Brains at the Museum

Yesterday, I spent a lovely morning with my family at my singularly favorite place in the entire world: New York City’s amazing American Museum of Natural History.  What drew me there was a new exhibit on the brain.  If you live anywhere near NYC, I have one very short word for you: go.

As with any museum exhibit, it’s rather wide ranging in scope, but it does have one section on behavioral economics.  They present the now classic “ultimatum” game in which one player decides how to divide a pile of money and the other player decides if they will each take that prescribed amount or if both of them walk away empty-handed.  No ‘rational’ person would ever walk away from any free money, so the first person should be safe in choosing to maximize his/her own payout and leave as little as possible for the other person.  But real-life experiments show that humans don’t accept this.  In the museum example, they presented that if the other person were to divide a $100 pot by allocating $80 to himself and $20 to you, that most people wouldn’t accept the deal and instead choose for both parties to gain nothing.  Many studies have shown that, across cultures, anything more one-sided than an 80/20 split is almost always rejected, and that any split more even than 60/40 is almost always accepted.  Some have interpreted this through the lens of Natural Selection: our brains evolved in a societal environment and along with the physical evolution of the neurons came the evolution of our morality, sense of fairness, our curiosity and a host of other characteristics that are often described as “uniquely human.”  Viewed from that evolutionary perspective, the fact that our sense of fairness trumps our own monetary gain implies that the notion of fairness somehow gave our ancestors an evolutionary advantage.  Now, it’s relatively easy to see that ancestors of ours who were curious about things had an advantage over their contemporaries who didn’t explore fire or weapons or tools.  It’s a little harder to grasp how that same unguided, non-designed and completely natural process gets us morality, fairness and our sense of economics, but there are some very intriguing results coming from studies of brains – human and otherwise – which show exactly that.  And it has implications for risk management.

One of my favorite examples dissects a common belief that humans are, as a rule, risk averse.  Here’s the simple question: would you rather take a guaranteed $25,000 cash or would you rather have a 1 in 4 chance of getting $100,000 (with a 3 in 4 chance of getting nothing).  Please note that in both cases you end up with the same amount on average: $25k, but you only get to play once.  Most people – including audiences of  financial services professionals I’ve shown this to many times – pick the sure bet and grab the $25,000.  After all, a bird in the hand is worth two in the bush.

Now, take the exact same situation but let’s reverse the cash flow – let’s say you suddenly owe $25,000.  Or, you could choose to have a 3-in-4 chance of owing nothing, with a 1-in-4 chance of owing $100,000.  Again, it’s the same average whichever way you go.  Which do you chose?  In this case most people – including those very same savvy financial services professionals – take the chance and chose to take a risk by opting for the 75% chance of owing nothing.

So it seems that we’re not always “risk averse.”  Rather, we tend to be risk averse when it comes to assets – things we have, and we are risk taking when it comes to loses.  Let’s take a hard look at what this means: the first choice shows that we tend to limit our potential gain (by taking the sure thing).  The second choice shows that we allow large loses to exist (by taking the risk).  This is exactly the opposite of what a good risk manager does, whose job is to allow large gains and prevent large losses. Now here’s the really interesting part: this way of thinking is actually part of our brain’s evolution.  Laurie Santos gave a wonderful TED talk about this exact phenomenon where she showed that a certain species of primate has the same tendency as humans do.  Poor financial risk management seems to be innate.

After we left the museum, we talked about what we liked most about the exhibits we saw.  My answer was simple: I’m glad to see that discussing human evolution and the fact that our brains are bio-chemical tools that evolved to give us consciousness and thought is no longer taboo and is now mainstream enough to be shown in a popular exhibit.  My wise-guy son quickly pointed out “Dad, this is NY.  It’s not like the rest of the country would allow this exhibit to go up.”  If only he weren’t so right…

Since you’ve come this far, please take a moment to comment on the post – it’ll help me make the blog better.

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