Daniel Kahneman coined a phrase for the human tendency to overestimate our level of competence in a range of activities – like driving, test-taking, and picking wining investments. He called it the “illusion of validity.”
It’s a behavioral bias that afflicts us all, says Kahneman, who won the 2002 Nobel Prize in economics for his work on this subject. From day traders to buy-and-holders, people have an unrealistically high degree of confidence in their own judgment, even after being confronted with evidence that their judgment is wrong.
But that mistake is just one of many cognitive errors identified by Kahneman. For more than a decade, he worked with fellow psychologist Amos Tversky in cataloging the ways the human mind systematically misjudges the world around it.
For example, one of the quirks they discovered is “anchoring bias.” Whenever you are exposed to a number, you are influenced by that number whether you realize it or not.
This is why the minimum payments suggested on your credit card bill tend to be low. That number frames your expectation, so you pay less of the bill than you might otherwise. As a result, your interest continues to grow, and your credit card company makes more money than if you had not had your expectations influenced by the low number they suggested in their advertisements.
Through their research, Kahneman and Tversky identified dozens of these biases and errors in judgment. Human beings, they concluded, don’t always make good decisions, and frequently the choices they do make aren’t in their best interest.
What Kahenman and Tversky discovered directly contradicts the assumption of mainstream economists – that humans are perfectly rational when it comes to decision-making. For most of the 20th century, and even today, the human beings imagined by economists have had a Spock-like rationality.
“Economists literally assume that the agents in the economy are as smart as the smartest economist,” says economist Richard Thaler. “And not just smart: We’re not overweight; we never overdrink; and we save just enough for retirement. But, of course, the people we know aren’t like that.”
So why do economists assume that human beings are so rational?
The short answer is that using a rational human in their mathematical models works. For decades, economists have been using idealized humans to predict everything from international trade to market prices, and they’ve done pretty well. They’ve been able to figure out all kinds of things. And besides, it’s hard to include more realistic human behavior in an economic model.
But there’s probably a better reason for economists to assume perfect human rationality. An imperfectly rational human being challenges a critically important idea: the notion that markets work well because individuals can be counted on to make the best choice for themselves.
“Merely accepting the fact that people do not necessarily make the best decisions for themselves is politically very explosive. The moment that you admit that, you have to start protecting people,” Kahneman says.
In other words, if the human brain is hard-wired to make serious judgment errors, that implies all sorts of things about the need for regulation and protection.
Richard Thaler and Cass Sunstein wrote a book on this issue called Nudge: Improving Decisions About Health, Wealth and Happiness.
The book proposed that if you want people to save for retirement, for example, it’s important to take account of the fact that people are easily overwhelmed by information and so are likely to simply opt for the status quo. The lesson for policymakers is clear, says Thaler.
“If you want people to enroll in the pension plan, then automatically enroll them — and let them opt out if they want to.” In other ways, to get people to make better choices, you sometimes have to push them in the right direction.