Thinking, Fast and Slow (39 page)

Decision makers who are prone to narrow framing construct a preference every time they face a risky choice. They would do better by having a
risk policy
that they routinely apply whenever a relevant problem arises. Familiar examples of risk policies are “always take the highest possible deductible when purchasing insurance” and “never buy extended warranties.” A risk policy is a broad frame. In the insurance examples, you expect the occasional loss of the entire deductible, or the occasional failure of an uninsured product. The relevant issue is your ability to reduce or eliminate the pain of the occasional loss by the thought that the policy that left you exposed to it will almost certainly be financially advantageous over the long run.

A risk policy that aggregates decisions is analogous to the outside view of planning problems that I discussed earlier. The outside view shift s the focus from the specifics of the current situation to Bght pecicy tthe statistics of outcomes in similar situations. The outside view is a broad frame for thinking about plans. A risk policy is a broad frame that embeds a particular risky choice in a set of similar choices.

The outside view and the risk policy are remedies against two distinct biases that affect many decisions: the exaggerated optimism of the planning fallacy and the exaggerated caution induced by loss aversion. The two biases oppose each other. Exaggerated optimism protects individuals and organizations from the paralyzing effects of loss aversion; loss aversion protects them from the follies of overconfident optimism. The upshot is rather comfortable for the d
ecision maker. Optimists believe that the decisions they make are more prudent than they really are, and loss-averse decision makers correctly reject marginal propositions that they might otherwise accept. There is no guarantee, of course, that the biases cancel out in every situation. An organization that could eliminate both excessive optimism and excessive loss aversion should do so. The combination of the outside view with a risk policy should be the goal.

Richard Thaler tells of a discussion about decision making he had with the top managers of the 25 divisions of a large company. He asked them to consider a risky option in which, with equal probabilities, they could lose a large amount of the capital they controlled or earn double that amount. None of the executives was willing to take such a dangerous gamble. Thaler then turned to the CEO of the company, who was also present, and asked for his opinion. Without hesitation, the CEO answered, “I would like all of them to accept their risks.” In the context of that conversation, it was natural for the CEO to adopt a broad frame that encompassed all 25 bets. Like Sam facing 100 coin tosses, he could count on statistical aggregation to mitigate the overall risk.

Speaking of Risk Policies

Except for the very poor, for whom income coincides with survival, the main motivators of money-seeking are not necessarily economic. For the billionaire looking for the extra billion, and indeed for the participant in an experimental economics project looking for the extra dollar, money is a proxy for points on a scale of self-regard and achievement. These rewards and punishments, promises and threats, are all in our heads. We carefully keep score of them. They shape o C Th5ur preferences and motivate our actions, like the incentives provided in the social environment. As a result, we refuse to cut losses when doing so would admit failure, we are biased against actions that could lead to regret, and we draw an illusory but sharp distinction between omission and commission, not doing and doing, because the sense of responsibility is greater for one than for the other. The ultimate currency that rewards or punishes is often emotional, a form of mental self-dealing that inevitably creates conflicts of interest when the individual acts as an agent on behalf of an organization.

Mental Accounts

Richard Thaler has been fascinated for many years by analogies between the world of accounting and the mental accounts that we use to organize and run our lives, with results that are sometimes foolish and sometimes very helpful. Mental accounts come in several varieties. We hold our money in different accounts, which are sometimes physical, sometimes only mental. We have spending money, general savings, earmarked savings for our children’s education or for medical emergencies. There is a clear hierarchy in our willingness to draw on these accounts to cover current needs. We use accounts for self-control purposes, as in making a household budget, limiting the daily consumption of espressos, or increasing the time spent exercising. Often we pay for self-control, for instance simultaneously putting money in a savings account and maintaining debt on credit cards. The Econs of the rational-agent model do not resort to mental accounting: they have a comprehensive view of outcomes and are driven by external incentives. For Humans, mental accounts are a form of narrow framing; they keep things under control and manageable by a finite mind.

