Debunking Homo Economicus

This is the third the Behavioral Finance and Macroeconomics series. We will explore the effect behavior has on markets and the economy as a whole--and how advisors who understand this relationship can work more effectively with their clients. (Access previous articles here.)

We will discuss the shortcomings of a concept in traditional economics called Homo Economicus or Rational Economic Man (REM). By understanding these shortcomings, you will be better equipped to speak with clients about irrational macroeconomic outcomes, such as bubbles, recessions, and crashes (which will be the subject of future articles).

REM describes a simple model of human behavior in which each individual in an economy strives to maximize his or her economic well-being by selecting strategies that are contingent upon predetermined, utility-optimizing goals. Basically, REM tries to achieve discretely specified economic goals, to the most comprehensive extent possible while minimizing economic costs. Theoretically, REM ignores social values such as charity, unless adhering to those values allows him to reach his goals.

The validity of Homo Economicus has been the subject of much debate. Do people actually behave this way? For instance, does Homo Economicus account for the fact that people have difficulty prioritizing short-term versus long-term goals (e.g., spending versus saving), or reconciling inconsistencies between individual goals and societal values?

To provide an alternative approach about how psychology influences economic decision-making, let's turn to the main players in a book I highly recommend reading by Michael Lewis called The Undoing Project.

In the book, Lewis discussed how Daniel Kahneman and Amos Tversky (K&T) revolutionized our understanding of individual economic decision making. Importantly, K&T discovered that most people are quite loss-averse. They estimated that avoiding loss is approximately 2 times as powerful as winning, for most. More practically, it would take a win of $50 to compensate for losing $25. Most people are willing to sacrifice gain to avoid loss, and this concept is known as loss aversion.

REM says losses and gains should be equal, but K&T proved otherwise. K&T’s findings help to explain why stocks have significantly higher long-term returns than bonds. Because stocks are risky, people overpay for bonds (like insurance) because they fear the risk of losses in stocks. In general, people prefer certainty to uncertainty, even if the value of the certain choice is less than the value of the uncertain choice. K&T demonstrated that people are willing to make a much larger sacrifice for certain choices--versus rational economists/Homo Economicus adherents who believe that people are willing to make only small sacrifices in exchange for certainty.

In the real world, we can see examples of loss aversion in our everyday lives. Say you’ve taken your friend out for a birthday dinner. On the way home, you look at your bill and you discover you’ve been charged $12 for a dessert you didn’t order. Annoyed, you resolve to call the manager the next day to get a refund and the apology you feel you deserve.

Now imagine that same birthday dinner again. But instead of overcharging you, the waiter brings out a complimentary dessert valued at $12 to celebrate your friend’s birthday. Do you offer to pay for the dessert? Do you track down the manager the next day because you simply must say thank you? Maybe--but probably not.

The point is, we are much more sensitive to loss than we are to gain. And we are biased in so many other ways. Factors such as religion, tastes and preferences, culture, and gender make us biased decision-makers, not Homo Economicus. Understanding that we are not REM after all is essential to gain insight into irrational macroeconomic situations such as bubbles, recessions and crashes, which we’ll discuss in future articles.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.