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2024, 10:49 Rationally Irrational

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Rationally Irrational
Posted December 22, 2016 by Michael Batnick

Human beings do not do well with decisions. Whether we’re wrestling with who
to start in fantasy football, which line to get on at the store, which stock to buy, or
even what to choose from on a dinner menu, there are certain glitches in our
brain that are really hard to avoid. We anchor to meaningless numbers, we make
decisions that will minimize potential regret, we use information that comes to
mind immediately, and we use simple rules of thumb. And all to our detriment.
In William Poundstone’s Priceless, he shares some incredible experiments that
demonstrate how easily our brains are manipulated.

It’s hard to believe how different answers to the same question are when just one
number changes.

Kahneman and Jacowitz tried asking:

(a) Does the average American eat more or less than 50 pounds of
meat each year?
(b) How much meat does the average American eat in a year?

The median answer was 100 pounds of meat. They asked another
group whether the average American ate more or less than 1,000

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pounds of meat a year. For this group, the median estimate was 500
pounds.

I, like most people, give the “wrong” answer to the problem below. What makes
these questions so fascinating is that even after it’s been proven that my decision
doesn’t make sense, I still wouldn’t change it.

Imagine that you are about to purchase a jacket for $125 and a calcu-
lator for $15. The calculator salesman informs you that the calculator
you wish to buy is on sale for $10 at the other branch of the store, lo-
cated 20 minutes’ drive away. Would you make the trip to the store?

Most respondent said they would. Another randomly selected group

heard a different version of the question in which the jacket was only
$15 and the calculator was $125. The calculator was on sale for $120
at the other store. Was that worth the trip? Most said no….In both ver-
sions of the question, the buyer is planning to spend $140 total and the
drive saves exactly $5. “Why are we more willing to drive across town
to save money on a small purchase than a large one?” Richard Thaler
asked.

Again, I’m with this. I am used to paying $8 for a beer at a bar, but I would never
spend $48 for a six pack at a bodega.

One of Richard Thaler’s best-known thought experiments concerns a

grocery store. You’re lying on a beach on a hot day and desperately
want a cold beer. A friend offers to go get a beer from the only place
nearby, a small run-down grocery store. He warns it might be expen-
sive, so he asks how much you’re willing to pay. He’ll buy the beer only
if the store’s price is no greater than your limit of $1.50…Another
group heard the same story, except that the place selling the beer was
said to be the bar of a fancy resort hotel. For this group, the average
price was $2.65…The ambiance of the hotel was irrelevant because the
beer was to be consumed back on the beach…The hotel bar that
charged $2 was understood to be offering a fair price; for a run-down
grocery, that $2 was price gouging.

We can all empathize with this one; I’m not buying that crappy T.V. for $300, but
that $4,000 T.V. is outrageous. $800 sounds about right.

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One of the key insights of behavioral pricing is that items that don’t sell
can change what does. Amos Tversky liked to tell this story. The
Williams-Sonoma chain, known for high quality and prices to match,
once offered a fancy breadmaker for $279. They later added a some-
what bigger model, pricing it at $429…The $429 model was a flop…But
sales of the $279 model nearly doubled…The only thing that stopped
them from buying was the price. It seemed high at $279. Once the store
added the $429 model, the $279 machine was no longer seen as such
an extravagance.

Unfortunately, just being aware of our sub par mental software doesn’t necessar-
ily lead to better decision making. Automation isn’t the answer to everything, but
it certainly helps. Anything that you can do to reduce the number of decisions
you have to make, the better off you’ll be.

Source:

Priceless

Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy
or sell any securities, please see my Terms & Conditions page for a full disclaimer.

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These Are the Goods

MICHAEL BATNICK, CFA

Michael Batnick is the Director of Research at Ritholtz
Wealth Management.

@michaelbatnick

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