Behavioural Economics 101

I've always found the field of Behavioural Economics mighty fascinating. Here's enclosed some very interesting and practical applications of the same.

1. You decide to clean your car yourself to save paying the monthly 300 rupees to the car cleaner. Would you agree to clean your neighbour's car for the same 300 rupees?

2. You research a stock and you found it unworthy of a buy at 150 rupees. Today to same stock is at 1500 rupees, but is working to your buy calculations. Would you still buy it?

3. People tend to be "loss-averse" i.e. they experience more pain over a loss rather than pleasure over a gain. This is one reason why people are very uncomfortable selling stocks on which they are/have lost monies.

4. The principle of fairness is what differentiates the price you might pay for a bottle of soft-drink at a mom-and-pop store, as compared to a 4-star hotel. People feel it is fair for the 4-star hotel to charge 7-8 times more than the neighbourhood store. This is probably one reason why companies tend to lay-off people rather than reduce salaries during tough times.

5. You have a 100,000 rupees to invest in stocks. Since it's your first time, you'd invest 4000 rupees in the first month. You did a fine job of that and made a good 20% on that sum of money. The second month, you put in another 4000 and lo behold! another 22% return after month 2. ... notice that in the third month, your investible amount would have increased from 4000 to perhaps a 12000 rupees. This "mental accounting" allows people to take more risks when a string of success reaches you.

6. Often, cab and auto drivers tend to stop working for the day when they have reached their targeted income for the day. So they nonsensically, work shorter hours on rainy days and work longer hours when fares are scarce. In context, they forego an opportunity to earn more on "make-hay-while-it-shines" days. On the investing front, day-traders are like the cab drivers. The author goes on to suggest that investors should be allowed to look at their portfolio only once in 5 years.

7. The use of incentives (cue) is another factor that determines behaviour. In Ireland, a small charge (15p) was levied on plastic shopping bags. Since then, most people carry their own shopping bag to save some money. On the other hand, when in Israel a nursery imposed a fine for parents who arrived late to pick-up their children ... the response was that parents arrived more late than ever. Reason - by making the payment, the parent no longer felt guilty (in other words, they have cleaned their conscience) ... this is a great illustration of how behaviour is often different in different situation though the premise is similar.

8. Most people crib on the taxes charged by the government on one's incomes but then tax deducted at source doesn't exhibit a more mellowed emotion. Similar instances ... annual performance evaluation by companies is a hot-bed for politics, prejudice often leading to attrition of "dis-satisfied with evaluation (and not necessarily non-performing)" employees.

Behavioural Economics is a fast growing field in research and study. Why not ... people are prone to error, irrationality and emotion, and they act in ways not always consistent with maximizing their own financial well being.

References:
> Behavioural economics: seven principles for policy-makers
> Exuberance is rational (The NY Times Magazine)
This was however one instance I didn't agree to in the article. It says: A team is trailing by 2 pts in a basketball match. With 3 seconds to go and the ball with them, should they go for a 2 pt - which will tie the game and take it to overtime OR, should they go in for a 3. A 2-pointer has a 50% chance of going in, while a 3-pointer has a 33% chance of winning it. The author feels coaches often go for 2 pts as it lowers the risk of sudden loss. ... this is where I disagree because when I go in for a 2-pointer and then my chances at OT (which is again a 50:50 chance) .. I have never ever moved below a 50% chance of a victory. However, going in for a 3-pointer would give my team only a 33% chance for a victory.