Trust only 1/3 of the results from Pscyhology, but 2/3 of the results from behavioral economics

Dan Ariely (psychologist and behavioral economist) was forced to retract a well-cited paper based on fraudulent data. Ariely, a frequent TED Talk speaker and a Wall Street Journal advice columnist, cited the study in lectures and in his New York Times bestseller The (Honest) Truth About Dishonesty: How We Lie to Everyone — Especially Ourselves. We have blogged about Ariely's work and want to warn readers that we may have retract the blog posts, pending the outcome of an internal investigation.  

Professor Ariely's problems are part of a larger "replication crisis." It began when the journal Science found that only 1/3 of the psychology experiments underlying the most cited papers in the field of psychology  could be replicated.  A bigger and more recent study finds much the same thing.  [Behavioral Economics does better than psychology, as 2/3 of the results can be replicated.]

Contributing to the crisis is what is called HARK, Hypothesis After Results Known.  Due to the pressure to publish statistically significant results, researchers do science backward.  They begin by looking for a statistically significant result (p hacking).  Then, they specify an hypothesis to explain it.  Now, good practice requires that researchers register hypotheses before testing them.  Note that a similar problem plagues non-experimental data as well (regression fishing).

We regularly blog about deviations from the rational actor paradigm, and include some of the more useful results in our textbook, notably loss aversion (losses hurt more than gains help), and hyperbolic discounting (overweighting the present).  To the extent that these findings cannot be replicated, we could be wrong.

For the sixth edition, we will do our best to determine whether these Behavioral Economics results can be trusted.  For now, place a 2/3 weight on them being right.  

Evidence of loss aversion in Golf

Loss aversion refers to irrational decisions that are made to avoid perceived losses, rather than maximize expected value (which weights losses and gains equally).  This paper finds "that golfers are more likely to protect par (the number of strokes that an average highly-skilled player should take to complete a hole) than they are to make birdies (a score of one less than par)."

Note that such loss aversion requires a "target" like par, around which losses and gains are measured.  When par changes on a hole, e.g., from 5 to 4,  professional golfers are likely to make sure they make par, rather than take a chance on making a birdie, even when doing so would be optimal from an expected value point of view.

Businesses react to consumer loss aversion, e.g., when companies frame variable pricing as a discount from a normally high price, rather than framing the exact same pricing as an increase from a normally low price.

How to get employees to stop smoking?

Make them pay.

Employees were randomly assigned to one of three groups. The first was “usual care,” in which they received educational materials and free smoking cessation aids. The second was a reward program: Employees could receive up to $800 over six months if they quit. The third was a deposit program, in which smokers initially forked over $150 of their money, but if they quit, they got their deposit back along with a $650 bonus. 

Compared with the usual care group, employees in both incentive groups were substantially more likely to be smoke-free at six months. But the nature of the incentives mattered. Those offered the reward program were far more likely to accept the challenge than those offered the deposit program. But the deposit program was twice as effective at getting people to quit — and five times as effective as just pamphlets and Nicorette gum.

People hate losing money ("loss aversion")

Psychological bias and bad decisions

Using Behavioral Economics to motivate workers

What's the difference between Keurig Coffee and Nashville city government?

Sunk-cost fallacy in real estate

Psychological pricing in action

Is Mark Sanchez a sunk cost?

Beware the Experts

How to Fight Cognitive Bias

Loss aversion

Rational actors?

Airline Revenue Part 2

REPOST: sunk-cost fallacy in real estate

Tuesday, August 24, 2010

Sunk-cost fallacy in real estate

In the post below this one, we show that the housing market can have excess supply.  This post shows that it is due to thereluctance of homeowners to sell at a loss, a version of the sunk cost fallacy.

Two homeowners, with identical houses, will list the houses at different prices, depending on what they paid for the house because of what psychologists call "loss aversion." Unfortunately for these loss-averse sellers, buyers don't suffer from similar delusions,

Properties listed above the market price just sat there. In the Boston market over all, sellers listed their properties for an average of 35 percent above the expected sale price, and less than 30 percent of the properties sold in fewer than 180 days. In other words, much of the market went into a deep freeze as many people held out for market prices that no one would reasonably pay.

Note that this reluctance is similar to the  reluctance of businesses to pull the plug.

Psychological pricing in action

Shalimar (Indian restaurant) in Nashville (try the Tikka Masala) gives you a discount if you pay cash instead of charging a premium if you pay with a credit card.  This is consistent with the predictions of "loss aversion," a part of Prospect Theory that says people will go to greater lengths to avoid losses, than they will to realize gains.  So even though the two pricing schemes--cash discount vs. a credit card premium--are identical, the former "frames" the pricing policy as a gain, which brings in more business.    

Sunk-cost fallacy in real estate

In the post below this one, we show that the housing market can have excess supply.  This post shows that it is due to the reluctance of homeowners to sell at a loss, a version of the sunk cost fallacy.

Two homeowners, with identical houses, will list the houses at different prices, depending on what they paid for the house because of what psychologists call "loss aversion." Unfortunately for these loss-averse sellers, buyers don't suffer from similar delusions,

Properties listed above the market price just sat there. In the Boston market over all, sellers listed their properties for an average of 35 percent above the expected sale price, and less than 30 percent of the properties sold in fewer than 180 days. In other words, much of the market went into a deep freeze as many people held out for market prices that no one would reasonably pay.

Note that this reluctance is similar to the  reluctance of businesses to pull the plug.

Should you get a personality assessment before you invest?

12 minute "chat" with Greg Davies about how insights from Behavioral Finance are being used to design investment strategies and products to accommodate investor's irrational behavior, like "loss aversion."

Loss aversion

In the new edition of our textbook ,we have a discussion of psychological theories of pricing, including what is known as "loss aversion" from prospect theory. Apparently this behavioral theory explains why pro golfers make more par putts than birdie putts:

Even the world’s best pros are so consumed with avoiding bogeys that they make putts for birdie discernibly less often than identical putts for par, according to a coming paper by two professors at the University of Pennsylvania’s Wharton School. After analyzing laser-precise data on more than 1.6 million Tour putts, they estimated that this preference for avoiding a negative (bogey) more than gaining an equal positive (birdie) — known in economics as loss aversion — costs the average pro about one stroke per 72-hole tournament, and the top 20 golfers about $1.2 million in prize money a year

Sunk-cost fallacy in real estate

In earlier posts, we have documented the sunk-cost fallacy in the reluctance of businesses to pull the plug; and now we have its appearance in the reluctance of homeowners to sell at a loss.

Two homeowners, with identical houses, will list the houses at different prices, depending on what they paid for the house because of what psychologists call "loss aversion." Unfortunately for these loss-averse sellers, buyers don't suffer from similar delusions,

Properties listed above the market price just sat there. In the Boston market over all, sellers listed their properties for an average of 35 percent above the expected sale price, and less than 30 percent of the properties sold in fewer than 180 days. In other words, much of the market went into a deep freeze as many people held out for market prices that no one would reasonably pay.

If homeowners know they have this bias, why don't they buy house price insurance against a drop in value? Maybe they dont even know.