Making better decisions?

Preparing for the Dan Ariely course next week by reading the pre-course material, and I'm still plodding through the Kahneman paper. To be more precise: Maps of Bounded Rationality: Psychology for Behavioral Economics which appeared in the American Economic Review. It's a revised version of the lecture Kahneman delivered in Stockholm, Sweden, on December 8, 2002, when he received the Nobel prize for his work in behavioural economics.

It's not an easy read, particularly for someone with no formal background in psychology such as myself. But there are lots of 'take-homes' from it, namely the few theories that Kahneman won the Nobel prize for, namely: prospect theory and the framing effect.

The framing effect in particular, set me thinking. In my profile for this blog, I say that I believe that financial education -- as well as a good understanding of our irrational behaviour -- can empower us to make better money and life decisions.

When I wrote that, it was an echo of the message that I used to drive home through my editorials in Personal Money (the personal finances magazine I used to edit). I used to write about how it is important to be informed, to have the necessary knowledge for your personal finances, to enable us to make the best decisions for our money. 

And I truly believed, at that point, that with the right information, you can make the right decisions. After all, that's what one of the first things we learn in Economics 101, right - that in a perfect market, an agent will have access to all market information to reach a stage of perfect information that will enable him or her to make the best rational decision. 


Except that is not what happens in the real world. There is no perfect information in the real world, no perfect market, and most of all, no best rational decision. And one reason for that is the framing effect. 

According to Wikipedia (which in turned quoted social psychologist Scott Plous), the framing effect is an example of cognitive bias, in which people react differently to a particular choice depending on whether it is presented as a loss or as a gain. (this seemed like a more straightforward explanation than Kahneman's paper). 

In other words, our reaction depends on how a certain situation is presented to us. And more crucially as Kahneman and Amos Tversky found in their work on prospect theory, 'a loss is more devastating than the equivalent gain is gratifying' (quoting Wiki again..)

So if an investment advisor wanted to push Fund A over Fund B, he or she could highlight how much Fund B could lose compared to Fund A, instead of mentioning that Fund B has a lower investment cost and better potential gains, albeit with higher risk. In other words, she frames it negatively rather than positively. 

So do we make the best rational decision - after dispassionately considering the research done on both funds and weighing the calculated risks? But what are the chances that many of us will make the decision based on our emotions, ie fear of potentially losing more money with Fund B than Fund A? And the fact is that we will do so because of the way the information was presented to us (ie how it was 'framed') plus the fact that we fear losses more than we value gains (loss aversion theory, also expounded in the paper).

So understanding our own irrational behaviour is important to help us see beyond the framing effect. But it doesn't necessarily mean we will  make the best decision for our money. More importantly, it should help us make a better decision for ourselves and our lives, based on our own risk appetite or what allows us to sleep at night. Does that make sense?!