the right way to
process data, to be looking for patterns that are
representative. And it invites manipulation. So, I’ll give you some
other bad behavior. If people believe in the Head
and Shoulders, if they believe that the Head and Shoulders
pattern of stock price movements predicts a decline,
here’s what I can do. I’ll take some thinly
traded stock. I’ll get a friend. We’ll trade back and forth and
we’ll influence the price to create — we’ll deliberately
create a Head and Shoulders pattern. And then we’ll short the stock
massively, right at the time when the head and shoulders
pattern would give a sell signal. We can make tons of
money doing that. So, why don’t we do that? Well, we don’t because
it’s a manipulation. [SIDE CONVERSATION] PROFESSOR ROBERT SHILLER: I
want to then just conclude with social contagion, because
it’s so important. This is my last — and this is really social
psychology. I’m running out of room here. That’s social contagion. Social psychology reflects on
the fact that people are interdependent, and what I
think is affected by what others think. There’s something called
herd behavior. That’s a popular term. It refers to the tendency for
people to move with the herd, not consciously. They don’t think that they’re
moving with the herd. I might bring up a little
sociology here and I’ll use a term. Everything has been psychology,
but the great sociologist, one of the founders
of the discipline of sociology, was the French
scholar Emile Durkheim at the late 19th, early 20th century. And he used the word
”collective consciousness.” And that is, that our opinions
about what’s happening are formed by a collective
understanding of what’s going on. We have a tendency to think of
ourselves as rational and common sense — all of our views come
from common sense processing of facts. I have a sense of belief about
what goes on in the world, but I underappreciate the extent to
which my views are a little bit arbitrary and shared by
millions of other people. You live in a certain point in
time in history, and there are certain kinds of facts and ideas
and anecdotes that are circulating. There’s another term, this is
a zeitgeist. That’s German, but it’s now English. That means “spirit
of the times.” So, what Durkheim and other
sociologists allowed us to understand is, that the
zeitgeist is determined by a collective memory, a collective
set of facts that we operate on. This herd behavior creates big
swings in the stock market and other things. So, it has a huge financial
impact. But anyway, I’ve listed a number
of Behavioral Finance principles that really come
from psychology, and I’ve talked about some tests or
examples of their proof of their importance in finance. But what do we conclude
from this? I think that my conclusion is,
that we are evolving toward better and better financial
institutions. There is a lot of manipulation
and exploitation, but we as a society have outlawed
a lot of it. For example, I mentioned doing
a stock market manipulation trick to create a Head and
Shoulders pattern. That is an offense. It will get you in jail
for doing that. And we prosecute that now. So, you can’t do that. I’m going to talk more about
this in the next lecture about regulation. But it’s also people’s moral
judgments that the people who evolve to become important in
finance are people who have an internal compass, a desire for
praise-worthiness that eliminates — I’m going to give just two
examples of some recent articles about this. In the current issue of the
Harvard Business Review that, I assume, is still
on newsstands — This is Harvard Business
Review. There’s an article by Michael
Porter and co-author Mark Kramer, Porter is a well-known
professor at Harvard, in which he argues that we’re coming to
realize more and more about a principle called — he calls it
”shared value.” Or they call it ”shared value.” And
that is that the manager of a company shouldn’t be
underestimating the importance of shared value creation with
society, with other people. That is, we’re all in this
together, and if we’re mature, we recognize, for example,
that I don’t want to be exploitative. I don’t want to make the local
people in my town upset with our company. I don’t want our labor force
to become disenchanted. Now, what he’s saying it’s not
really about morals exactly. It’s more about long-term
value. But I guess morals somehow
creeps into the same judgment. That mature businesspeople see
shared value and that there was maybe not enough
emphasis on that. Financial theory was leading
us too much toward thinking that a manager should be
selfishly pursuing a narrow focus, like maximizing
the short-run value of their shares. Anyway, the other example I
have, which is also recent, not quite as recent as that, is
a book that came out last year by Anna Bernasek,
who is actually a journalist, not an academic. But it’s called Economics
of Integrity. Is that the title exactly? Yes. Economics of Integrity. And her point in that book is,
that a sense of personal integrity has dominated what
people do in the business world much more than we
thought recently. There has been too much
disregard of the fact that people do things because
they’re right. She gives an example in the book
— and I’ll close with this concept. She said, let’s consider milk. Now, you drink milk
regularly, I hope. It’s good for you. But it could poison you. People used to get sick from
drinking contaminated milk. And you don’t ever hear of
anyone getting sick. So she said, why is that? Well, we have government
regulation of milk production and there are laws about
purity of milk. But she looked into it
and found that — actually, she didn’t think it
was mostly the regulation. She thought that you are safe
drinking milk because of the integrity of our
people, mostly. That if you go out to some milk
company and talk to the employees, they might not
generally even know about the regulations. But if you ask them,
they’ll tell you — I mean, are you careful to
keep this milk clean? They’ll tell you, well,
someone’s going to drink this, so obviously it’s common sense
I’ll keep it clean. And what she says, it’s not
primarily the regulation, it’s the integrity of the people that
makes the economic system work as well as it is. So, anyway, I’ve emphasized
both sides. I’ve talked about human failings
and about people exploiting these failings, about
people with antisocial personalities. But we have a system that
somehow eliminates this from being the major factor
in our markets.

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