Behavioural Economics In Context

We take a practical example to show how effectively this can be used within investment management

Last month we celebrated the birthday of Sigmund Freud, by all accounts the father of modern psychoanalysis.  His work on psychopathology led, at least in part, to significant developments in psychology, psychiatry and psychotherapy, and continues to have influence today.

Roughly 100 years after his birth, Behavioural Economics was having its own birth, beginning with a movement away from the rigid definition of “economic agent” to a more nuanced appreciation that these agents were in fact human beings, and as such prone to imperfection. Amos Tversky, Daniel Kahneman and Richard Thaler were pioneers in the field, transforming it from an academic backwater to a topic central to economic analysis today.

Behavioural economics has at its core the idea that the human is fallible, and will make individually sub-optimal decisions. In doing so, they take account of how individuals actually make decisions, enabling theories to be built that better explain market and economic behaviour.

To exemplify the use of behavioural economics in real-world economic analysis, we focus on a topical discussion: the oil dividend and the consumer.

Since mid-2014 the oil price has fallen precipitously, and currently remains roughly 55% below its 2014 high. The ultimate beneficiary of this is the consumer, who, after paying for petrol, has more cash in his or her pocket to spend as they wish (the “oil dividend”). Traditional economic theory would have consumers take this additional resource and spend it – dollar-for-dollar – elsewhere. However, this does not appear to be the case. Indeed, what households appear to have done is take this cash and save it.

Why is this? There is no simple, clear explanation, backed up by data. However, if we look to the tenets of behavioural economics there are some intuitive and behaviourally-linked explanations.

First, households’ unwillingness to spend may be attributable to a behavioural bias called “mental accounting”. Mental accounting describes a phenomenon where individuals split their spending into different buckets based on subjective criteria. On this topic specifically, Dr. Thaler writes that “On average, if a family’s income goes up by $1,000 a year, their propensity to buy something other than regular grade gasoline increases by only 0.1%”[1]. His point is that people have budgets for certain portions of their lives, and any surplus in each of these budgets is used within the remits of the budgeted activity. So, where a family comes into a surplus from falling oil, they are more likely (a) to take more trips, (b) to buy a bigger car or (c) trade-up and buy the “good stuff”, i.e. higher quality petrol.

Second, although not a behavioural economist per se, Keynes displayed tendencies in his writings to focus on what the consumer did in order to better inform his economic theories. He drew the distinction between short- and long-term changes in consumption, suggesting that one’s propensity to consume a certain amount is less dependent on the windfall received today, and more dependent on the expectation of future cash receipts[2]. Applying this to today’s “missing” spending, a possible explanation is that households view the oil dividend as fleeting in its nature, and reversible at any time, and as such prefer to save the cash for a rainy day.

Thaler’s mental accounting explanation neatly explains the reason for the rapid rise in auto sales in the US, particularly of gas-guzzling pick-up trucks, while the latter explanation goes some way to explaining households’ recent preference for savings over spending; until wages begin to pick up in a sustainable manner, many will avoid excessive spending.

By James Mee

[1] The Making of Behavioural Economics, Misbehaving -  Chapter 9, p.76

[2] Keynes; The General Theory of Employment, Interest and Money - p.109-111

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