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Saturday, September 28, 2013

Where's My Nobel Prize??

I enjoyed Daniel Kahneman's TED Talk about the experiencing self and the remembering self.  Definitely food for thought -- i.e. when deciding what to do next, consider whether you are doing it for your "experiencing self" -- which only exists for a window of about 3 seconds at a time -- or your "remembering self" which will remember the whole event or vacation or whatever.

But I'd never been very impressed with Kahneman and Tversky's Nobel Prize winning work. Here's a summary of what I think is their most famous experiment, followed by a summary of a somewhat-related experiment by Richard Thaler.  I lifted them both from Thayer Watkins' San Jose State Economics Department web page, although I had to fix some typos.   So the quotes are there because this is Watkins' explanation.

"One very important result of Kahneman and Tversky's work is demonstrating that people's attitudes toward risks concerning gains may be quite different from their attitudes toward risks concerning losses. For example, when given a choice between getting $1000 with certainty or having a 50% chance of getting $2500 they may well choose the certain $1000 in preference to the uncertain chance of getting $2500 even though the mathematical expectation of the uncertain option is $1250. This is a perfectly reasonable attitude that is described as risk-aversion. But Kahneman and Tversky found that the same people when confronted with a certain loss of $1000 versus a 50% chance of no loss or a $2500 loss do often choose the risky alternative. This is called risk-seeking behavior. This is not necessarily irrational but it is important for analysts to recognize the asymmetry of human choices.

"Peter Bernstein cites an experiment by Richard Thaler in which students were told to assume they had just won $30 and were offered a coin-flip upon which they would win or lose $9. Seventy percent of the students opted for the coin-flip. When other students were offered $30 for certain versus a coin-flip in which they got either $21 or $39 a much smaller proportion, 43%, opted for the coin-flip."

I'll start by saying I'm glad Thaler didn't win a Nobel prize for his work.  Yes, people think he's in line for one, but we can hope if he wins it, it won't be for that study, since that study tells us nothing at all about human nature, just about how humans can be tricked with math.  In other words, the choice in both cases is exactly the same -- you get $30 to keep, with the opportunity to bet $9 on a coin flip.  The two results -- the two choices offered the subjects -- are truly identical.  The only thing the study shows is that Thaler was able to trick his subjects into thinking there was a difference, so that they preferred one option that sounded better.  That's probably useful information for marketing professionals, and other people who like to use numbers to influence the masses -- and it's useful for those of use trying to avoid being manipulated by presentation -- but it tells us nothing about human nature.  It's just another example of illogical thinking by test subjects.

The Kahneman-Tversky study is better than the Thaler study, because unlike in Thaler's study, the subjects are being presented with a real choice, not a false choice. But neither result is surprising, and contrary to what Watkins says -- and what I presume Kahneman and Tversky said -- they are NOT asymmetrical.  In fact, if you consider these examples just after listening to Kahneman's TED talk on happiness, you'll understand why.

Note:  I haven't gone back and looked at Kahneman's study.  Relying on Watkins for that.

Also, I should probably doublecheck to see if my conclusion below in fact matches Kahneman's.  But no time right now.

So the first test is:  you get $1000 in the bag or a fifty-fifty chance of winning $2500.  Here's why they chose the thousand.  When you think about it, an unexpected gift of $1000 gives you a whole lot of happy, as does an unexpected gift of $2500.  But it's not necessarily mathematically twice the happiness.  You're just unexpectedly happy.  Think back to a time when you unexpectedly got some money.  Were you twenty times happier the time you got $500 vs. the time you got $25?  No, either way, you were just happy.  But now think of the problem with the 50-50 chance.  There's a real chance -- 50% -- that you'll get nothing.  Worse, you'll get that nothing KNOWING that you could have had $1000.  That's almost like losing $1000 (which admittedly you didn't have).  But it really hurts.  So if you think about the happiness equation, the unhappiness that comes from essentially LOSING $1000 dominates your thinking and you pick the lesser value, especially since you know you'll be very happy if you get either $1000 or $2500.  Yes, if the person tells you he'll let you play 100 times, then the logical thing to do would be to pick the $2500 bet 100 times in a row.  But when it's a one shot deal, the happiness equation is very different.  So they are right to call this risk-averse behavior, and it's extremely rational behavior, if the pursuit of happiness is the subject's guiding principle, which it almost certainly is.  So no surprise here.

Then the second test:  you get the choice between a thousand-dollar certain loss, and a 50% chance of losing $2500.  In this case, the subjects - who are not actually at risk for losing any real money - say they choose the 50% chance, which means they lose an expected value of $1250.  Watkins -- and presumably Kahneman and Tversky -- call this "risk seeking behavior" and consider it an asymmetrical result.

But in fact, it's perfectly symmetrical.  Looking  at it again from a happiness-maximizing perspective, the subjects here are behaving very rationally (at least for test subjects, see below), just like they did the first time around.  A loss of $1000 and a loss of $2500 both inflict a whole lot of hurt.  The difference in the amount is not quantifiable.  It's really just figures on an account statement somewhere.  Or if you're poor, it's one more debt you won't be able to pay.  Either way, it hurts.  But there's one way to avoid the hurt.  And that's to take the 50-50 chance that you won't lose anything at all.  In fact, if you pick that chance, and win nothing, it will FEEL like you won a thousand dollars, since otherwise you would have suffered that thousand dollar loss.  So from a sheer happiness-maximizing perspective, the same thinking governs both kinds of behavior.

But this does call into to question the value of studies like this -- where people are basically making decisions with play money.  In real life, I think someone would think a lot more carefully about the second choice.  A purely logical person (like me) would choose to take the thousand dollar loss, really because of the odds -- logically speaking I save $250, and I'll always be able to tell myself I did the logical thing.  For some people, the $1000 choice will be even more obvious -- a person living close to the edge might be able to handle a $1000 loss, but if it were $2500, then they'd be bankrupt -- e.g. they;d miss their car payments, the car would be repossessed, and they wouldn't have transportation to work.  For them, the $1000 choice would be all the more logical.

Put another way, taking the $1000 hit on the second choice is the responsible and logical thing to do, and if it turns out that e.g. only 40% of people would do that in real life, that just means that 60% of the people are not acting logically.  It doesn't say anything about human nature as a whole.  And when the money is considered only in the abstract, then logic takes a holiday and, apparently, people will take the bigger risk, thinking they are maximizing their (abstract) happiness, as above.

So where's my Nobel Prize?

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