Or ‘How Expected Utility Theory was Successfully Challenged by a Nobel Prize-winning Hypothesis’
By Jessica King
2002’s Nobel prize-winning economist Daniel Kahneman wrote about Prospect Theory, which is hard to summarise succinctly because he wrote an entire thesis to explain it.
He and his academic partner Amos Tversky examined how economic decision-making is not always rational, whereas orthodox economic theory held decisions were made on the basis of utility – the maximum return on a given amount of resources. Expected utility theory originated in Bernoulli’s 1738 essay, which argued that when faced with a choice involving risk, the logical action is to “maximize the expected utility of wealth.” In other words, the more capital you have, the more likely you are to put it at risk for expected returns. It follows that poor people will be more risk averse and less inclined to invest in financial products with a concerning risk profile.
Hence, poor people do not sell insurance products, because they cannot afford to pay an insurance premium if the owner makes a claim.
Kaheman et al had a problem with the assumption of expected utility, on the basis of a number of experiments they had conducted where even highly intelligent people like students at Princeton and University of Michigan failed basic logic and maths tests because they took a cognitive short cut. Let System 1 be our ‘intuitive’ reasoning, one which has evolved to be rapid response and influenced by emotions and immediate concerns as much as by experience. And let System 2 be our ‘analytical’ reasoning, which is slower but more thorough and draws more on our learned experience.
Also central to prospect theory is the concept of ‘accessibility’, which is highly subjective to priming, selective attention and stimulus salience. The latter two reflect our bias towards things we want to perceive, and towards things which are relevant to our learned experience. Priming is how our responses can be influenced subtly by immediate stimuli. Say a group of reluctant savers were told about a great new app which made saving easy and intuitive, automating it as a result of spending in certain categories. They might, when they found out how much people were saving using the app, respond positively to the idea of starting to put money aside themselves.
One of the things which might explain those in low income brackets’ unwillingness to save, which has formed the subject of a recent study by thinktank Toynbee Hall,* is the emotional pressure of scarcity. Kahneman acknowledges in his Nobel lecture speech how ‘the“hot” states of high emotional and motivational arousal greatly increase the accessibility of thoughts that relate to the immediate emotion and current needs, and reduce the accessibility of other thoughts (George Loewenstein,1996)’. So if you’re worried about meeting your financial obligations, you are unlikely to plan to set some aside.
Many participants in the Nobel-winning study, when faced with potential financial wins or losses, did not uniformly make decisions based on the maximum utility of their wealth. Their reactions to the scenarios presented was more dependent on the way the question was phrased. If making a bet was positioned in an attractive way, even if the circumstances were identical to a question with different phraseology, people were more likely to take the risk.
Take the following two examples:
Would you accept this gamble?
- 50% chance to win $150
- 50% chance to lose $100
Would your choice change if your overall wealth were lower by $100?
Please estimate your total wealth, call it W
Which of these situations is more attractive:
- You own W
- 50% chance that you own W – $100
- 50% chance that you own W + $150
“The manipulation of accessibility that produces this framing effect is
straightforward. The gamble of Problem 2 is likely to evoke an evaluation of
the emotions associated with the immediate outcomes, and the formulation
will not bring to mind thoughts of overall wealth.
In contrast, the formulation
of Problem 4 favors a view of the uncertainty as trivially small in relation to W,
and includes no mention of gains or losses. In this perspective it is hardly sur-
prising that the two problems elicit different representations, and therefore
The applications of this research have influenced the development of a number of modern savings technology apps. It seems while our emotions and learned experience can dissuade us from transferring money to a segregated account, little primers like an attractive user interface, and frequent updates that tell us how well we’re doing at meeting our savings goals, can actively change our behaviour.
AI tech start-up WithPlum, which lets users chat to a virtual financial adviser to review linked account balances and spending and saving targets, made a splash on the savings app scene in 2017 after it raised £500.000 the previous year, in a seed funding round led by 500 Startups’ microfund.
“Behavioural science tells us humans are not wired to save; instead, we actually prioritise our current desires over future goals. Plum’s intelligence sidesteps our pre-programmed human tendencies, ensuring our future selves are looked out for,”
Another start-up informed by behavioural economics is launching its public crowdfunding round at the moment. Oval Money, which already has a user base of around 46,000, links saving directly with spending behaviour. Users can select spending categories where they might over-spend, and select fixed sums or percentage amounts to be transferred to their savings account. They even link saving with social media usage, so the more selfies you post, the more you save…
Jessica King has acted as marketing consultant to several boutique investment consultancies, has been published across a range of financial magazines, and was formerly PR counsel to the Cobden Centre. Her areas of interest, beside behavioural psychology, include alternative finance, fintech infrastructure and blockchain technology.