‘Misbehaving’ by Richard Thaler: The power of irrationality in economic decisions
Throughout the book, Richard Thaler’s storytelling abilities and simple explanations help the readers easily navigate such an advanced topic
Human beings are irrational, it is human nature to make mistakes and carry out bad decisions. Yet for almost a hundred years, economic models and theories were populated by perfectly rational individuals whom the author calls "Econs". These beings have perfect knowledge, self-control and the foresight to always make the right decisions that maximise their utility.
Due to traditional economics writing off human behaviour as "supposedly irrelevant factors" (SIFs), unsurprisingly, this led to the development of problematic models and policies that could not accurately predict human behaviour with terrible consequences (like the financial crash of 2008).
Economics Nobel Prize-winner Richard Thaler faces this challenge to develop human-centric head-on in this memoir-style, beginner's guide to behavioural economics that is filled with relatable anecdotes and humour while presenting and explaining his findings and research that helped revolutionise the field.
"My only advice for reading the book is, stop reading when it is no longer fun," the author says. Readers can not only expect to learn the basics of behavioural economics and finance but also about our cognitive biases and how to avoid them.
The book starts chronologically with the author noting and investigating certain "misbehaviours" he had noticed as a graduate student but could not explain with any economic theory prompting him to create "The List".
For example, you are more likely to walk 10 minutes to a different store to save Tk500 on a headphone worth Tk2000 than if for a television worth Tk20,000. Even though in both circumstances, the amount saved is the same, we are more willing to go out of our way to save money on the headphone.
For a rational consumer, there would be no difference between the two situations as he/she disregards context when making financial decisions. Throughout the book, Thaler refers to these 'misbehaviours' often and offers an evidence-based explanation for each one of them.
One of the core principles of the book is "Endowment Effect" which proposes that we value something more when it is in our possession due to the effect of framing. Imagine that you inherited a Rolex watch worth Tk50,000. Although you may be willing to sell it at that price, Thaler shows that most people would not buy it at that price.
For an Econ, whether he/she owns the item does not impact their willingness to buy. Framing is so important to us that businesses often utilise it to promote their sales.
In that regard, the author also talks about our tendency to perform mental accounting when making decisions. Specifically, we weigh 'sunk costs' or the unrecoverable costs when making decisions. For example, choosing to sit through a bad movie to get your 'money's worth'.
Another consequence of mental accounting is our tendency to budget that violates the fungibility of money. To put it in perspective, while we may regard cash to be more liquid or accessible than a retirement savings account, for an Econ both sources are equally fungible.
This assumption along with many others is incorporated into economic models which limit their accuracy.
Using Prospect Theory, the author argues that due to various systematic biases (like hindsight bias or bounded rationality), human beings are 'loss averse' in the way we make decisions. Using the value function, Thaler shows us that we hate losing Tk100 more than we love winning Tk100, for example.
The author also addresses the many arguments he faced from colleagues and seniors who wanted to preserve the status quo of traditional economics. He categorically dismantles each argument with the help of his research and findings while simultaneously answering any questions the readers may have.
Thaler also presents the debates and arguments he had had with his critics like Eugene Fama and Merton Miller in a humorous and engaging manner. Throughout the book, he shows us that unlike what the models suggest, economic agents do not always maximise their utility. They make worse decisions when the stakes get higher and often change their minds.
The author also delves into financial markets to explore the pitfalls of financial economics. He challenges the theory of "efficient market hypothesis" that suggests that the price is always right and that we cannot 'beat' the market by choosing winning stocks.
While offering investment advice (value investing) and looking into market trends, Thaler illustrates how markets overreact causing shareholders to overvalue "winner" companies while undervaluing promising "loser" companies which post higher returns in the long run due to mean reversion.
In fact, he was so successful in beating the market with his value-investing strategy, that he started an asset-management company on the side. Moreover, using mutual funds as an example, he is also able to show that mispricings are very common in financial markets which result in arbitrage opportunities. For example, in 2014, Yahoo's stake in Alibaba was worth more than the stock price of Yahoo itself.
As a consequence of his research into financial markets, not only did he prompt academics to scrap the CAPM to develop better models (six-factor models comprising factor, size, value, profitability, investment and momentum) but also started the new field of behavioural finance and predicted economic bubbles caused by overreaction.
Thaler remarked that the 'smart money' or expert money managers did not keep the market efficient enough to prevent overvaluation and rather rode the economic bubble (like the real-estate one in 2008) and cashed out before it popped.
The book also discusses the author's pursuit to measure what humans perceive as 'fair' in a transaction while using his findings from various thought experiments and real-world scenarios (Uber and surge pricing).
He uses behavioural economics to explain the decisions the subjects in his experiment had made and concluded that unlike what game theory suggests, most people are 'conditionally cooperative' or what's known as a bargaining game with alternate offers.
This also means that when people feel like they are being treated unfairly, they will go out of their way to retaliate at a cost to their own (grim trigger strategy).
Most importantly, he re-emphasised that the perception of fairness is more important than being fair to people when it comes to making decisions, so framing matters.
Similarly, our struggles with self-control are thoroughly investigated and discussed. There is a reason the phrase, "out of sight and out of mind" is so relevant, Thaler tells us why.
One of the greatest impacts of the author's work in behavioural economics is policy reforms in retirement savings through his 'Save More Tomorrow' program that companies adopted to help employees save more for their retirement funds by overcoming certain cognitive biases.
Another notable achievement of his work was when British Prime Minister David Cameron's 2010 government had formed a Behavioural Insights Team (BIT) under his guidance which found innovative solutions to raise tax collection simply by changing the wording of the tax reminder notices.
Not to mention the fact that he won the Nobel Prize in Economics in 2017 for his contributions to behavioural economics as well.
In the end, the author emphasises the scope for further research in the field of behavioural macroeconomics, urges readers to encourage their own governments to form their own BITs and encourages leaders to reduce the cost of failure for their subordinates so that they are inclined to make more bold decisions for their company.
Throughout the book, Richard Thaler's storytelling abilities and simple explanations help the readers easily navigate such an advanced topic. It should be noted that despite highlighting the flaws of traditional models in his book, the author maintains that they are an essential starting point to develop better theories that focus on human beings rather than Econs.
Richard Thaler has made valiant attempts to engage his readers by adding interesting footnotes at the end of each chapter. Whether it's using behavioural economics to boost sales at a ski lodge, telling us to rarely check our investment portfolios to increase earnings or analysing the decisions made by game show participants, this book is a must-read for every economics, finance and business student.
I would not, however, recommend it for casual readers because even though the author tries to give thorough explanations about the economic theories he works with, many concepts may be hard to grasp without prior understanding of economics.
(Misbehaving: The Making of Behavioral Economics; Edited by Richard H. Thaler, W. W. Norton & Company, pp. 415)