Overconfidence. How Westpac ended with egg on its face

One of the Behavioural Economics principles is Overconfidence. Rather than having a realistic assessment of the chance that we might be wrong, or something might go awry, we are naturally wired to be sure that we are right.

Last week, this happened to one of Australia's foremost economists, Bill Evans from Westpac.

Bill Evans, Westpac

For months now, Westpac has been declaring that Australian interest rates will keep coming down.

In September, they said...

The RBA Board will have to balance potential "bubble" risks, for which there is little evidence after 21 months, with the obvious advantage lower rates imply for a lower AUD and a boost to domestic activity. We think they are likely to opt for another cut in November.

In October was the first backtrack...

We have pushed back our timing for the next rate cut by the Reserve Bank to February next year. Our previous forecast was for one cut of 25bps in November and a second of 25bps in February. Our revised call is for a 25bp cut in February to be followed by a further cut of 25bps in May. 

By Christmas, they were still just as confident that there would be interest rate cuts. However, the signs of lower confidence were creeping in, as they pushed back the timing to May and August.

In February, more creaks were appearing in the forecast but the confidence in the language remained...

We do not expect rates to be lowered before the second half of 2014 when many of the apparent puzzles in today's statement will be resolved. Our current view is for a move in August to be followed up with a further move later in the year.

And finally, the great confession

On the 17th March, Bill Evans made the great confession.  Rates are not going down at all. No, they will go up. Let's pull apart this statement.

Westpac has revised its profile for the RBA cash rate in 2014. Previously we expected that rates would be reduced by 25bps in both August and November. The forecast is now for flat rates throughout 2014. 

- It doesn't say, "we were wrong". It doesn't say "we're not sure about this forecast either". It says, "we are still steadfastly confident in our new prediction despite the fact that the last prediction was plain wrong"

As before we do not forecast a rate hike until the third quarter of 2015 with a 25bp hike in both the September and December quarters.

- This sentence is even more extreme! It basically says, "we were right all along, and we are still right that rates are going up in 2015, but let's all just forget about the bit where we said it would go down first"

How it happens

There are two main reasons why this overconfidence takes place.

First, it's a natural human condition. Once we form a conclusion, we treat it as binary: it's either A or B. In reality, every decision is a bit of B and a bit of B, but our mental processes don't handle that at all.

The second reason is that Bill Evans was the first to call the previous rate cut cycle that the Reserve Bank started in Novermber 2011. So, once you've predicted correctly on one occasion, that provides confirmation that your predictions are going to be correct again in the future - even if you are smart enough to know your odds of being right, well, you can just ignore that!!

Our screens are our commitment posts

Before the Internet, before wearable computing and before any sort of personal computers at all, the only way to create a commitment post for yourself was to write yourself a note, tell a friend of your plan or in extreme cases, place an ad in the newspaper. Laudable ideas, but not easy to influence your behavior at the very moment that the commitment is required.

A commitment post is a decision we make in advance that binds us to a behavior we want in the future

With apps and now wearable computing, its easier to create a commitment post. When you decide to diet, any number of apps will tell you of the number of calories you have consumed and prompt you not to eat that donut.

For exercise-phobes, wearable devices like the Fitbit record your activity and link it to other apps like runkeeper.com.  They provide a commitment post by buzzing you to reward you for achievement, and send messages to your friends to advise that you have or have not reached your goals.

For drunk-texters, there are a host of apps that allow you to prevent you from texting an ex, a boss, or someone you simply shouldn't text at 1am after a night out.  These apps work.

Wearable devices are the next frontier for behavioural commitment 

Rather than relying on another person, or a buzzing phone, the newest phase in technology is wearable, and will be with us all the time.  Like an extension of the Fitbit, concepts like Google Glass have the potential to read signals from our bodies and then it's a short jump to a commitment post.

If the device can tell that our sugar level has risen - for diabetics for example - it could easily send an electric shock if we look at a sugary beverage of food item. Sure, that might be a little way off, but the concept and the technology are rapidly converging.

The ideas are only limited to our imagination, but the behavioral economics applications are clear. Small nudges, delivered directly to the person (voluntarily), that can make important changes to behavior.

Let me know what you think

Mark S

Half of two scoops doesn't equal one scoop of ice cream

My wife and I went out for breakfast this morning and ordered pancakes.  Ricotta pancakes with banana and maple syrup to be exact. Quite decadent for breakfast, but it is Sunday, and what the heck, let's add ice cream, but we will share a scoop.

The meals arrived and there wasn't one scoop of ice cream, but two scoops.

