Why people believe weird things about money

Why people believe weird things about money

Evolution accounts for a lot of our strange ideas about finances.


By Michael Shermer
/ LA Times
January 13, 2008

Would you rather earn $50,000 a year while other people make $25,000,
or would you rather earn $100,000 a year while other people get
$250,000? Assume for the moment that prices of goods and services will
stay the same.

Surprisingly
— stunningly, in fact — research shows that the majority of people
select the first option; they would rather make twice as much as others
even if that meant earning half as much as they could otherwise have.
How irrational is that?

This result is one among thousands of
experiments in behavioral economics, neuroeconomics and evolutionary
economics conclusively demonstrating that we are every bit as
irrational when it comes to money as we are in most other aspects of
our lives. In this case, relative social ranking trumps absolute
financial status. Here’s a related thought experiment. Would you rather
be A or B?

A
is waiting in line at a movie theater. When he gets to the ticket
window, he is told that as he is the 100,000th customer of the theater,
he has just won $100.

B is waiting in line at a different
theater. The man in front of him wins $1,000 for being the 1-millionth
customer of the theater. Mr. B wins $150.

Amazingly, most
people said that they would prefer to be A. In other words, they would
rather forgo $50 in order to alleviate the feeling of regret that comes
with not winning the thousand bucks. Essentially, they were willing to
pay $50 for regret therapy.

Regret falls under a psychological
effect known as loss aversion. Research shows that before we risk an
investment, we need to feel assured that the potential gain is twice
what the possible loss might be because a loss feels twice as bad as a
gain feels good. That’s weird and irrational, but it’s the way it is.

Human
as it sounds, loss aversion appears to be a trait we’ve inherited
genetically because it is found in other primates, such as capuchin
monkeys. In a 2006 experiment, these small primates were given 12
tokens that they were allowed to trade with the experimenters for
either apple slices or grapes. In a preliminary trial, the monkeys were
given the opportunity to trade tokens with one experimenter for a grape
and with another experimenter for apple slices. One capuchin monkey in
the experiment, for example, traded seven tokens for grapes and five
tokens for apple slices. A baseline like this was established for each
monkey so that the scientists knew each monkey’s preferences.

The
experimenters then changed the conditions. In a second trial, the
monkeys were given additional tokens to trade for food, only to
discover that the price of one of the food items had doubled. According
to the law of supply and demand, the monkeys should now purchase more
of the relatively cheap food and less of the relatively expensive food,
and that is precisely what they did. So far, so rational. But in
another trial in which the experimental conditions were manipulated in
such a way that the monkeys had a choice of a 50% chance of a bonus or
a 50% chance of a loss, the monkeys were twice as averse to the loss as
they were motivated by the gain.

Remarkable! Monkeys show the
same sensitivity to changes in supply and demand and prices as people
do, as well as displaying one of the most powerful effects in all of
human behavior: loss aversion. It is extremely unlikely that this
common trait would have evolved independently and in parallel between
multiple primate species at different times and different places around
the world. Instead, there is an early evolutionary origin for such
preferences and biases, and these traits evolved in a common ancestor
to monkeys, apes and humans and was then passed down through the
generations.

If there are behavioral analogies between humans
and other primates, the underlying brain mechanism driving the choice
preferences most certainly dates back to a common ancestor more than 10
million years ago. Think about that: Millions of years ago, the
psychology of relative social ranking, supply and demand and economic
loss aversion evolved in the earliest primate traders.

This research goes a long way toward debunking one of the biggest myths in all of psychology and economics, known as "Homo economicus."
This is the theory that "economic man" is rational, self-maximizing and
efficient in making choices. But why should this be so? Given what we
now know about how irrational and emotional people are in all other
aspects of life, why would we suddenly become rational and logical when
shopping or investing?

Consider one more experimental example
to prove the point: the ultimatum game. You are given $100 to split
between yourself and your game partner. Whatever division of the money
you propose, if your partner accepts it, you each get to keep your
share. If, however, your partner rejects it, neither of you gets any
money.

How much should you offer? Why not suggest a $90-$10
split? If your game partner is a rational, self-interested
money-maximizer — the very embodiment of Homo economicus — he
isn’t going to turn down a free 10 bucks, is he? He is. Research shows
that proposals that offer much less than a $70-$30 split are usually
rejected.

Why? Because they aren’t fair. Says who? Says the
moral emotion of "reciprocal altruism," which evolved over the
Paleolithic eons to demand fairness on the part of our potential
exchange partners. "I’ll scratch your back if you’ll scratch mine" only
works if I know you will respond with something approaching parity. The
moral sense of fairness is hard-wired into our brains and is an emotion
shared by most people and primates tested for it, including people from
non-Western cultures and those living close to how our Paleolithic
ancestors lived.

When it comes to money, as in most other aspects of life, reason and rationality are trumped by emotions and feelings.

Michael
Shermer is the publisher of Skeptic magazine, a columnist for
Scientific American and the author of "The Mind of the Market:
Compassionate Apes, Competitive Humans, and Lessons from Evolutionary
Economics."

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