Change is hard to accept, but if China is to continue growing, that attitude must change

Reform and innovation are two words that seem to attract much attention from leaders and experts around the globe.

In part that is because the global economic recovery is finally on track, and leaders again can turn to solving global economic, political, social and environmental problems.

Many people expressed concern over China's financial system and stability, and strong desire for greater reforms soon. As I have said repeatedly, I also believe that financial reform holds the key to China's next step in many important ways.

Be it interest rate liberalization, Internet financing, relaxation of capital accounts or the development of a modern bond market, any major progress in financial reform will bring tremendous opportunities and wealth to Chinese residents, investors, enterprises and financial institutions. Financial reform can help diversify and alleviate risks accumulated through changes in China's economic growth model. It needs more attention from Chinese leaders who are now making critical reform decisions.

As with reforms in any major area in China, many people hold very different views on the path and pace, despite agreeing on the eventual objective. Because reforms concern people's current feelings and future expectations, a better understanding of human nature and behavioral decision-making may offer fresh insights into why reform at the next step may face increasing reservations or even resistance.

First, people are inherently averse to change. Psychologists have documented that people have a very strong tendency to maintain their status quo.

When research participants are asked to evaluate objects in their possession, and objects in other people's possession, participants systematically value their own possessions over those of others. Even when they are asked to value the same item owned by others, they give it a much lower valuation than if they possess it. One direct consequence of this is that people are often slow to make changes because they have a very strong psychological attachment to the present state. This provides an explanation for challenges when pushing forward any reform anywhere in the world.

Of course, it also explains why it is relatively easier to reform through creating new markets and new opportunities. Psychological experiments show that if subjects have to choose between two relatively simple objects (such as sweets as opposed to drinking mugs), they are normally unwilling to give up what they already have.

Those who are randomly assigned sweets feel that these are more valuable; those randomly assigned drinking mugs feel they are more valuable. Most people prefer what they already have and few choose to exchange it.

On the other hand, if subjects are asked to choose between two relatively complex things, such as personal computers and mobile phones, they will make a choice using a multitude of factors. Such considerations can, as experiments show, increase subjects' willingness to consider alternatives and engage in transactions. One implication from such experiments is that it may be relatively easier to push forward reform in multiple areas, making it easier for people to accept changes and participate in reform.

Secondly, psychological experiments show that people are easily influenced by their surroundings. People tend to make projections for the long term based on short-term experiences. People who had previously watched basketball games (that have higher scores) tend to overestimate on random questions (such as the number of countries in Africa) than people who had previously watched baseball games (that have lower scores).

And those who have watched video showing people walking slowly tend to slow down after the experiment. Consciously or not, people are influenced by their recent experiences.

Consequently, people become complacent over economic policy after a prolonged period of rapid economic growth. Especially since the 2007-08 global financial crisis, when major developed economies were hit hard by the crisis whereas China remained largely stable and healthy, some investors and regulators have felt that the Chinese financial system is superior to those in the West and therefore does not need reform. As a result, some lack the incentive to push through further and bigger financial reforms.

Finally, there is overconfidence, one of the most documented phenomena. Psychologists find that people are universally confident when it comes to making subjective judgments about their appearance, popularity, IQ or EQ. People tend to overestimate their own ability while underestimating that of others. For example, most retail investors feel that they understand the market and can make money from trading. Statistical analysis of many large samples of investors reveals that instead, most retail investors lose money in trading, largely because of their overconfidence about the reliability of their information and abilities.

It is worth mentioning that such overconfidence is not limited to individuals or retail investors. Senior corporate executives and government officials are found also to display varying levels of overconfidence, sometimes even stronger than retail investors. Because of that, policymakers may at times overestimate their abilities to manage situations and therefore become unwilling to make changes.

No matter what the reasons, reform remains the single most important driver for Chinese economic growth and social development. Everyone should encourage reform through behavioral, legal and institutional changes. In light of the risk that further reforms may face, delaying and avoiding reform may be the biggest risk of all.

The author is a faculty fellow at the International Center for Finance, Yale University, and deputy dean of the Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University. Part of the article is adapted from the author's new book, The Investors' Enemy. The views do not necessarily reflect those of China Daily.