Sunday, June 30, 2013

Our Unconscious Plays An Active Role in Problem Solving

In the previous blog post we learned about incubation - “the process whereby a problem is consciously ignored for a while after which the unconscious offers a solution.[1]” We learned that distraction plays a role in incubation by fading the memory of the heuristics (or mental set) [2] that led to a dead-end. 

Today we embark on a bolder explanation on the mechanisms of incubation. Consciously ignoring a problem does more than decrease associative connections to incorrect strategies. Indeed, our unconscious also plays an active role in problem solving by continuing to work on the problem when we are not thinking of it.[3]

Our unconscious thought is powerful and can solve many problems more efficiently than our conscious thought. We can even start and complete goals to a desired outcome all completely outside of consciousness.[4] Look out for the theme of unconscious vs. conscious thoughts throughout my upcoming posts. We shall further explore which decisions are better suited for our unconscious, versus which situations require the guided effort of our conscious attention.                                          

[1] Ap Dijksterhuis, Think Different: The Merits of Unconscious Thought in Preference Development and Decision Making, Journal of Personality and Social Psychology, 2004, 588.
[2] "Mental Set" is defined as "the tendency to solve certain problems in a fixed way based on previous solutions to similar problems." See Michael Ollinger, Gary Jones, and Gunther Knoblich, Investigating the Effect of Mental Set on Insight Problem Solving, Experimental Psychology, 2008, 269.
[3] See Dijksterhuis, supra note 1. In pertinent part:
Other evidence for unconscious thought processes comes from research by Bowers, Regehr, Balthazard, and Parker (1990). Their participants were asked to identify words while from time to time they were given a hint, such as an associated word. After each hint, they were pressed to guess. When people solve such problems, they “feel” as if they suddenly know the answer. Indeed, the answer suddenly pops up in consciousness (“red . . . bowl . . . fresh . . . of course, they mean fruit!”). However, people’s successive guesses indicated that the process is not quite as sudden if seen from the perspective of the unconscious. Successive guesses converged, and the unconscious seemed to be closing in on the right answer quite a while before the answer was accessible to consciousness. Related findings come from research on tip-of-the-tongue phenomena. Yaniv and Meyer (1987) offered participants definitions of rare words they could not recall but felt they knew. In a lexical decision task, the target tip-of-the-tongue words were highly accessible. Although the words were inaccessible to consciousness, the unconscious had found and activated them.
[4] See Generally, John Bargh, P. Gollwitzer, A. Barndollar, R. Trotschel, The Automated Will: Nonconscious Activation and Pursuit of Behavioral Goals, Journal of Personality and Social Psychology, 2001.

Saturday, June 29, 2013

Stuck on a Difficult Problem? Distract Yourself!

You've racked your mind but the solution to your problem is still incomprehensible. You know you should be able to solve the problem, yet you cannot. Such problems can range from an abstract math question, deciphering statutory language, or something more mundane like remembering your former colleague’s name.

Problem Solving Through Incubation

Empirical evidence suggests that incubation can be a wise strategy for solving your problem. [1]

Incubation Defined

The process whereby a problem is consciously ignored for a while after which the unconscious offers a solution.[2]

The Role of Distraction

Incubation is seen as fruitful because one is distracted from the problem at hand. Not thinking about a problem for a while may lead people to forget wrong heuristics or inappropriate strategies in general. Distraction, then allows people to give the problem a fresh look.[3]

So next time you’re stuck on a seemingly incomprehensible problem, distract yourself. Take a short walk, then return to face the problem with a fresh look.

[1] Ap Dijksterhuis, Think Different: The Merits of Unconscious Thought in Preference Development and Decision Making, Journal of Personality and Social Psychology, 2004, 588.
[2] Id.
[3] Id.

Sunday, June 23, 2013

[TAG] Loss Aversion Keeps You From Higher Stock Returns

TAG (Tangential, Associative, Germane)

An investor who is prepared to wait a long time before evaluating the outcome of the investment as a gain or a loss will find [stocks] more attractive than another investor (equally loss averse, but more myopic) who expects to evaluate the outcome soon.[1]

[1] Richard H. Thaler, Amos Tversky, Daniel Kahneman, Alan Schwart, The Effect of Myopia And Loss Aversion on Risk Taking, The Quarterly Journal of Economics (1997). 649.

Saturday, June 22, 2013

Loss Aversion Keeps You From Higher Stock Returns

Now that we are familiar with the concept of loss aversion we can explore how it may help explain a range of behavioral paradoxes. Specifically, today’s post focuses on loss aversion and the Equity Premium Puzzle; the paradox in which equity (stocks) receives a higher premium than risk-free government bonds, although they have comparable risks[1].

