The Hindu Business Line : Our trading biases have deep evolutionary roots

HORSES are tied by the heads, dogs and bears by the neck, monkeys by the loins, and men by the legs, says the Fool to King Lear, and adds, "When a man is over-lusty at legs, then he wears wooden nether-stocks." I'm sure you'd be happy that bears are well in tether, and that the Bard hasn't spoken of controlling the bull in this snatch from his work.

To add to your Sunday fun, therefore, here's a monkey story. Not the one about how two cats made the mistake of getting a monkey to mediate, or the one about the costly lesson that a tailorbird learnt after preaching to a drenched monkey, but a study of capuchin monkey trading behaviour from three researchers of Yale — M. Keith Chen, Venkat Lakshminarayanan and Laurie Santos.

But first, something about the capuchin monkey. "Small mammal, any of four species of monkey familiar as the `organ-grinder' monkey," explains an encyclopaedia article on http://uk.encarta.msn.com. "Capuchins are found in the tropical forests of Central and South America. The name is derived from the cap of dark hair on the monkey's crown, which resembles the cowl worn by a Capuchin monk." You'd also learn that this monkey keeps its tail coiled at the tip, and is therefore called ringtail monkey too.

"The monkeys are active by day and go about in troops, mainly in the tops of tall trees, feeding on fruits and small animals. There is a fairly rigid social hierarchy among both male and female capuchins. The dominant male helps to break up some fights, but other individuals also assist. Members of the troop may sound an alarm call to warn of an approaching enemy."

How nice, you may say, and ask if there's anything to learn from them, now that we have all evolved into human beings. That's exactly the point, because if we have come from monkeys, we should be able to find origins of our fears in our ancestors too, right? Which is what the Yale trio attempted to do. They went in search of the roots of our `decision-making biases' such as `reference-dependent choices and loss-aversion'.

If you think we're now up against two hills, let us take them one after the other. First, reference-dependent choice or preference (RDP) is a hot phrase in behavioural economics to explain many things. "Reference dependence is defined as a choice between two assets, where the investor's decision depends on their reference point (where they are now)," explains Canadian Investment Review (www.investmentreview.com) in a paper titled `Measuring Performance: A New Direction'.

Reference dependence based on the previous sale price can result from `rule of thumb' learning, often referred to as `anchoring', observe Alan Beggs and Kathryn Graddy in a March 2005 paper titled `Testing for Reference Dependence: An Application to the Art Market'. They give an example: "Suppose that an expert wishes to value a painting. He knows the price at which the current seller previously purchased the painting and makes an initial judgement about price. Psychologists would call this partial information processing."

Daniel Kahneman and Amos Tversky formulated prospect theory to explain observed behaviour. Tversky died in 1996; and Kahneman won the 2002 Nobel Prize in Economic Sciences. They discovered "how human judgment may take heuristic shortcuts that systematically depart from basic principles of probability," as http://nobelprize.org would inform. "A key element in prospect theory is that individuals compare uncertain outcomes with a reference level which depends on the decision situation, instead of evaluating the outcome according to an absolute scale," stated the presentation speech.

In his Prize Lecture titled `Maps of Bounded Rationality: A Perspective on Intuitive Judgment and Choice' on December 8, 2002, Kahneman cited Shane Frederick's simple experiment to study cognitive self-monitoring: "A bat and a ball cost $1.10 in total. The bat costs $1 more than the ball. `How much does the ball cost?' Almost everyone reports an initial tendency to answer `10 cents' because the sum $1.10 separates naturally into $1 and 10 cents, and 10 cents is about the right magnitude."

"The reference value to which current stimulation is compared also reflects the history of adaptation to prior stimulation," he'd explain elsewhere in the lecture, and provide an example. "A familiar demonstration involves three buckets of water of different temperatures, arranged from cold on the left to hot on the right, with tepid in the middle. In the adapting phase, the left and right hands are immersed in cold and hot water, respectively. The initially intense sensations of cold and heat gradually wane. When both hands are then immersed in the middle bucket, the experience is heat in the left hand and cold in the right hand." For the research-hungry, let me suggest looking up: `The Pygmalion Effect: An Agency Model with Reference Dependent Preferences,' by Kohei Daido and Hideshi Itoh and `Keeping up with the Joneses, Reference Dependence, and Equilibrium Indeterminacy' by Livio Stracca and Ali al-Nowaihi.

What is loss aversion? It is "a widespread pattern, evident in many aspects of decision making, in which people seem particularly sensitive to losses and eager to avoid them," defines www. wwnorton.com. "In many cases, this manifests itself as an increased willingness to take risks in hopes of reducing the loss." Wikipedia explains, "In prospect theory, loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains."

A typical question is, "Will you rather get a 5 per cent discount, or avoid a 5 per cent surcharge?" Some studies suggest that losses are as much as twice as psychologically powerful than gains, notes http://en.wikipedia.org. "Two persons get their monthly report from a broker: A is told that her wealth went from $4 million to $3 million. B is told that her wealth went from $1 million to $1.1 million. `Who of the two individuals has more reason to be satisfied with her financial situation? Who is happier today?'" reads a problem on loss/gain in Kahneman's Lecture.

Let's return to the `monkey' paper, `The Evolution of Our Preferences: Evidence from Capuchin-Monkey Trading Behaviour' on www.som.yale.edu. It begins with a quote of Adam Smith from Wealth of Nations: "Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog. Nobody ever saw one animal by its gestures and natural cries signify to another, this is mine, that yours; I am willing to give this for that."

Quite important, because the three Yale authors decided to see how capuchins did such a swap. Instead of bones, though, the authors introduced into a capuchin colony a fiat currency of `aluminium discs' and got the monkeys to `trade' the tokens for `food reward' such as apples, grapes and jello cubes. "We are able to recover their preferences over a wide range of goods and risky choices."

Such choices, you'd learn, as capuchins did, were gambles where the experimenters showed two pieces of apple but gave only one after receiving the token, or show one but give two, to introduce an element of lottery in the process. Monkey-lovers may rest assured that the Yale researchers didn't bother the animals with any wild shots.

The paper's `conclusion' states that the biases (reference dependence and loss-aversion) are not confined to humans but present in "our closest evolutionary neighbours". Our behaviour is most likely the result of `an evolutionarily ancient and common behavioural mechanism,' opine the authors. "If these biases are an innate feature of how our brains represent choices, we may be more inclined to believe they will be broadly present in both common and novel settings, stable across time and cultures, and resistant to elimination by either market exposure or education," it adds, hinting at the limited success that training can achieve.

Let me wrap, therefore, with this quote from Macbeth: "Now, God help thee, poor monkey!"

dmurali@thehindu.co.in

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