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The death of homo economicus

Experiments in behavioural finance are questioning the dominant economic theory and astute investors are already taking advantage of them.

Imagine the following game: someone gives you 10 Swiss francs. You can keep some of it as long as you share with someone else. You can split the money however you’d like: nine francs for you and one for the other person or five francs each or any other combination. But if the second person refuses your offer, you both lose all 10 francs. The dominant economic theory, known as “neoclassical”, suggests that the first person would give the minimum possible and the second would accept it. For the second person, one franc is better than none, after all, and should understand that the first person is just maximising their profits. The problem is that in reality, it doesn’t work like that. Studies have shown that most of the time, the second person declines any amount less than half and the first person, anticipating the refusal, will give more than the minimum amount.

“The dominant economic model was designed as if people made their decisions with the sole purpose of maximising their personal gain,” said Mickaël Mangot, economist and founder of BEFI consulting. “But that is entirely untrue. The completely rational Homo Economicus doesn’t exist. Behavioural finance shows that our choices are disrupted by several cognitive biases. We are led by our emotions – such as anger or jealousy – beliefs, intuitions and diverse social norms.”

Scientists have established a whole repertoire of behavioural biases that lead us to make decisions that are not optimal for either us or the general interest. “Thinking that the market self-regulates and that we can trust it is an illusion. Studies have shown that the individual and collective behaviours of traders play an important role in volatile markets and the creation of speculative bubbles,” said Sacha Bourgeois-Gironde, professor of economics at University Paris 2 Panthéon-Assas and a specialist in neuroeconomics. “To avoid crises, it’s not enough to simply monitor how financial markets function. The classic market models also need to include the cognitive biases that traders fall victim to.”

For the time being, the dream of recreating the dominant economic model with the behavioural paradigm isn’t yet a reality. But several companies are starting to take an interest in it. Banks such as JP Morgan, for example, are already applying strategies from behavioural finance in order to grow their profits. Concretely, banks need to identify and correct their traders’ biases and/or take advantage of biases of others, particularly by picking up shares that are poorly priced because investors had an inappropriate reaction to them. “I often hold training sessions for portfolio managers to identify their biases and learn how to discover other people’s biases,” said Mangot. “This is important, because cognitive biases lead to market anomalies that investors can take advantage of.”

Finance isn’t the first field to take an interest in this subject. For the past few years, companies have been working on behavioural economics in order to refine their marketing strategies. For example, behavioural economics can be used to identify the price at which consumers will no longer buy a product and as a result, companies can maximise margins. But this economic paternalism brings about doubt and fear, especially since the next step no longer seems very far away. Let’s go back to our 10 Swiss francs. Scientists have demonstrated that people who offered an equal share showed increased activity in their prefrontal cortex. This information led some specialists to imagine, for example, that in the future, traders could be chosen based on their behavioural biases, with the help of brain imaging. “Developments in neuroeconomics must be accompanied by serious ethical discussions,” warned Sacha Bourgeois-Gironde, a specialist at Université Paris 2. “Especially since a physiological particularity can explain a tendancy to act in a certain way, but can never predict with certainty how a person will behave.”

 

Science used for civics

Several countries are applying behavioural science theories when establishing public policies. They use nudges designed to counteract behavioural biases. One example is a fly drawn at the bottom of a urinal. With this simple tactic that encourages men to aim better, the Amsterdam Schipol Airport was able to reduce its cleaning expenses for toilets by 8%. Playing on social norms, the UK tax authority collected £2.8 million by writing on reminder letters that “nine out of 10 people pay their taxes on time”.

 
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