SI recently started going back through my library of finance books. I want to revisit stuff I've read in the past. So as I get through these books again, I'll post a little summary of what I've learned. The first one will be Freakonomics.
Freakonomics by Steven Levitt and Stephen Dubner has three key themes. The first is incentives, or how we respond to rewards and penalties. Another is information asymmetry, including the effects of different knowledge gaps and our efforts to make up for them. The final major issue is causation vs correlation and how we frequently attempt incorrect explanations.
- Three different motives dominate your life.
- Experts frequently have an incentive to take advantage of your ignorance.
- Simply because two events occur concurrently does not imply that they are related.
Lesson 1: Three different motives dominate your life.
Your entire life, incentives have been held in front of your face. From "if you finish your plate, you'll get some pudding" when you were a kid to "if you sell 100 cars this quarter, you'll get a 25% bonus" all the way to "Grandpa, if you don't stop bugging the cleaning lady, we'll put you in a home!"
People use incentives to try to change your behavior because they believe they will make you do more of the good or less of the bad.
Stephen Dubner and Steven Levitt say there are three kinds of incentives:
- Economic - usually involves a gain or loss of time and/or money.
- Social - when you either stand out among your peers or are excluded from them.
- Moral - appealing to your sense of morality and inner motivation to act morally.
For instance, the disincentive to commit a crime is fairly potent (a negative incentive, the stick in the stick and carrot technique). It is one of the most morally repugnant things you can do (moral), you could lose your job, home, and personal freedom (economic), and of course, you'd lose your friends and your reputation would suffer (social).
Lesson 2: Experts frequently have an incentive to take advantage of your ignorance.
In any human-to-human interaction, incentives play a key role as the driving factor. Therefore, you may make wiser selections as soon as you understand what motivates the person sitting across from you (and are aware of the same factors in yourself).
Sadly, many systems encourage us to lie and cheat. One of these is the imbalance of information. Everybody occasionally needs an expert's assistance. You visit a specialized physician when your knee hurts, have a professional handle your hair styling, and contact a real estate agent when you want to sell your home.
The agent in that last case receives a commission from the sales price, so you would think that they would work just as hard to optimize the selling price as you would.
Now, some basic math shows that it's frequently preferable for the agent to take advantage of the fact that she is more knowledgeable than you in order to sell you quicker. If your agent can secure you a $100,000 bid in only two weeks and earns a 10% commission, it translates to $10,000 in just two weeks. Knowing it will take her an additional two weeks to receive a $120,000 offer reduces her total earnings for the two weeks to just $6,000 (a 20% gain in money, at a 100% increase in time spent).
She can convince you to sell more quickly and for less money, by using the information she has that you do not. According to studies, agents who sell their own homes typically list them for sale for a lot longer and receive larger commissions.
Lesson 3: Simply because two events occur concurrently does not imply that they are related
We typically believe we are intelligent and can easily put two and two together when anything like the aforementioned scenario occurs. But more often than not, we confuse correlation with causation, which results in two plus two is five.
For instance, even if a car salesperson offers you a wonderful price on a car on the last day of the month, you would undoubtedly think that he merely does so in order to sell one more car, meet his quota, and receive a sizable bonus, regardless of how awful the car is.
But just because the deal coincides with the last day of the month doesn't mean you can infer what motivates him to offer it to you.
This may be the last car he needs because he plans to improve his selling techniques and double his sales that month. Perhaps he made a commitment to his wife that he would sell enough cars to pay for his son's daycare. Maybe any of a myriad of additional factors.
Consider the impact of money on election results. Everyone believes that whoever spends the most will win the most votes. However, successful politicians might really halve their spending while losing only 1% of the electorate (and vice versa). Voters really want to make a difference in a close game or support an obvious favorite. Money is not the cause of election results, despite the fact that it is connected with them.