Priceless: The Myth of Fair Value (and How to Take Advantage of It) (15 page)

Neither gains nor losses are additive. The pleasure of a $20 windfall is less than twice that of getting $10. This was the moral of S. S. Stevens’s little riddle, where it took about $40 to feel “twice as good” as $10. Economists always knew that
large
gains and losses aren’t additive, but prospect theory extends this rule to amounts that may be completely trivial. People act as if “wealth effects” apply to small change.

One pop metaphor expresses some of the ideas behind prospect theory: “Money is a drug.” The addict, of crack or of cash, adapts to a certain level of the abused substance. Thereafter he must score more than that baseline to achieve a new high. When the addict fails to achieve the baseline, he experiences a painful withdrawal. The withdrawal is more painful than the high is pleasurable.

Kahneman observed that loss aversion “extends to the domain of moral intuitions, in which imposing losses and failing to share gains are evaluated quite differently.” There’s a law against being a thief, not against being a tightwad. And while avarice makes the list of seven deadly sins, and charity the top three Christian virtues, the Ten Commandments forbid only stealing or coveting someone else’s wife and property. Charity is just a suggestion.

A third important idea of prospect theory is the
certainty effect
. Kahneman and Tversky’s surveys confirmed Allais’ thesis, that there is a subjective chasm between the certain and the merely very probable (between 100 percent and 99 percent probability, say). This finding too can be reflected: there is also a big psychological difference between the very unlikely and the guaranteed-not-going-to-happen (between 1 percent and 0 percent probability).

Between gains and losses on the one hand and likely and unlikely events on the other, there are four domains of behavior. This can be summarized in a simple four-cell diagram (see above). The fourfold pattern of prospect theory explains not only Allais’ paradox but also such mysteries as why compulsive gamblers buy insurance.

Take Allais’ first riddle. You can have (a) a sure $1 million
or
(b) a tempting gamble that carries a 1 percent risk of coming away empty-handed. No matter what you do, you are almost certain to end up with a million dollars or more. In other words, you are in the happy position of choosing from among likely gains. That puts you in the upper left cell above.

That cell is marked “risk-averse behavior.” You are likely to feel that a million dollars is within your reach—all you have to do is choose option (a). You’d be
sick
if you gambled on (b) and lost. This makes the risk of (b) unacceptable.

Allais’ second riddle presents a choice of an 11 percent chance of $1 million or a 10 percent chance of $2.5 million. These are still gains; the all-important difference is that winning is now unlikely. You’d be telling yourself,
Don’t get too excited—you’re probably not going to win
. This changes the psychology, triggering risk seeking, as shown in the upper right cell. You are willing to gamble on the higher prize, and the 1 percent difference in probability doesn’t seem so important.

Flipping the gains to losses flips the types of behavior. When losses are likely, reckless gambles become acceptable (lower left cell). At the end of the day, racetrack bettors are willing to “throw good money after bad” in the hope they can recoup their losses. When losses are unlikely (lower right), people are willing to insure themselves against them.

Financial advisors tell clients to consider their “risk tolerance” in making money decisions. The trouble is, these four domains of behavior coexist in all of us. A person who is risk-averse in one situation will turn reckless in another. All it takes is a changed reference point.

Investors regard bonds as “safe” and stocks as a gamble offering a higher average return. Since both investments promise gains, many investors are risk-averse (upper right cell) and load their portfolios with bonds. There are other ways of looking at it. When you factor in inflation and taxes, bonds may have zero or negative real return. “Put your money in bonds, and you’re sure to lose purchasing power!” This is a highly effective argument—for anyone trying to sell someone stocks.

When real estate bubbles collapse, sellers remember what their home would have fetched at the top of the market. This becomes the reference point, and selling at the current market price becomes a “loss” (lower left cell). Rather than accept a reasonable current-market offer, they say no and gamble on getting a better offer—someday. It can take years for sellers to readjust their reference points to the new realities. During that time, few transactions take place.

Kahneman has said he believes the concept of loss aversion to be his and Tversky’s greatest single contribution to the theory of decisions. The basic idea has certainly been around for a while. In his
Philosophical Enquiry into the Origin of Our Ideas on the Sublime and Beautiful
(1757), Edmund Burke wrote, “I am satisfied the ideas of pain are much more powerful than those which enter on the part of pleasure.” What Kahneman and Tversky offered was a degree of rigor and scope never
attempted before. “The major points of prospect theory aren’t hard to state in words,” Harvard’s Max Bazerman said. “The math was added for acceptance, and that was important.” Tversky, the self-taught mathematician, gave prospect theory the full mathematical treatment needed for economists to take it seriously.

They published their theory in
Econometrica
, possibly the toughest of all economic journals. Economists had long shed demonstrations of human unreasonableness as ducks do water. These dismissals were often reduced to one word: “psychology.” The implication was that psychology was not a very serious or important topic. “Prospect Theory” did a great deal to change that mind-set. By one account, it had become, by 1998, the most cited article ever to appear in
Econometrica
.

In 2009 German billionaire Adolf Merckle committed suicide by jumping in front of a train. He was distressed over financial reverses. His net worth was still apparently in the billions.

Traditional economic theory deals in absolute states of wealth. A billion dollars is a billion dollars, and you should be happy with it. The human reality is that a billionaire who’s lost half his fortune can feel destitute, and a $5,000 lottery winner can feel on top of the world. It’s all about contrasts.