Reference dependence in ice cream

Initially, our reference point was one scoop...to be divided.
In fact, there are two reference points here:

• One scoop of ice cream
• One half of the ice cream each

One of our reference points has now changed. Which will we remain dependent on?

Clearly, the result of this breakfast experiment is that we remained bound to the second reference point. We simply divided the ice cream that was delivered.

Three scoops?

The first case meant that one of our reference points had been breached, but only by a relatively small amount, that is doubled from one scoop to two scoops. Our automatic system seemed to cope seamlessly with this problem!

On the other hand, what would happen if we were served three scoops, or four scoops?

Do we still take half of the ice cream, keeping the other reference point in tact? When do we get to the point where the original references are so badly breached that they no longer serve a useful purpose?

If we had been served six scoops, rather than one, there is no doubt that our original reference points would be discarded. At that moment, we would adopt a different approach entirely. We might only take a small spoon of ice cream. We might take one scoop; or two scoops ... or four scoops. Initial bets would be off, and now we would be bound by a different set of heuristics, and social norms, depending on the context.

The reference point of abundance - the supply-side factor

This example of more and more as a reference point is often seen in food retailing. As a general rule, a shop that displays mountains of sandwiches will encourage more purchasing that a shop which displays only a few.

A sale with hundreds (or thousands) of items of knickers, bras, shirts and ties available encourages a greater volume of purchasing than a sale where fewer items are on display.

So, you do need to understand the reference point of your customer/friend/associate, but also be aware that it can be "broken" if you move the environment far enough.

Celery sticks, yoga classes and all time best movies

One of my "favourite" heuristics (rules of thumb) that normal people use is the "availability heuristic".  This explains that people will use whatever is available, whether that's physically available or mentally.

Sometimes I call this the "coffee book" or "bump into" effect. If you put something on a coffee table, like a newspaper, a magazine, or brochures for yoga classes, it's highly likely that you will pick it up and have a look.

If you want celery sticks, don't leave out the chocolate

The same happens if you put a bowl of M&Ms on the kitchen bench, or a plate of celery sticks.  If it's there, you'll most probably eat it.

Having just left the Christmas season behind us, I'm sure you can recognise the lure of the little bowls of peanuts/potato chips/jelly beans etc. If your Christmas is anything like ours, there weren't any plates of celery sticks! They were hidden away in the fridge, inside the vegetable crisper requiring the average person to 1. go to the fridge 2. open the fridge, 3. open the crisper 4. take the celery out of the bag. That's a lot of steps compared to grabbing a handful of sweets as you walk past.

Likewise, if you want to read a book or a magazine article, leave it out on the bench. Yes, I know it might be a challenge for clean freaks, but you don't read what isn't available. Think of how many times you will pick something up, just because it's there.

So, if you want to sign up for yoga, leave the brochure lying around. This is also an effective way to influence others in your house.  Just leaving material lying around sharply increases the chance that it will be read, and therefore acted upon.


The best movies are the ones you can remember

Have you ever tried to compile your list of the best movies, best songs, or best footballers. Typically, the experts, such as the American Film Institute, will compile a list that covers many decades and treats each movie with an equal chance of being selected. In fact, the AFI's 2005 list doesn't have one movie in its top 10 that is less than 10 years old. (http://www.afi.com/docs/100years/movies100.pdf)

In contrast, take a few lists compiled by a popular vote by non experts. The Empire poll has 20% of its top 20 from the last 10 years (http://www.empireonline.com/500/99.asp) and 35% of the Lifehack list by a populist writer were in the past 20 years (http://www.lifehack.org/articles/lifestyle/30-best-movies-all-time.html).

Of course, these stats aren't at the level of statistical purity that we can be sure they prove the point, but then again, they are consistent with what we know about availability, and they help to illustrate the principle. If a movie is old, like Citizen Kane, which is no. 1 on the AFI list, it is often left off the other "all time" lists because of a lack of mental availability.  In contrast, the number of dubious modern selections on all of these "all time" lists makes the principle of the availability heuristic easy to identify!

Caddyshack, really, in the top 20 films of all time??


Watch the chocolates and the lists

If you don't pay attention to what is available to you, physically and mentally, you aren't taking notice of the effects of the availability heuristic.  Put the things you want to attend to front and centre. If you want to eat chocolates, make them accessible. If you don't, then hide them away AND replace them with celery sticks.

If you want to compile a list, be aware that the lazy system of your brain will grab the most recent items it can remember and convince you that is the list. It almost certainly isn't, so put in strategies to work around that bias.

...and my top movie, The Usual Suspects.
OK, so it isn't really, but American Hustle reminded me of it (availability) and Keyzer Soze is sooo much better a character than anyone in this year's Golden Globe winner!!

