Predictable Mistakes
A Review of Richard Thaler’s Misbehaving
It’s the holiday season and you’re looking to buy a new AI OLED Smart UHD [insert other acronyms] TV. You drive over to the nearest Best Buy and pick out a sleek model. As you head to the register, a service rep tells you that if you go to another store location you can get an extra ten dollars off your $1000 order. But the store is a 15 minute drive away. Your brain weighs this offer behind the scenes and ultimately decides ten bucks isn’t really worth the drive given such a big purchase. You take the TV home and hope your eyes are able to notice the barely perceptible difference in screen resolution.
The next day, you realize you forgot to pick up another gadget while you were getting the TV. You head back to the Best Buy and see the item is priced at thirty dollars. The same friendly service rep walks over and tells you that the gadget also happens to be on sale at the other location, a full ten dollars off. This time it’s obvious you need to make the drive over — that’s a full third off the regular price! After driving to the other store and picking up your item, you feel smart about the deal you snagged.
The same $10 offer — two totally different decisions. What gives?
In academic circles it used to be widely believed that humans were completely rational. When they made decisions, they would fully weigh the costs and benefits of each choice, ultimately picking whatever option would give them the most utility. Economists would use this rational human (or what they called “Econs”) in all the models they created to explain reality. The problem is Econs isn’t actually a great representation of the average person. Humans make inconsistent and seemingly irrational choices all the time. Sometimes we drive to the other store for that ten dollars, and other times we don’t. Behavioral economics is the field that has set out to explain these quirks in our choices.
Richard Thaler, winner of the Nobel Memorial Prize in Economics, chronicles the founding and evolution of the field since his time in graduate school to his most current research, particularly his efforts in getting people to save more for retirement. Misbehaving is part auto-biography, part history, and part primer on the extremely fascinating field of behavioral economics. Because Thaler worked closely with Daniel Kahneman and Amos Tversky, anyone who has read Thinking, Fast and Slow will recognize a lot of the studies and material Thaler presents here. Prospect theory is really the core of what these men were working on and researching for many years, and it can be summed up nicely in this chart:
Quite a number of psychological insights can be gleaned from just this picture and other facets of Prospect Theory:
- We experience life in terms of changes, not absolute levels
- We feel diminishing sensitivity to both gains and losses
- Losses hurt about twice as much as gains feel good (what economists would call loss aversion)
- People are more risk-seeking when it concerns losses
That first insight reminds me of a hypothetical that I can’t remember who to attribute to (and I may be mis-remembering its exact phrasing). Say a corporate ladder consists of 100 levels. One worker is on the first rung, but because of his hard work is promoted to the fifth rung. Another senior worker is on the 99th level, and for whatever reason, gets demoted to the 98th level. The first worker is going to feel way happier than the second, even though the second worker is still almost at the top of the ladder! We don’t think in absolutes, but rather changes from what we had. While this insight alone isn’t revolutionary, the decisions it can lead us to make are certainly a departure from rationality. Charlie Munger phrased it well:
“I mean people are really crazy about minor decrements down. … huge insanities can come from just subconsciously over-weighing the importance of what you’re losing or almost getting and not getting.”
Thaler also made huge inroads into the study of what he called “mental accounting.” This is how our brains tally up costs and benefits, fairness, and utility. For example, there is a large difference between what Thaler calls acquisition utility (our willingness to pay for an object minus what we actually paid) and transaction utility (the price we pay minus the price we would expect to pay). Transaction utility is what drives retailers to provide coupons or always have an illusory sale going on — the perception of a deal (whether it is real or not) gives us some mental surplus. It’s also the reason why JC Penny failed so miserably when they tried to eliminate their coupons and provide “everyday low prices” instead. Without the perception of a deal, consumers felt they were getting ripped off relative to what they were used to. Mental accounting also encompasses mistakes we make with regards to sunk costs and budgeting. The predictable errors we make here are not at all in-line with the actions of rational Econs.
The author details mistakes and inefficiencies in stock markets, the NFL draft, retirement savings, and numerous other fields or markets. The last portion of the book recounts the research and efforts he made with other behavioral economists to get people to save more for retirement with automatic enrollments and savings bumps over time (the topic of his popular book Nudge). His insights into how we can improve our policy-making and the process for improving policy-making over time itself were quite fascinating. Thaler stresses observing and collecting data, being strictly evidence-based, iterating and tinkering with tests over time, and allowing ideas to flow freely so that the best ideas win out.
