“Outcomes that are better than the reference points are gains. Below the reference point they are losses.”
Daniel Kahneman writes extensively about our subjective experiences of the world in his book Thinking Fast and Slow and about how those subjective experiences can have very serious consequences in our decisions, political stances, and beliefs about the world. One area he focuses on are reference points, our baseline beliefs and expectations about the world. As it turns out, our expectations can influence whether we think things are going well or going poorly, regardless of what the actual outcomes are. On top of that, we will make adjustments to our behavior based on what we expect in regard to those outcomes.
Kahneman continues, “When directly compared or weighted against each other, losses loom larger than gains. This asymmetry between the power of positive and negative expectations or experiences has an evolutionary history. Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.”
Without diving into the evolutionary psychology component of Kahneman’s quote (something that I normally would love to do) I want to focus on how complex our reality and decision making becomes when we predict outcomes, shape our behavior in response to those predictions, and bias those predictions based on personal reference points.
In the United States, two major economic indicators that are used by banks, economists, and the media for deciding whether we have a good economy or a poor economy are GDP growth and interest rates. Both of these measures are represented as percentages, both have specific targets that we have decided are good, and from both follow a set of decisions that we hope will improve the numbers in the direction we want to see. What is interesting, is that we have reference points for the numbers in terms of what percentages we believe reflect a strong and growing economy, and our subjective experience of the economy can be changed by those outcomes.
A 1% increase in GDP growth is growth in overall GDP, but to an economist, that growth is abysmal, and actions need to be taken to get that growth rate closer to 3 to 4%. At the same time, if expectations for GDP growth are only .8% and we hit the same 1% outcome, we might be very happy. In both situations, our decisions and behaviors might change based on the delta from our expected reference point and the final reference point. A gain can feel like a gain, but it can similarly feel like a loss depending on where exactly we placed our reference point.
Interest rates reflect similar dynamics, and might be even more complicated by more clear competing interests and desires in terms of interest rates. Banks might want to see higher interest rates, to earn more money, while people taking out loans may love the low interest rates. A 2% interest rate might feel like a huge loss to one entity, while simultaneously feel like a gain to another.
This creates strange competitive dynamics, because our brains hate losses. We generally need an expected or realized gain to be 2 times larger than a potential or realized loss before we will risk money or accept an outcome. If we have a certain reference point in mind for the outcome we want or would be happy with, we may need to see a large skew in a positive direction for us to be happy, while even a minor loss will feel disastrous. (At this very moment in the United States this is what is taking place with the presidential election. Several journalists have noted that in December of 2019, the Democrats would be thrilled with the election outcome we have today, but many adjusted their reference point to a Biden landslide win, so a close win feels like a tragic loss – and somewhat of a win for Trump).
Reference points feel like a simple idea, but what I hope this post shows is that they can be hugely consequential, and incredibly complex, especially when we have multiple actors with multiple reference points all interacting on small and large issues. Choose your reference point carefully, and try to recognize when you are operating with a certain refence point in mind and be willing to adjust or discard it when necessary. Don’t let a win get wiped away because it ended up being slightly smaller than your reference point expectation.