Mental accounts are used extensively to keep score. Recall that professional golfers putt more successfully when working to avoid a bogey than to achieve a birdie. One conclusion we can draw is that the best golfers create a separate account for each hole; they do not only maintain a single account for their overall success. An ironic example that Thaler related in an early article remains one of the best illustrations of how mental accounting affects behavior:

The answer is immediate: we know that the fan who paid for his ticket is more likely to drive. Mental accounting provides the explanation. We assume that both fans set up an account for the game they hoped to see. Missing the game will close the accounts with a negative balance. Regardless of how they came by their ticket, both will be disappointed—but the closing balance is distinctly more negative for the one who bought a ticket and is now out of pocket as well as deprived of the game. Because staying home is worse for this individual, he is more motivated to see the game and therefore more likely to make the attempt to drive into a blizzard. These are tacit calculations of emotional balance, of the kind that System 1 performs without deliberation. The emotions that people attach to the state of their mental accounts are not acknowledged in standard economic theory. An Econ would realize that the ticket has already been paid for and cannot be returned. Its cost is “sunk” and the Econ would not care whether he had bought the ticket to the game or got it from a friend (if Eco B Th5motketns have friends). To implement this rational behavior, System 2 would have to be aware of the counterfactual possibility: “Would I still drive into this snowstorm if I had gotten the ticket free from a friend?” It takes an active and disciplined mind to raise such a difficult question.

A related mistake afflicts individual investors when they sell stocks from their portfolio:

A plausible way to formulate the choice is this: “I could close the Blueberry Tiles account and score a success for my record as an investor. Alternatively, I could close the Tiffany Motors account and add a failure to my record. Which would I rather do?” If the problem is framed as a choice between giving yourself pleasure and causing yourself pain, you will certainly sell Blueberry Tiles and enjoy your investment prowess. As might be expected, finance research has documented a massive preference for selling winners rather than losers—a bias that has been given an opaque label: the
disposition
effect
.

The disposition effect is an instance of
narrow framing
. The investor has set up an account for each share that she bought, and she wants to close every account as a gain. A rational agent would have a comprehensive view of the portfolio and sell the stock that is least likely to do well in the future, without considering whether it is a winner or a loser. Amos told me of a conversation with a financial adviser, who asked him for a complete list of the stocks in his portfolio, including the price at which each had been purchased. When Amos asked mildly, “Isn’t it supposed not to matter?” the adviser looked astonished. He had apparently always believed that the state of the mental account was a valid consideration.

Amos’s guess about the financial adviser’s beliefs was probably right, but he was wrong to dismiss the buying price as irrelevant. The purchase price does matter and should be considered, even by Econs. The disposition effect is a costly bias because the question of whether to sell winners or losers has a clear answer, and it is not that it makes no difference. If you care about your wealth rather than your immediate emotions, you will sell the loser Tiffany Motors and hang on to the winning Blueberry Tiles. At least in the United States, taxes provide a strong incentive: realizing losses reduces your taxes, while selling winners exposes you to taxes. This elementary fact of financial life is actually known to all American investors, and it determines the decisions they make during one month of the year—investors sell more losers in December, when taxes are on their mind. The tax advantage is available all year, of course, but for 11 months of the year mental accounting prevails over financial common sense. Another argument against selling winners is the well-documented market anomaly that stocks that recently gained in value are likely to go on gaining at least for a short while. The net effect is large: the expected after-tax extra return of selling Tiffany rather than Blueberry is 3.4% over the next year. Cl B Th5inge liosing a mental account with a gain is a pleasure, but it is a pleasure you pay for. The mistake is not one that an Econ would ever make, and experienced investors, who are using their System 2, are less susceptible to it than are novices.

A rational decision maker is interested only in the future consequences of current investments. Justifying earlier mistakes is not among the Econ’s concerns. The decision to invest additional resources in a losing account, when better investments are available, is known as the
sunk-cost fallacy
, a costly mistake that is observed in decisions large and small. Driving into the blizzard because one paid for tickets is a sunk-cost error.