While Thaler’s writing is unassuming and not particularly stylish (I didn’t write down that many memorable phrases or quotes here), he is witty, funnily self-deprecating, intelligent, and clear in his explanations. You can tell he would make would make an excellent professor to study under or colleague to work with. If you’re interested at all in economics, psychology, or decision-making, I found this to be a great read. Other books that might complement this:
- Influence by Robert Cialdini
- Thinking, Fast and Slow by Daniel Kahneman
- Poor Charlie’s Almanack by Charlie Munger
- The Undoing Project by Michael Lewis
Score: 7/10
Notes:
· Endowment effect — people value things they already own more highly than things that are available but not yet owned
o Perceptions of fairness are related to the endowment effect — both buyers and sellers feel entitled to the terms of trade they have grown accustomed to
o Any deterioration in those terms is treated as a loss
· Heuristics — rules of thumbs or mental shortcuts we use to simplify complex problems; using heuristics causes people to make predictable errors
· Prospect theory
o We experience life in terms of changes, not absolute levels
o We feel diminishing sensitivity to both gains and losses
o Losses hurt about twice as much as gains feel good (loss aversion)
o People are more risk-seeking when it concerns losses
· Learning
o In order to learn from experience, we need frequent practice and immediate feedback
o We do small stuff often enough to learn to get right, but when it comes to large choices (buying a house/car, choosing a job, getting married), we don’t get much practice or opportunities to learn
o Because learning takes practice, we are more likely to get things right at small stakes than at large stakes; so as stakes go up, decision-making quality is likely to go down
· Mental Accounting
o Difference between acquisition utility (classic consumer surplus) and transaction utility (the price you paid minus what you would expect to pay)
o Transaction utility can both prevent purchases that are welfare enhancing and induce purchases that are a waste of money; TU is what leads retailers to provide coupons or always have a “sale” going
o The sunk cost fallacy is in some ways a form of loss aversion — paying money for an event you don’t end up going to feels a lot like losing money; we end up making suboptimal decisions to justify what we paid
o We often separate our wealth and budgets into discrete buckets, the money in each not treated as equal
o The house money effect causes us to be more risk-seeking when “up” in some mental account; the break-even effect says we won’t be more risk-seeking with losses if there is not chance to break even
· The Planner and the Doer
o An individual consists of two selves at any point in time — the planner who has good intentions and cares about the future, and the doer who lives for the present
o Our planner selves can try to influence the decisions of the doer through rewards or penalties, or implement rules (like commitment strategies) which limit the doer’s options
o Problems of self-control and willpower come down to conflicts between the two selves
· Behavioral economics in finance
o Equity premium puzzle — people hold too many bonds given expectations of stock returns because of myopic loss aversion (taking too short-term a view of their investments)
o Markets are difficult because the game is not to pick the best stocks, but rather to buy stocks you think other investors will later decide should be worth more (Keynes’ beauty contest)
o Value stocks tend to outperform expensive growth stocks over time because investors tend to generally overreact to short-term fluctuations; over the long-run, performance tends to mean revert
o Stocks move much more than the changes in underlying cash flows and dividends, which means sentiment can irrationally drive price action
o CEF’s trade at discounts to NAV for similar reasons — retail investors get too optimistic and too pessimistic relative to the value of the underlying assets
· Decision-making mishaps [NFL draft example]
o Overconfidence and over-trusting of intuition
o Making forecasts that are too extreme given the data
o The winner’s curse — winners tend to overvalue the objects being sold in an auction
o The false consensus effect — people tend to think other people share their preferences
o Present bias — an unwarranted preference for urgency in decision-making (valuing now much more than later)
o Following conventional wisdom can prevent you from getting fired, but leads to suboptimal decisions
· Retirement savings problems and Nudging
o Most people realize they’re not saving enough for retirement but never actually get around to changing their behavior; automatic enrollment overcomes the inertia that comes from status quo bias
o Loss aversion also prevents people from saving more because any cut in the paycheck feels like a loss in nominal dollars
o Insights about self-control also show us that people are better at being more responsible later; if we get them to commit to saving more tomorrow today, we can overcome present bias
o The idea of nudging is based on the fact that people make predictable errors (like in how much they save every year); policy should be designed to correct these errors without reducing people’s options
§ Changing phrasing can be an extremely cheap and effective way of getting people to change their behavior (UK tax-payer example)
§ The key principle is to remove all barriers or difficulties in achieving the desired behavior
Phrases/Quotes:
· We don’t have to stop inventing abstract models that describe the behavior of imaginary Econs. We do, however, have to stop assuming that those models are accurate descriptions of behavior, and stop basing policy decisions on such flawed analyses. And we have to start paying attention to those supposedly irrelevant factors.
· The bottom line is that in many situations in which agents are making poor choices, the person who is misbehaving is often the principal, not the agent. The misbehavior is in failing to create an environment in which employees feel that they can take good risks and not be punished if the risks fail to pay off.
· If policy makers simply take it as a matter of faith that prices are always right, they will never see any need to take preventive action. But once we grant that bubbles are possible, and the private sector appears to be feeding the frenzy, it can make sense for policy makers to lean against the wind in some way.
