Bad decisions habits research won Nobel Prize in economics

Bad decisions habits research won Nobel Prize in economics

Oct 25th, 2017

We welcome the fact that Bad decisions habits research won Nobel Prize in economics.
We are going to expose why we are so enthusiastic about the research by Prof. Thaler of the University of Chicago. We will discuss why this research is useful in explaining the difficulties some organizations have in supporting risk-management programs.

Bad decisions habits research won Nobel Prize in economics

In the past we have already cited behavioral economics, for example the work by Kahneman and Tversky to show how human judgment is often clouded by prejudices and misconceptions.

Classic economics assumptions

Economists assume that rational decision-making occurs as people desire to increase their economic well-being. The concept of “perfect equilibrium” between offer and demand dominates the discipline.

Economists know, however, that that basic assumptions are not always true and the real world is way more complicated.

Human nature can be quite irrational and, thus, human decision-making complex.

Nobel Prize Thaler’s research

Thaler’s research basically shows that “in order to do good economics, you have to keep in mind that people are human.”

Professor Thaler’s has found that decision-makers (investors) simplify their environment by conceptually separating accounts, thus focusing on the narrow impact of each single decision, blinding themselves to the overall (negative) effects.

This human trait results in limited rationality, social preferences and a lack of auto-control with widespread consequences.

Thus Thaler classifies “humans” and “econs”. The second category is populated by people capable of rational optimum decision-making, and constitute a small minority.

Reportedly 130 countries have incorporated Thaler’s concepts in their tax and public health policies to some extent.

Bad decisions habits research won Nobel Prize in economics: what is the link with risk management?

The similarities between the behavioural economics research and some difficulties organizations encounter in the application of risk management are staggering.

For instance:

  • in order to succeed with risk management programs you have to keep in mind that people are human and cognitive biases very real.
  • Decision-makers like to simplify their risk environment by creating and maintaining informational siloes . The “high-level” syndrome is an epidemic: everyone requires high-level summaries, no one wants to delve in details, where we all know that with risk, devil lies in details.
  • It is a general practice to perform simplifications which conceptually separate accounts, thus focusing on the narrow impact of each single decision, blinding everyone to the overall (negative), interdependent effects.

These human behaviours inevitably result in limited rationality, social preferences. Add to that lack of auto-control up to the point of influencing the risk assessment community as a whole and exposing the corporate world to unidentified overexposures.

Using Thaler’s classification, adapted to risk management we can bin humans and corporations in two classes: “self-blinding” and “risk-aware”.  Those capable of rational optimum risk based decision-making constitute a small minority, populating the second category.

Among a population of humans and corporations that seemingly practice and apply risk management “self-blinding” and “risk-aware” merrily co-exist. Time, changing conditions, climate change and other systemic chocs will make the difference visible in the long run.

Why not run a “risk stress test” and see to which category you belong?

Call us to learn how we would do that for you.

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Category: Risk analysis, Risk management

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