By James Kwak
Although I have written many blog posts pointing out that people are not actually rational maximizers (that is, they don’t know what their preferences are, and even if they did they don’t make rational choices to maximize those preferences), I actually try to be a rational maximizer as much as possible. That is, when making decisions, I try to think about what my expected utility (admittedly, some vague combination of immediate happiness, reflective happiness, reduction in stress, and increase in leisure time*) is from each course of action and decide accordingly. When I was working and very, very busy, this translated into the $25 rule: for personal stuff, I valued my time at $25 per hour.** So if I had to return something to the store, but it cost $10 and it would take me half an hour, I wouldn’t bother.
The problem is that although we human beings are not terrible at comparing expected utility across amounts (e.g., more french fries vs. less french fries***) or within narrow product categories (e.g., LG vs. Samsung TVs), we are very bad at comparing expected utility across different categories of experience and products (e.g., skiing for a day versus a new pair of good earbuds). I just read “Coherent Arbitrariness,” a 2003 QJE paper by Dan Ariely, George Loewenstein, and Drazen Prelect that makes this point beautifully, with some interesting implications. (That link requires some sort of affiliation, but you can just Google it as well.)
The content is probably already familiar to anyone who knows some behavioral economics. The basic point is that our valuations of goods can be manipulated by arbitrary anchors. In one experiment, they first asked people if they would be willing to pay more or less than the last two digits of their social security numbers (in dollars) for each of six common consumer goods, and then asked what their willingness to pay was for each good. (Both answers could determine whether the transaction would actually take place at one of those price points.) People with high SSNs were willing to pay roughly three times as much as people with low SSNs. At the same time, their relative orderings between goods made sense (WTPs were higher for rare wine than for average wine****). Other experiments show that relative orderings over various quantities of the same thing make sense. So the point is that once people’s anchors are set, they will look like they have orderly demand functions, but those anchors can be completely arbitrary. Another experiment shows that market forces (after anchoring, participants bid for things) do not cause convergence between people with different anchors.
The implication they draw for financial markets may be obvious, but it touches on something that has interested me for a while. If preferences are susceptible to anchoring but more or less orderly thereafter, then market prices will respond predictably to changes in information, but they have no fundamental level:
“Thus, studies showing that the market follows a random walk are consistent with fundamental valuation, but are insufficient to demonstrate it; indeed, Summers presents a simple model in which asset prices have a large arbitrary component, but are nevertheless serially uncorrelated, as predicted by fundamental valuation.”
I say this is interesting because, on the one hand, I accept the random walk studies (and I personally believe I have no ability to predict where any security price is going tomorrow), but on the other hand I think that any idea that markets have fundamental levels is flawed. For example, housing prices are still falling. Some people try to predict how far they will fall by looking at the Case-Shiller Index and figuring out where the long-term trend line will be. But how do you look at a chart and figure out what the right value is? What if there has been something different about the market over the last one hundred years from the market today? It’s really a fool’s errand.
On the other hand, in your personal life, you should be aware of anchoring, because it can help you use your money more wisely. For example, for several years I would complain about being cold in the winter in New England. I was coldest when I was walking my dog, because then I had to be outside for half an hour at the time, and my hands were one of the coldest parts of my body. Finally I asked my wife to buy me the warmest mittens she could find for Christmas, and since then my hands have never been too cold. They probably cost $150 or something, but in the three winters since then they have probably given me something like one hundred hours of extra warmth, and they should give me at least another three hundred hours. That comes to less than a penny per minute of warmth (and less than a quarter per walk with the dog), and I would gladly pay more than that. Compare that to, say, two nice dinners that last for a total of four hours, and there’s no contest.
But until I asked for the mittens, I was overconsuming dinners and underconsuming warm mittens — because I was inferring my own preferences from market prices. In short, you are different from the average person, so at the same price level, some things will give you a lot of utility and some will give you not very much. The more you are aware of that, the happier you will be.
* Why isn’t money on the list? Because I usually try to translate money into some combination of reduction in stress and increase in leisure time. That is, the more money I have, the less I have to work in the future or the less I will worry about money.
** You might say this is irrational because my after-tax wage was much higher than $25. But I had no way of cashing in more time for more money. And also, when you’re already working too much the psychological disutility of more work can be pretty high.
*** Actually, this isn’t a great example. We often eat too many french fries because we assume more is better, and we are susceptible to anchoring by portion size.
**** Another interesting case, since rare wine does no better than average wine in blind taste tests. But presumably people are paying for some utility other than taste when they buy rare wine.