Book Review: Misbehaving

Summary: This fun read was Richard Thaler’s account of his both his own journey and how behavioral economics started as a fringe movement and ended up being widely accepted as more explanatory of how decisions are made in the real world than classical economics.  Thaler is a Nobel Prize winner, and probably best know for his book, “Nudge”, which he wrote with Cass Sunstein.  They introduce what they call “Libertarian Paternalism”.  It is all about choice architecture – giving people the freedom to do what they want, but stacking the deck through how choices are presented.   Behavioral economics looks at how people actually make decisions, while classical economics looks at how perfectly rational creatures would make decisions.  Experiments have shown that what people actually do differs significantly than what a mathematical optimization formula would decide.   Classical economics assumes that all “errors” cancel out so that what any one individual would do is irrelevant – as a whole, the crowd makes rational choices.  It is a tight, theoretically appealing way of looking at the world, with one major flaw – it isn’t very predictive of how people actually make decisions.  Early on, Thaler was viewed as a heretic by the Economist establishment, and he collaborated with psychiatrists nearly as much as economists.  He picked his spots, showing how classical economics failed in specific arenas, such as stock market efficiency in corners of the markets.   While Thaler still believes classical economics is important for describing how things would work optimally, he has shown that understanding human behavior is important to the study of economics and especially to designing systems to maximize benefit to all.

Thaler started as a classical economist, believing that people make decisions based on hard, cold mathematical calculations.  He soon discovered what he calls, “Supposedly Irrelevant Factors”.  He abbreviates these as SIF.  SIF are factors that should not affect a decision, but often do.  He first discovered this in teaching an economics class.   He designed a test to have a wide distribution of scores among the students, which he would then curve to get to a regular distribution of grades.  The average student scored 72/100.  The class was irate that his test was unreasonably hard, even though the low average score had no bearing on the distribution of grades.  The next time, he changed the exam from 100 points to 137 points.  The average was 70% of possible points, but students were much happier seeing their scores average in the 90s, even though grades were still distributed on a relative basis.  While it shouldn’t matter to an economics student what the average raw score is when grades are relative to others in the class, students were much happier with a higher raw score – even when it was a slightly lower percentage!  This piqued Thaler’s interest, and he started a list of SIF.  As he pursued exploring “exceptions” to classical economic theory in actual practice, he found collaborators.  Someone introduced him to an unpublished paper called “Value Theory” by a couple of Israeli psychology professors named Daniel Kahneman and Amos Tversky.  The paper’s title was later changed to “Prospect Theory” and won Kahneman a Noble prize.  It was the basis for Kahneman’s landmark book, “Thinking Fast and Slow.”   Thaler was so impressed with the paper that he took a one-year stint at Stanford to be close to Kahneman and Tversky, who were there at that time. The two became mentors to him, and he quipped that if he is the father of behavioral economics, they are the grandfathers.

Thaler outlines several ways in which “mental accounting” – how we track and categorize things – causes people to act sub-optimally, or inconsistently.   For instance, a far higher percentage of people would drive 20 minutes to save $5 on a $15 item than on $115 item, even though the time expense and the money savings are the same.  Sunk costs are allowed to influence decisions- an already purchased ticket weighs more heavily in one’s decision to attend an event than a free ticket being offered, even though looking forward they are the same decision.  People tend to prefer a discounted item that doesn’t fit their need to a full-price item that does.  Pre-determined budgets cause households and companies to forego more needed or useful items in an already depleted category and to prefer unnecessary or undesired items in a category with unspent funds, even though money is fungible.  Gamblers tend to increase risk-taking when they get behind – especially toward the end of a game or session – in an attempt to get back to even (i.e. not lose money.)

Thaler also notes inconsistent behavior related to self-control and our view of time.  While classical economics considers more options better, giving each individual the opportunity to maximize utility, in the real-world people often choose less desirable options.  This is partially because humans prioritize the short-term over the long-term.  For instance, when a bowl of nuts is left out at a party before dinner, people will keep eating, even though this will reduce their appetite for dinner.  People are generally willing to pay more for an experience happening soon than for one off in the future.  This gives rise to the planner and the doer paradox.  When people are planning, they imagine endless discipline and are willing to do whatever it takes to attain their goals.  When it comes time to execute, however, the effort is often not as planned.  While it seems like a contradiction to the time preference, people also tend to look at spending differently when it is separated from consumption.  Paying now to enjoy something in the future, such as a bottle of wine or a season pass, is viewed as an investment, particularly if it considered is a good deal. Later, when the consumption takes place, it is not viewed as spending.  In this way, consumption can be enjoyed without ever feeling like money was spent.   

People also have an innate sense of fairness.  Rather than simply optimizing their own satisfaction, most people will hurt themselves to punish someone else deemed to be acting unfairly.  The price we are willing to pay for something is not just what it is worth to us, but is also influenced by what we think is a fair price for the seller to charge.

To demonstrate irrational behavior, Thaler and his collaborators look to the stock market.  Prevailing wisdom was that all securities at all times traded at prices that reflected all information in the market.  Any changes in prices were due to new information, and the performance of individual stocks relative to the market is purely random, as it is driven by what could not yet be known.  This is called the Efficient Market Hypothesis (EMH), and it was accepted as fact by economists and finance academics for decades.  With abundant data available, Thaler and his peers were able to show clear exceptions to EMH.  Stocks that had recently fallen the most outperformed those that had recently risen the most, showing that investors had overreacted.  Thaler found other obvious examples of market prices being inconsistent with clear mathematical relationships.

For the rest of the book, Thaler goes on to show other areas where “sub-optimal” behavior happens consistently.  He ends with discussing how understanding actual decision-making, rather than just optimization can help choice architects present choices in a way that encourages people to act in their own best interest.

Conclusion: While this book is more about the story of Behavioral Economics than behavioral economics itself, it still gives compelling evidence that people tend to be inconsistent in their thinking, with a lot of examples. Understanding Behavioral Economics can help us to make better decisions in finance and investing, and in life in general.