I hope to underscore a vital point about behavior science with this topic; having a key grasp on behavioral concepts like loss aversion are not just intellectual curiosities. In light of the recent market crash of 2009, the loss felt by others illustrates that a lesson from loss aversion can protect you from making grave errors in judgment with stakes as high as your life savings on the line.  

Equity Premium Puzzle

The Equity Premium Puzzle investigates the phenomenon of investors investing in bonds as opposed to equities. More plainly put, why does a market for government bonds exist at all when an investor can get consistently higher returns through stocks with the same exposure of risk?[2] Since stocks far out-perform bonds, a rational actor seeking to maximize his expected utility should always choose stocks over bonds. Therefore, the equity premium puzzle at its core queries why actual observed stock returns far exceed the average investor’s expected utility as evidenced by their investment behavior. 

Myopic Loss Aversion: Explaining the Puzzle

Loss Aversion Defined

Loss Aversion stands for the idea that losses loom larger than gains.[3] “Empirical estimates find that losses are weighted about twice as strongly as gains… The disutility of losing $100 is roughly twice the utility of gaining $100.[4]” 

Myopia Defined

Myopia in this context is similar to mental accounting, the practice of individuals constantly monitoring and evaluating the success or failure of their financial investments.[5]

Combined: Myopic Loss Aversion Explains The Equity Premium Puzzle

Combined these two concepts asserts that individuals are prone to frequently evaluate their stock purchases. In contrast to bonds, since stocks prices fall almost as often as they rise on a daily basis, and since their losses are psychologically doubled[6], the average investor is unduly aggravated when engaging in mental accounting, and as a result will irrationally undervalue the stock’s expected utility.[7] The irrational myopic risk aversion towards stocks thereby act to induce a demand for bonds as an alternative investment.

Myopic Loss Aversion & The Recent Recession

In the recent market crash of 2009, many people lost half their investments in the stock market almost overnight. This sparked a debate amongst investors everywhere; should they pull out now to stop the bleeding, or stick it through in hopes of a recovery. Those prone to myopic loss aversion abandoned their investments in equities, being overly sensitive to the pains of their losses.[8] However, since 2009 markets have rebounded - client account balances at Fidelity investments have since increased 75%, while those who abandoned equities all together in light of the market crash only saw their accounts increase 26%.[9] Those who were alert to watch out for their tendency for myopic loss aversion could adjust their behavior to hold on to their investments rather than trust their instincts which are overly sensitive to the pains of loss.

Like this post? For more on loss aversion, see [TAG] Loss Aversion Keeps You From Higher Stock Returns.                       

[1] Jeremy J. Siegel and Richard Thaler, Anomalies: The Equity Premium Puzzle, Journal of Economic Perspectives, 192.
[2] Id.; Also See Rajnish Mehra and Edward C. Prescott, The Equity Premium: A Puzzle, Journal of Monetary Economics. 143. (In pertinent part: “ Historically the average return on equity has far exceeded the average return on short-term virtually default-free debt. Over the ninety-year period...the average real annual yield of the Standard and Poors 500 Index was 7%, while the average yield on short-term debt was less than 1%.)
[3] Daniel Kahneman, Thinking Fast and Slow, 415.
[4] Richard H. Thaler, Amos Tversky, Daniel Kahneman, Alan Schwart, The Effect of Myopia And Loss Aversion on Risk Taking, The Quarterly Journal of Economics (1997). 648.
[5] Line Isager-Nielsen, Myopic Loss Aversion and the Equity Premium Puzzle, Copenhagen Business School, 21.
[6] See Thaler, supra note 4, at 650. (In pertinent part: "The probability of observing a loss is higher when the frequency of evaluation is high. If losses cause more mental anguish than equivalent gains cause pleasure the experienced utility associated with owning stocks is lower for the more myopic investor."
[6] See Siegel, supra note 1, at 197.
[9] Id.

Tuesday, June 18, 2013

Humans and Econs: Homo Economicus vs. Homo Sapiens

The theme of many of my posts involve the struggle between our human behavior and judgment as they function in reality vs how they are incorrectly, but commonly, perceived to function. Actors Homo Economicus and Homo Sapiens are at the forefront of this long ensuing battle for public validity. 

At a Glance

Homo Economicus (Econs[1])

Homo Sapiens (Humans)

  • Intelligence of Albert Einstein.[2]
  • Willpower of Ghandi.[3]
  • Stores as much memory as IBM blue. [4]
  • Limited cognitive abilities.
  • Prone to foreseeable weaknesses in willpower.
  • Memory fails to store much of the information that is presented to it. [5]
Overview: Errs only occasionally, usually due to circumstances not knowable at the time of decision making.
Overview: Errs Systematically.

