丁香园AV

New research from 丁香园AV (丁香园AV) shows that people can make better decisions by more carefully considering how their choices are interconnected.

Why do people make the choices they do? Economists break this down into two components: the choice set and preferences. The choice set refers to all the options available to choose from, while preferences capture what people think makes them better off. For example, at an ice cream store, the choice set contains all of the flavours available, and the option to walk out. Some people prefer chocolate ice cream while others prefer vanilla.

Behavioural economics is the study of the systematic biases in the ways people perceive their choice set and how they sometimes apply preferences that seem irrational. 丁香园AV economics professor David Freeman is a behavioural economist who uses experiments to inform how economics models non-rational behaviour. His recently published paper, , (), looks at bias in how people perceive their choice set when making decisions.

The paper, co-authored with Andrew Ellis from the London School of Economics, provides a new theoretical framework and experimental design to study how a person considers interconnections between choices when evaluating their choice set, a concept called 鈥渃hoice bracketing.鈥�

The study is the first individual-level measure of its kind, demonstrating evidence of the heterogeneity, or diversity of ways, in how people bracket. The study was published in the American Economic Review, one of the oldest and most respected economics journals.

We spoke with Professor Freeman about his research.

Why it is important to know how people make decisions?  

People make many decisions every day鈥攖o go to work, how to get there, what to eat for dinner and so on. Some decisions are minor, however, some are really life altering鈥攚hat to study in school, what career path to take, the choice of a romantic partner, or buying a home. Casual observation suggests that people sometimes make mistakes in big decisions, and academic research shows some mistakes are systematic and show up even in big decisions. Academic research into such behavioural biases gives behavioural economics a basis to understand how firms can exploit some bias. In some cases, research suggests how firms or governments can nudge people to make better decisions.

The way a person brackets their decisions determines how they evaluate gains or losses and what they will view as a fair split. So, bracketing is central to understanding how two of the most important phenomena in behavioural economics鈥攍oss aversion and social preferences鈥攊nfluence decisions.

What did your experiments demonstrate about how people make decisions?

My recently published paper documents a particular systematic mistake in decision making called narrow bracketing. A fully rational person who faces multiple choices should account for interdependencies between choices and make a jointly optimal set of choices, which is called broad bracketing.

For example, when it comes to investment decisions, previous literature on risk-taking has documented two stylized facts, which are core to most of the economics of risk-taking. First, almost everyone prefers more money to less. Second, almost everyone usually prefers less risk to more risk鈥攂ut most will make a trade-off between a desire to make more money on average versus a desire to avoid risk.

However, our experiment on investment allocation showed that only about 13% of people engaged in broad bracketing. Instead, most people, about 74%, made each choice in isolation, as if they did not face another related choice. This is called narrow bracketing. Narrow bracketing leads to lower payoffs in our experiment and can lead to substantial losses in real-life decisions.

Why do you think the majority of people engage in narrow bracketing?  

To make the best possible decisions, you should consider all choices faced in life. That is what broad bracketing requires in order to make a set of choices that are globally optimal when viewed together. Taken to the extreme, it is really hard to do. Narrow bracketing is easy鈥攋ust look at the options in front of you and your preferences without factoring in how these options might interact with other choices you face.

Narrow bracketing still requires a person to consult their preferences, so generally should not yield bad choices. But when different choices interact in important ways, like in our experiment where each good in one choice can perfectly substitute for a good in the other choice, narrow bracketing makes a person demonstrably worse off, but not by a lot鈥攊n roughly the 5-10% range in our experiment.

This is actually a common question I receive when presenting my work to other academics, and I am excited to try to better understand the 鈥渨hy鈥� of narrow bracketing, and how we might nudge people to overcome it and bracket more broadly.

Can learning to broad bracket result in better return on investments?  

Yes. My experiment gives a stark illustration. A broad bracketer will use one account to hedge risks from the other. In contrast, a narrow bracketer won't, and will make a risk-return trade off in each account which may lead them to unnecessarily forgo some returns.

The same logic applies to real world settings where different risk-taking choices might be used to hedge each other.

Perhaps the most important real-world example is in retirement saving. If you look at an investment in stocks over a one-year time horizon, the stock market is risky and there is a decent chance you would lose money. But if you invested in the S&P 500 for a 15-plus year horizon, at almost every point in the last 50 years you would have made a decent return, at almost no point would you have lost money. It strikes me as a common mistake that people under 50 invest retirement savings in 鈥渟afe鈥� bonds鈥攊f you bracket your investment returns over the relevant horizon, a diversified portfolio of stocks is almost as safe and will most likely yield a substantially higher return.

Do you have advice for readers on how they can make better decisions in their lives?

I recommend that people plan things out, especially when making a major decision. When grocery shopping, you will probably make a list of what you need and that will help. If you are a student at 丁香园AV picking your courses, you should think of those choices as part of a longer sequence of related choices and plan ahead. Ask yourself what career you might pursue, pick a major and courses that will set you up to succeed.


 

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