The unanswered question is why losses sting more than gains feel good. Why is the deck stacked against us? In the years since Kahneman and Tversky’s paper, evolutionary explanations have become popular. “Humans did not evolve to be happy, but to survive and reproduce,” Colin Camerer, George Loewenstein, and Drazen Prelec wrote. Picture a starving animal in the dead of winter. To forage for food is risky; it exposes the animal to predators. To play it safe by staying in the den is to slowly starve to death. It makes sense for the animal to gamble on finding food. In the summer, the same animal has plenty of food, and its strategy should change. It should
not
bet its life on finding berries it doesn’t need.

Replace “food” with “money” or any other gain, and you have prospect theory. We act as if losing $500 at poker is a life-or-death issue. Camerer suggests that loss aversion is a form of unreasoning fear, like that an acrophobic experiences looking out the window of a penthouse.
“Many of the losses people fear most are not life-threatening, but there is no telling that to an emotional system overadapted to conveying fear signals,” Camerer wrote. “Thinking of loss-aversion as fear also implies the possibility that inducing emotions can push around buying and selling prices.”

Kahneman and Tversky spent the 1977–78 academic year at Stanford, polishing their prospect theory paper. This time was a watershed in their lives and careers. In short order, both decided to accept permanent appointments in North America—Tversky at Stanford and Kahneman (along with his new wife, psychologist Anne Treisman) at the University of British Columbia.

In 1982, Tversky and Kahneman traveled to Rochester for a meeting of the Cognitive Science Society. They had a beer with a psychologist named Eric Wanner, vice president of the Alfred P. Sloan Foundation. Wanner told them of his interest in bringing together economists and psychologists to encourage them to learn from each other’s fields. He wanted advice on how to do that. Kahneman and Tversky’s answer was that there was no way to “spend a lot of money honestly” on that goal. Wanner couldn’t force people to be interested in another field if they weren’t. They did believe that there were a few economists willing to learn psychology, and they mentioned Richard Thaler.

Shortly thereafter, Wanner was appointed president of the Russell Sage Foundation. The long-dead Russell Sage, a Wall Street speculator and notorious miser, left a tax-free $100 million fortune to his second wife, Margaret Olivia Sage, in 1906. The following year, Margaret established the Russell Sage Foundation, devoted to “the improvement of social and living conditions in the United States”—a subject in which the late Mr. Sage had shown no particular interest. Sage’s foundation, still handsomely endowed, has been a principal financial backer of behavioral research in economics. One of the first Sage grants under
Wanner’s tenure allowed Thaler to spend the 1984–85 academic year working with Kahneman at the University of British Columbia. As Kahneman put it, “That was the year that behavioral economics began.”

Thaler, then a Cornell associate professor, was just shy of forty, personable and witty. He joined Kahneman and another economist collaborator, Jack Knetsch of nearby Simon Fraser University. There was then a Canadian public works project that paid unemployed university graduates to conduct nationwide telephone surveys on public issues. “They were short of questions,” Kahneman said, “and Jack and I had been feeding them questions every day. It was like a dream come true—every day we had an opportunity to get a national sample.”

The group became interested in
fairness
. Listen in to any real estate negotiation, union contract talk, focus group, or executive compensation meeting. Sooner or later, the speakers will say the magic word—“I only want what’s
fair
.” A visitor from another planet might conclude that fairness is the secret ingredient of prices and wages. Yet most 1980s economists wouldn’t have known what to do with a fuzzy concept like fairness. So Kahneman, Knetsch, and Thaler set out to discover the “rules of fairness.”

They devised little scenarios and passed them on to the survey takers. Their telephone subjects were simply asked to judge how fair a hypothetical action was.

A hardware store has been selling snow shovels for $15. The morning after a large snowstorm, the store raises the price to $20.

Eighty-two percent judged this unfair. “Supply and demand” was no excuse for raising prices.

Thaler, who had a young daughter, came up with a question about Cabbage Patch dolls. (Kahneman had never heard of them. They were grotesque dolls that became so popular they caused shortages and even riots during the 1983 Christmas shopping season.)

A store has been sold out of the popular Cabbage Patch dolls for a month. A week before Christmas a single doll is discovered in a storeroom. The managers know that many customers would like
to buy the doll. They announce over the store’s public address system that the doll will be sold by auction to the customer who offers to pay the most.

Seventy-four percent of the public found this unfair.

Another question had a football team selling limited seats for a big game. The team has three options: auction the tickets; have a lottery in which randomly chosen fans get to buy the tickets; or have a line, with tickets sold on a first-come, first-served basis. The subjects overwhelmingly rated the line fairest. The auction was overwhelmingly judged the
least
fair.

A severe shortage of Red Delicious apples has developed in a community and none of the grocery stores or produce markets have any of this type of apple on their shelves. Other varieties of apples are plentiful in all of the stores. One grocer receives a single shipment of Red Delicious apples at the regular wholesale cost and raises the retail price of these Red Delicious apples by 25% over the regular price.

This question throws the oddness of the price-gouging taboo into stark relief. A 25 percent increase is less than ordinary seasonal swings in produce prices. The scenario makes it clear that children aren’t starving for lack of Red Delicious apples. They can eat a Granny Smith. Yet raising the price of Red Delicious was rated unfair by 63 percent of the public.