A Closer Look

Homo Economicus (Econs)

Homo Economicus is "a rational actor who employs complex algorithmic processing that follows rules of logic and probability in order to maximize expected utility."[6]

While Homo Economicus does not always make perfect forecasts, she never makes systematically wrong forecasts.[7] Instead, when an error occurs she becomes aware of it and accordingly adjusts her judgment, or upon finding insufficient regularities to draw a judgment from, declines to make a forecast all together.

She is aware of all publicly known information and responds accordingly.[8].If a company’s accounting statements shows a looming liquidity crisis, prototypical Econs are immediately aware and will sell off shares until the stock price lowers to adequately reflect its true value.[9]

She is influenced by incentives – if a government taxes candy less, then she will buy more candy. She is not influenced by immaterial environment circumstances such as the order in which options are presented to her.

Homo Sapiens (Humans)

Homo Sapiens, here played by Homer, employ judgment primarily guided by a handful of leading heuristics (mental shortcuts). These heuristics are used particularly when facing incomplete information, an absence of stable environment, or complex problems.[10] These heuristics, although fast, and efficient, can lead to imperfect judgment in a slew of contexts, especially when forecasting future events.

Homer is influenced by superficial and irrational factors.  The order in which food is presented to him in a cafeteria can increase his fruit and vegetable consumption respectively 13% and 23%.[11]

Homer’s imperfect decision making is most easily illustrated in the financial decision making domain. Whether in the context of a divorce proceeding, saving for retirement, or regular consumer habits, we can find many examples in which Homer fails to maximize his expected utility. For instance, Homer will forget to cancel his 30 day free trial subscription resulting in the undesired outcome of a debit charge.[12] Even worse, Homer will thereafter fail to cancel his subscription and continue paying for goods or services he has no desire to have (and sometimes for many months!).

Homer has a profound lack of awareness of known rules of logic and probability[13] and even easily accessible facts like occurrence rates of natural disaster[14].  


Humans are NOT Econs. Further investigation should be done to examine differences in how the actors respond in various situational conditions.

[1] Richard Thaler, Nudge: Improving Decision Making about Health, Wealth, and Happiness, 18. (Framing the Homo Economicus vs Homo Sapien concepts in regards to “Humans and Econs” was taken directly from Richard Thaler’s Econs and Humans chapter in Nudge. Moreover, the term "Homo Economicus" is widely used and was not created by me).
[2] See Thaler, supra note 1. (This, along with the next two anecdotal examples, was taken directly from Richard Thaler’s Econs and Humans chapter in Nudge).
[3] Id.
[4] Id.
[5] See Generally Atkinson-Shiffrin Model; In pertinent part states that only a select amount of information processed through our sensory memory is eventually stored in our working memory (short-term memory) or long-term memory. More information available at,
[7] See Thaler, supra note 1.
[8] In essence she encompasses the semi-strong form of the Efficient Capital Market Hypothesis which asserts that a stock price incorporates all past and present public (but not non-public) information. For more on Efficient Capital Market Hypothesis see Robert Rhee, Essential Concepts of Business for Lawyers, (2012), 290.
[9] Of course the semi-strong form hypothesis is directly contradicted by evidence of bubbles - extended periods of times in which stock prices were clearly mispriced. Id.
[10] See, Daniel Kahneman, Thinking Fast And Slow, “In the absence of valid cues, intuitive “hits” are due either to luck or to lies. If you find this conclusion surprising, you still have a lingering belief that intuition is magic. Remember this rule: intuition cannot be trusted in the absence of stable regularities in the environment [emphasis added]”
[11] Andrew Hanks, D. Just, B. Wansink, Smarter Lunchrooms Can Address New School Lunchroom Guidelines and Childhood Obesity, The Journal of Pediatrics (2013), 2.
[12] Thaler, supra note 1, 203-4.
[14] See Kahneman,  supra note 10, at 204. In pertinent part:
Strokes cause almost twice as many deaths as all accidents combined, but 80% of respondents judged accidental death to be more likely. 
Tornadoes were seen as more frequent killers than asthma, although the latter cause 20 times more deaths. 
Death by lightning was judged less likely than death from botulism even though it is 52 times more frequent.
Death by disease is 18 times as likely as accidental death, but the two were judged about equally likely.
Death by accidents was judged to be more than 300 times more likely than death by diabetes, but the true ratio is 1:4”)