Let me know what you think

Mark S

The famous Christmas mineral water experiment

Here's the setting. It's Christmas 2012 and our family are all sitting around the table. There's turkey, ham, salads, a few beers and wines, and party hats. There is also our star of the evening - mineral water!

Price as the cue to set expectations

Option 1 for mineral water was priced at $4.41 per litre.
Option 2 was priced at $0.70 per litre

Which do you think would taste better?

Most people are conditioned by the price, to expect that the more expensive product will be better.

Don't forget about the brand

In addition to price, products like mineral water have brands.  We didn't have the opportunity to do a controlled test that isolated price and brand, so the reality is that we were testing a combination of price and brand, which is, of course, the real-world scenario.

Option 1 was the imported, Italian brand, San Pellegrino

Option 2 was the private label version from Australia's second largest supermarket, Coles

The great Christmas experiment

Well, the debate was on.  Deon claimed that nobody could tell the difference.  Some of us (including me) disagreed, and argued in favour of the expensive liquid.  This set the scene for our very own behavioral economics experiment! Claire was in the San Pellegrino camp, but nevertheless she was entrusted to run the controlled trial.

The glasses of fizzy water were carefully prepared. Glass A was sipped with the care of a fine French champagne. Glass B was tasted likewise.

Deon gave his verdict. Glass B was definitely the more expensive, San Pellegrino.
I thought and thought, and tasted again, and finally conceded - nope, I can't tell the difference! A win for Deon!
And then Claire announced - Glass B was the Coles $0.70 option, so Deon had proved his own point as well.

The aftermath

So, we all went to our own homes, having had our expectations shattered (except for Deon, whose expectations were confirmed). Did anything change?

Well - yes.  We've become Coles mineral water loyals! Claire doesn't buy San Pellegrino anymore. Deon never did.

How does this happen? The very personal experience of sensing, tasting and feeling facts that contradict your prior expectations is sufficient to break those expectations.

Whether your expectations will change or not will depend on the strength of your prior expectations, the new facts you encounter and the power of this information to the old part of the brain.  Those prior expectations aren't purely logical, so they can't be overridden by pure logic, you need to feel that they are now invalid before you can discard them, you can't just think that they are invalid.

John Kenneth Galbraith summed up how tough it is to discard those prior expectations with this quote:

Faced with the choice between changing one's mind and proving that there is no need to do so, almost everyone gets busy on the proof.

But, the great mineral water experiment of Christmas 2012 shows that it actually does happen quite often, given the right conditions.

Let me know what you think

Mark S

Why a house isn't worth what an owner thinks it is

There's a house for sale near my place that has been on the market for months while everything around it has sold. This is a classic case where Behavioural Economics (BE) can explain why.

Here is the house at 237 Princes St Port Melbourne as it actually is.

And here is the house as the owner sees it, after the new owner buys it, knocks it down, and builds to the approved plans that the owner has paid a substantial sum for.

Two BE principles at play

There are two main BE stories here: sunk-cost bias and the endowment effect.

Sunk cost bias:

The owner has spent money on getting these plans prepared and approved. He wants to get a return on that spend. The problem is that this is now a sunk cost.

Let's imagine that he instructed his architect and town planner to design an 8-storey tower on the block for 4 separate apartments. And let's say that the architect and planner told him he was completely mad and it would never be approved, yet he insisted they do the work. So, $50,000 later and the proposal is rejected. That $50,000 is clearly a sunk cost. It's never going to be recovered, much like backing a loser at the racetrack.

In this case, though, it's a bit more subtle. The work was done, the approvals have been achieved, and there is some value in that. Yet, it's still a sunk cost. It's been spent. Any focus on what's been spent has no bearing on what the market will pay. The owner is still fixated on the past. The buyers are only interested in the present and future.

The endowment effect:

This is even more emotional, and has a substantial impact on the owner's state of mind. He has owned this property for some time and has put in a lot of effort (that he "owns") to ready it for sale. BE research shows that his value on the property is much higher than a potential buyer's value. In some studies by a factor of 14!

No deal!

So, we have a situation where the owner feels that the property is worth $850k or more and the buyers clearly do not. No deal will be done here until the owner can rid himself of the sunk cost bias and endowment effect. The buyers will not shift their view.

Of course, there are a lot of other complicating factors in a real estate market but this case shows how important the BE factors are. And they impact on everyone, on major commercial deals worth hundreds of millions a single house like this or even the purchase of a new kettle.

This new blog, Behavioural Economics Australia will explore these fascinations.


Let me know what you think

Mark Solonsch