Behavioural Traps

If interest rates are high compared with past averages, it's always a good idea to choose a fixed-rate mortgage to protect yourself against the risk of further rate increases.

Correct answer FALSE.

Research has shown that those taking out mortgages seem to focus on short-term benefits, but not sufficiently on long-term risks. This is called the 'present bias', a behavioural trap that leads us to give more importance to the present instead of the future. This tendency is typical of financial investment choices.

When we choose the rate, we may opt for the fixed rate when rates are already very high, in case they rise further. Since rates seem to follow an inverse trend in the long run, it's likely that by choosing the fixed rate at such times, we are tying ourselves to a very high rate that will, however, fall in the following years. Fear therefore makes us take the wrong decision.

Imagine playing a game in which you are presented with two options for winning:

Win €1,500 for sure without doing anything
You can flip a coin: if it comes up 'heads' you win €1,950, if it comes up 'tails' you (only) win €1,050.

What do you do?

Now imagine that you have to pay out a bet and suffer a loss. You can choose between two options:

Paying €750
Flip a coin: if it comes up 'heads'; you have to pay €525, if it comes up 'tails' €975.

What do you do?

Most people subjected to this experiment chose option A in the first scenario and option B in the second.

Correct answer TRUE.

This is true. In a situation such as the one above, many individuals choose to accept the safe €1,500 in the first case because of risk aversion, whereas in the second they prefer the coin toss to try to lessen the certain loss, showing a greater appetite for risk.

Theoretically, if it's only your risk appetite driving the choice, there would be no reason to behave differently with respect to the two scenarios. In practice, there is a cognitive bias called 'loss aversion' at play here; we're willing to take risks to avoid a certain loss (and pick option B in the second scenario), risks that we wouldn't take to make an extra gain (in the second scenario, most people prefer to avoid taking risks).

Investing in the securities of the Alpha company has a 75 per cent chance of gains; investing in the Beta company leads to losses 25 per cent of the time. Investing in the Alpha company is safer than investing in the Beta company.

Correct answer FALSE.

In reality, both companies have the same chance of making gains or losses, but the so-called 'framing effect', i.e. how the information is presented (by highlighting possible gains in the case of the Alpha company and losses in the case of the Beta company), may divert the reader's attention to the information they consider 'important' and distort their attitude towards risk.

You buy a bat and a baseball for €1.10. The bat costs exactly €1 more than the ball. How much does the ball cost?

The ball costs 10 cents.

Correct answer FALSE.

Kahneman discovered, surprisingly, that at least half of the people who try to answer this question get it shockingly wrong. Many answer that the cost of the ball is €0.10, whereas the correct answer is €0.05.

In fact, if the ball cost €0.10, the total would be €1.20 instead of €1.10. This is an example of the mistakes we can make when taking 'mental shortcuts' (cognitive biases).

Sometimes we have a tendency to manage our money as if it were divided into many separate mental accounts. What behavioural trap is this?

Framing effect
Naive diversification
Mental accounting
Overconfidence

Correct answer FALSE.

Understanding how 'mental bookkeeping' works is simple: it's as if we stored money in many different wallets, each containing sums intended for one type of expenditure.

For example, we imagine that we have one wallet for groceries, one for holidays, one that holds savings for retirement, another one for leisure and entertainment, and yet another one for investments.

Considering money differently depending on where it comes from, how we plan to use it, our payment instruments or the way we store it can lead us to make mistakes, such as spending a bit carelessly on leisure. To avoid falling into this trap, we mustn't forget that money is a fungible asset, i.e. it's interchangeable.

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Behavioural Traps

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Behavioural Traps