Have you ever received $300 tickets to an event for which you never would have paid that price yourself? Yet you still kept them instead of selling them for the $300 they were worth? Or perhaps it was well within your budget to contribute to your 401(k) plan but, instead of doing so, you let your employer’s matching funds go to waste? According to traditional economic theory, this should not happen because, when allowed to make their own decisions, humans are expected to act rationally. So if you are not willing to pay $300 for the tickets then you should want to sell those tickets for that price, and a rational person would not let the company’s 401(k) match go unclaimed if they could afford to make their portion of the contribution. But as we know, humans don’t always act rationally, and that is why historically it has been hard for economists to study and model human behavior.
3 Ways People Can Be Predictably Irrational
Last December, University of Chicago economist Richard Thaler received the Nobel Prize in economics for being a pioneer in the field of behavioral economics and integrating economics with psychology by studying people’s irrational behavior. Prior to his research, economists created models with the assumption that people always made rational economic decisions that were in their own best interests. According to Thaler, this is not the case. In his words, “Although we try to make rational decisions, we have limited cognitive abilities and limited willpower. While our decisions are often guided by self-interest, we also care about fairness and equity. Moreover, cognitive abilities, self-control, and motivation can vary significantly across different individuals.” (Many people have studied Thaler’s work through his books such as Nudge and Misbehaving and have learned how people predictably act in irrational ways. Some key insights I take away from Thaler include:
- Loss aversion and the endowment effect: People tend to place a greater value on things they already own rather than on what they don’t and the pain someone feels from losing money is roughly twice as powerful as the joy they feel from a gain. This causes people to hold on to an asset, such as a stock that is on a downward spiral, instead of “cutting their losses short” and investing in a better performing asset. The investment world refers to this behavior as “anchoring.” Loss aversion also feeds the endowment effect, which causes us to overvalue something that we already own, such as the home we grew up in, regardless of market value.
- Mental accounting: Rather than treating every dollar the same, people and organizations often divide money into different accounts for different purposes. While in some ways this might make sense, we tend to create these accounts based on subjective criteria that cause us to use money less efficiently. For example, at the end of the year a business may need new computers but lack funds allotted to IT. At the same time, another division of the business has extra money it spends on something it doesn’t need. Additionally, people treat money differently based on the source of that money. For instance, many people treat their tax refund like it’s a bonus when it’s actually an accumulation of money they could have gotten in smaller parts through their paycheck throughout the year.
- Hot-hand fallacy: This is the belief that a person who experiences success with a random event has the same or a greater probability of future success in additional attempts. The notion brings to mind the classic story of the gambler who initially wins some money and therefore keeps gambling only to lose it all and then some. Or the person who invest in stocks during a bull market and assumes the good times will continue indefinitely.
Irrationality Relevant to Investigations and Security Risk Management
In many ways, the corporate investigations and security risk management industries exist because of the fact that humans do not always act rationally. People’s irrationality can often be a root cause of what gets them in trouble with money or the way they act around others.
Many clients hire us because they know that even though someone may look good on paper, it is always best to double-check because people do not always act as you would expect. My colleagues on our investigations team have many stories about investigative subjects who have found themselves in trouble for acting irrationally, such as an executive who steals from his company even though he is highly compensated, or a well-qualified job candidate who, nonetheless, fabricates details on her resume.
Conversely, some clients feel that they are not at risk from a bad business partner or security issues simply because they have not had such issues in the past. They don’t see the need to spend money on a pre-transaction due diligence investigation or security assessment. In actuality, they may just have a “hot-hand” and their luck may run out soon. That is why, unfortunately, some of the clients who see the most value in our work are the ones who have had deals go bad because of a poor business partner or investment in which information was available, but they chose not to look into them for whatever reason.
Because, as Thaler argues, humans are irrational by nature, well-informed clients will always be looking to manage that risk. Some folks will still take a pass on mitigating human irrationality though, maybe because of mental accounting, the endowment effect or because they have a “hot hand.” Eventually that hot hand is likely to run its course, though, and a potential client will learn that in some cases the risk of human irrationality needs to be mitigated.