Field of Behavorial Economics Presents Opportunities for Actuaries
|Targeted News Service|
By combining economics, psychology, sociology, biology and neuroscience, the discipline of behavioral economics focuses more on the process of decision-making, not the result. And its conclusions can be incorporated by actuaries in their own work.
Behavioral economics is emerging as a leading decision science, said
Rather than seeing the entire human species as the hyper-rational homo economicus, behavioral economists see individuals along a behavioral continuum, from homo economicus to the altruistic homo reciprocan, the type Wheeler describes as "the Kumbaya-I'll-chop-the-wood-if-you-collect-the-berries" type.
Example 1: What causes more deaths in
Most people say motor accidents. The answer is colon cancer. And the reason they get it wrong is a common mental flub called the availability heuristic. When we think of several reasons for something, we put more importance on the ones that come to mind quickly.
And few things come to mind more readily than a good story. So, Wolf said, when you want to convince your client or your boss of something, tell it in a story.
Example 2: First, would you rather have
Second, would you rather pay out
But really, the two problems are identical, or at least flip sides of the same coin: a chance of gain versus a chance of loss. Most people prefer to lock in a gain than take a chance for a bigger one. And they would rather take a chance to avoid a loss than to lock in a smaller loss.
"We are risk-averse, supposedly," Wolf said. Then he clarified. "We are risk-averse to gains. We are risk-seeking to loss."
Example 3: In this scenario, you ask one group of financial auditors one pair of questions, and a second group of auditors a second pair.
Ask the first group of auditors if significant executive fraud happens in more or less than 10 cases per thousand. Then ask for their estimate of how often it happens.
Next, ask the second group if significant executive fraud happens in more or less than 200 cases per thousand. Then ask for an estimate of how often the fraud happens.
Researchers ran just such an experiment. The first group on average said fraud happened in 16.52 cases per thousand. The second group gave an answer more than twice as high, 43.11.
This behavior is called anchoring. The first group anchored its estimate to the 10 case per thousand estimate it had just been asked about. The second group anchored its estimate higher, because it had just been asked about 200 cases per thousand.
"We tend to be affected by numbers," Wolf said, "even if they aren't valid."
Other behavioral biases include confirmation bias (we seek out evidence that confirms our biases while ignoring evidence that contradicts them); and overconfidence (we are often too confident in estimates of events about which we know little).
* The endowment effect, in which we value things more highly when we own them.
* Hindsight bias, or the "I told you so" effect, meaning we reassign a higher probability to an event after it is over than we did before.
* The recency effect, in which we place more visibility and gravitas on recent events. Gorvett's example was a list of the greatest quarterbacks ever - all of whom played in the past five years.
* Representation bias - viewing an event based on how much it resembles other events. "We think we can fill in blanks," Gorvett said, "by one data point."
How can actuaries handle these anomalies? Wolf and Gorvett suggested:
* Search for disconfirming information, and have a private collection of information ready to use in group settings. And try to obtain information one on one, which helps to overcome the hindsight bias, the confirmation bias and others.
* Conduct highly structured meetings, making key decisions early, before the biases can take root.
* Ask outsiders for information and maximize diversity in getting information.
* Every company should have, at meetings, a "chief skeptical officer" who questions everything. (It doesn't have to be the same person in every meeting.)
* Refine, reframe and flip every problem you confront.
* Carefully test the models you build and seek significant peer review of your work.
* Create a diverse work force - the diversity encourages different viewpoints.
With all that, Gorvett said, it's important to recognize these are human traits that can't be expunged from our psyche. They can only be recognized and accounted for. These thought processes are products of "millions of years of evolutionary psychology" and they developed for a reason. Change is "not going to be that easy," Gorvett said.
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