Imagine a company that has already spent $50 million on a project. The project is now behind schedule and the forecasts of its ultimate returns are less favorable than at the initial planning stage. An additional investment of $60 million is required to give the project a chance. An alternative proposal is to invest the same amount in a new project that currently looks likely to bring higher returns. What will the company do? All too often a company afflicted by sunk costs drives into the blizzard, throwing good money after bad rather than accepting the humiliation of closing the account of a costly failure. This situation is in the top-right cell of
the fourfold pattern
, where the choice is between a sure loss and an unfavorable gamble, which is often unwisely preferred.

The escalation of commitment to failing endeavors is a mistake from the perspective of the firm but not necessarily from the perspective of the executive who “owns” a floundering project. Canceling the project will leave a permanent stain on the executive’s record, and his personal interests are perhaps best served by gambling further with the organization’s resources in the hope of recouping the original investment—or at least in an attempt to postpone the day of reckoning. In the presence of sunk costs, the manager’s incentives are misaligned with the objectives of the firm and its shareholders, a familiar type of what is known as the agency problem. Boards of directors are well aware of these conflicts and often replace a CEO who is encumbered by prior decisions and reluctant to cut losses. The members of the board do not necessarily believe that the new CEO is more competent than the one she replaces. They do know that she does not carry the same mental accounts and is therefore better able to ignore the sunk costs of past investments in evaluating current opportunities.

The sunk-cost fallacy keeps people for too long in poor jobs, unhappy marriages, and unpromising research projects. I have often observed young scientists struggling to salvage a doomed project when they would be better advised to drop it and start a new one. Fortunately, research suggests that at least in some contexts the fallacy can be overcome. The sunk-cost fallacy is identified and taught as a mistake in both economics and business courses, apparently to good effect: there is evidence that graduate students in these fields are more willing than others to walk away from a failing project.

Regret

Regret is an emotion, and it is also a punishment that we administer to ourselves. The fear of regret is a factor in many of the decisions that people make (“Don’t do this, you will regret it” is a common warning), and the actual experience of regret is familiar. The emotional state has been well described by two Dutch psychologists, who noted that regret is “accompanied by feelings that one should have known better, by a B Th5="4ncesinking feeling, by thoughts about the mistake one has made and the opportunities lost, by a tendency to kick oneself and to correct one’s mistake, and by wanting to undo the event and to get a second chance.” Intense regret is what you experience when you can most easily imagine yourself doing something other than what you did.

Regret is one of the counterfactual emotions that are triggered by the availability of alternatives to reality. After every plane crash there are special stories about passengers who “should not” have been on the plane—they got a seat at the last moment, they were transferred from another airline, they were supposed to fly a day earlier but had had to postpone. The common feature of these poignant stories is that they involve unusual events—and unusual events are easier than normal events to undo in imagination. Associative memory contains a representation of the normal world and its rules. An abnormal event attracts attention, and it also activates the idea of the event that would have been normal under the same circumstances.

To appreciate the link of regret to normality, consider the following scenario:

The results are not surprising: 88% of respondents said Mr. Brown, 12% said Mr. Smith.

Regret is not the same as blame. Other participants were asked this question about the same incident:

The results: Mr. Brown 23%, Mr. Smith 77%.

Regret and blame are both evoked by a comparison to a norm, but the relevant norms are different. The emotions experienced by Mr. Brown and Mr. Smith are dominated by what they usually do about hitchhikers. Taking a hitchhiker is an abnormal event for Mr. Brown, and most people therefore expect him to experience more intense regret. A judgmental observer, however, will compare both men to conventional norms of reasonable behavior and is likely to blame Mr. Smith for habitually taking unreasonable risks. We are tempted to say that Mr. Smith deserved his fate and that Mr. Brown was unlucky. But Mr. Brown is the one who is more likely to be kicking himself, because he acted out of character in this one instance.

Decision makers know that they are prone to regret, and the anticipation of that painful emotion plays a part in many decisions. Intuitions about regret are remarkably uniform and compelling, as the next example illustrates.