Jan 23, 2018
Richard Thaler winning the 2017 Nobel Prize in Economics was a breakthrough for the discipline of behavioural economics and finance, a growing field that has wide-ranging implications for classic economic and financial theory. The basis of the subject-area is that perhaps the most essential underlying assumption of economic theory, that humans act rationally, is wrong. Pursuant to this, the predictably irrational behaviour of businesspeople should therefore create profit opportunities in financial markets. The substantial work done in the field, however, also serves another purpose; it provides exceptional insights for young professionals and leaders.
When people think of leaders, they tend to think of energetic, charismatic individuals who lead sports teams and business through their inspirational charm. Yet, one of the most important commonalities between these people tends to be overlooked: their deep understanding of human behaviour and emotion. Comprehending why people do what they do allows leaders to better predict, influence, and benefit from the thoughts and actions of others; a skill that would surely be useful in any professional domain, even outside of financial markets.
The insights that behavioural economics has added to our understanding of the human mind come largely from the identification of “heuristics and biases”, an academic term for the shortcuts that our brains take which lead to common errors. While there are dozens of such mental shortcuts, there are three specific concepts of which all leaders should be cognizant.
The first is the “anchoring bias”. This bias was exemplified in a study in which participants were asked to spin a wheel which had been divided in several spaces, each with a random number ascribed to it, much like a roulette wheel. The participants were then advised to completely disregard the number that they had spun, as it had no bearing on the second part of the study. For the second part, they were asked a question, like “how tall is a redwood tree”. While the numbered-wheel and the average height of redwood trees are completely independent of one another, there was a highly statistically significant correlation between their guesses and the number that they had spun (Kahneman and Tversky, Subjective Probability: A Judgement of Representativeness, 1972). Despite rationally knowing that the wheel provided no useful information, people allowed it to influence their guesses. This tendency for the first number in our minds to influence our choice of numbers in the near-future has far-reaching implications in the business world.
One of the more obvious implications is the effect the “anchoring bias” could have on the types of negotiations leaders face daily: over salary, a sponsorship package, or purchases in financial markets. Making the initial offer in these negotiations is critical, as it will very likely have a strong bearing on the eventual outcome. The human mind is lazy, as it consistently tries to save energy, and as a result it is prone to take the first number it hears and generally stick with that figure, making only minor adjustments to the number to get it within an acceptable range. The lesson here for professionals is simple: have a number in mind before any negotiation, keep that number in mind regardless of what the other party offers, and try to make the first move.
A second critical concept for young leaders is groupthink. Defined as the tendency to conform to the opinion of a group regardless of one’s original position, groupthink is another example of cognitive laziness. It is often easiest to bow to peer pressure and agree with others than to try to change opinions. The problem from a leader’s point of view is that this gives way too much weight to the ideas of those who are quickest to speak up in meetings. Great ideas may very well get lost and never brought forward merely because those who have them are less loud than others in the group. A good leader can counteract this behaviour by having everybody in meetings write down their opinions of a subject before launching into discussions. Forcing everybody to share the summary of their idea before opening the floor, thus ensuring a wider range of options for consideration.
Thirdly, young professionals must be aware of the substitution heuristic. This behavioural tendency causes people to replace a difficult question that requires an mentally strenuous response with a simpler question to which they can give an immediate answer. The substitution happens instantaneously and subconsciously. This heuristic also frequently lends itself to faulty logic and poor decision making.
A perfect example of the dangers of this substitution is given by Nobel-Prize winning psychologist Daniel Kahneman, one of the founders of behavioural finance., in his book Thinking, Fast and Slow. He recounts the story of a Chief Investment Officer who invests tens of millions of dollars in Ford’s common stock. When asked why he had such confidence in the stock, the CIO replied that they make great vehicles (Kahneman, Thinking, Fast and Slow, 2011, pp. 12). The CIO never considered whether the stock was undervalued or any of the other financial questions that one normally does before investing. This analysis would be have been incredibly difficult to conduct and thus the CIO simply replaced the question: “Is Ford a good investment?” with “Do I like Ford?”. Quality of product is certainly a factor when investing in a company, but surely it is not the only consideration. Any young professional must ensure when working that they have a clearly defined problem statement, question, or goal. Knowing exactly what question they are trying to answer, whether that be “how do we increase sales?”, “which staff member is best suited for this project?”, or any other work-related inquiry, will lead to a more precise and topical response on the part of the professional. If the answer does not directly answer the original question then a professional or leader may have fallen victim to the substitution heuristic.
Unfortunately, the revelations in the field of behavioural economics and finance are much too numerous to be documented in a single article. That said, the lessons from these findings can be extraordinarily helpful to any young professional and leader. To get a better understanding of human behaviour as it relates to business I would highly recommend the book mentioned earlier by Daniel Kahneman, Thinking, Fast and Slow. A pioneer in the field, Kahneman’s book is a bible to those who study the discipline. It chronicles Kahneman’s findings as well as those by others in the field, including discussions of the experiments used to prove the validity of these concepts and should therefore be a must read for anyone with an interest in behavioural finance.
Behavioural finance allows people to thoroughly understand human behaviour in business, including the effects and influencing factors of predictable human irrationality. It opens doors to better navigate day-to-day life and spot opportunities that others might overlook. Richard Thaler’s Nobel Prize shows that the field is continuing to grow in prominence and will be a force in the business world in coming years.