Jonah Lehrer on Decision-Making

So, your first book is Extraordinary Popular Delusions and the Madness of Crowds by Scottish journalist and songwriter Charles Mackay, first published in 1841.

This is a wonderful eclectic history of mass human irrationality, and a great history of financial bubbles. If you ever thought that irrational exuberance was a modern invention, a by-product of CNBC and day traders, this book will put you in your place. It’s everything from Tulipmania [in the Netherlands in the early 17th century] to the Mississippi Company and he would have loved the sub-prime mortgage bubble. It shows that as long as we’ve had financial markets, there have been these insanely irrational bubbles: the history of finance is really the history of financial bubbles.

But is it that irrational? Say with Tulipmania, if you know that one tulip bulb is not worth 10 florins, as long as you can sell it for 20 florins, it’s worth it – even if you know it’s ridiculous.

Yes, and what he highlights is that these are historical moments when financial markets basically look like Ponzi schemes. They work great, until they no longer work, and then they just collapse like a house of cards. So they work well for all the people who are selling tulips for 20 florins or 30 florins, but all of sudden, for whatever reason, when they reach 101, the market disappears. And you realise you’re paying insane amounts of money for a flower. And there’s always the moment, when you read these stories, where looking back on it, it seems so absurd. And yet you know that for every person trading tulips or investing in the South Sea Bubble it felt like a very prudent investment. It felt irrational not to invest in tulips. Just like the smartest minds on Wall Street thought that it was irrational and irresponsible to not invest in mortgage-backed securities. So this book gives you a hint of what it must have felt like on the inside, to be in the grip of this irrational exuberance – just like when Cisco was the most valuable company in the world in 2000, or when dotcom stocks that had no business plan (or a barely intelligible business plan) and never turned a profit were incredibly valuable companies. And, of course, as soon as the bubble ends, we see it for what it was – a completely irrational burst of exuberance.

And Mackay also covers topics like witchcraft and witch-hunts and alchemy?

It’s best known for the financial escapades, and that’s the stuff I find most compelling in terms of decision-making. But it’s also just a history of human mania and irrationality generally.

So, the next book you chose, Judgment under Uncertainty, is by, amongst others, Daniel Kahneman, the psychologist who won the Nobel prize for economics, despite, he says, never taking an economics course.

This is one of the most influential books in modern economics. But first of all, it’s just this list of incredibly clever experiments. They don’t use any fancy tools, there’s no microscopes or telescopes involved: Kahneman and Tversky just asked their undergraduates hypothetical questions.

So how much would a student want in return if they were betting $1 on the flip of a coin? You can’t get a simpler question to ask in a science experiment, and yet that very simple question eventually led to a thing called ‘loss aversion’. And this is now viewed as a very important phenomenon – with implications for everything from how taxi-cab drivers think, to how people act when they evaluate their stock portfolio. So what I like about this is book is how they took these very simple protocols – really just idle conversation with students – and transformed them into the first really hard proof that people consistently violate the expectation of rational agents. That we don’t think like homo economicus at all. That our behaviour, our responses to very simple questions, don’t look at all like what a rational person would do – there are these deep inconsistent flaws in the human mind. It makes no rational sense to have such a strong loss aversion, or to be so vulnerable to any one of the long list of biases that Kahneman and Tversky demonstrated. But across all the big-end, large sample sizes, this is the way people responded. So it’s an incredibly powerful piece of work that really showed that people aren’t just occasionally irrational, they don’t just act stupidly when they’re in the midst of a bubble. Irrationality is embedded deep into our operating system.

But this is quite an academic book?

Yes it’s a very academic book. But it happens to be about as accessible as a bunch of academic papers can be, simply because it’s just fun to go through and do the hypotheticals – these questions they’re giving to undergraduates at Hebrew University in the mid-1970s – and then testing yourself against them. And the collection does a very nice job of mixing together the original papers with subsequent results in the field of economics which then take, for example, loss aversion and apply it to the real world. So you can see how this actively influences the decisions of mutual fund managers, with very important negative consequences. And this book not only pointed out this core irrationality, but really changed the economics field as well.

I think the Nobel prize speaks of the importance of the work to economics. But doesn’t it show these biases affecting all sorts of things, including potentially life-and-death medical decisions?

That’s actually an offshoot of loss aversion. So there are different ways of framing a question, and one way to demonstrate loss aversion is that the ultimate loss is, of course, death. So if you go to doctors and ask them to choose between options, and one, the riskier option, is framed in terms of saving people, and the other in terms of people dying, most doctors will risk everything on the all-or-nothing approach. Even when it’s the exact same numbers, if it’s framed in terms of death, people are twice as likely to avoid that option. Because framing the question in terms of losses, making us even think about death, is so ugly, it feels so bad to us, that the person thinks, ‘Oh I’ve got to go for the risky approach.’ [Read a more detailed explanation of the experiment here] And Kahneman and Tversky argue that it does indeed affect the way doctors discuss, for instance, cancer treatments. You can get doctors who work in cancer wards to think very differently about treatment if you frame it as a five per cent chance of surviving, or a 95 per cent chance of dying.

And, as a patient dealing with cancer, you often do have to make decisions based on statistics you are given – doctors say there’s a five per cent chance of this if you do that, or a 10 per cent chance of that if you don’t do this, and it’s all very confusing.

Yes. We’re given all these statistics, but the human mind wasn’t designed very well to deal with statistics. What we’re left with is this feeling. A feeling of either fear – that’s a risk we’re taking – or that’s a potential gain I should pursue. A lot of it really is about these emotions which, in the end, drive our decisions. So simply by reframing the question one way or the other, you can dramatically influence these feelings. Human beings really aren’t rational agents for the most part, because we’re actually being driven by these emotions triggered by dreams of losses or gains.