Misbehaving: The Making of Behavioral Economics

Richard Thaler’s book, Misbehaving: The Making of Behavioral Economics, is both a fascinating look at the way humans make economic decisions and an interesting account of the history of this field within economics. Despite being an easy read, this book teaches important lessons.

I had no idea that claiming humans are not completely rational was once controversial in the field of economics. The term used for a person who makes perfectly rational financial decisions is “Econ.” The entire field of economics was built on the notion that we are all Econs. Of course, we aren’t. Economists used to deny that our irrationality had any serious impact on markets, but Thaler devoted his career to showing how our mistakes are an important part of economics.

One interesting finding is that “people who are threatened with big losses and have a chance to break even will be unusually willing to take risks, even if they are normally quite risk averse.” Perhaps this is the source of the common offer of “double or nothing.”

One part of the book was particularly tough on dividend investors. Thaler says that “in a rational world,” preferring dividends to capital gains “makes no sense.” “A retired Econ could buy shares in companies that do not pay dividends, sell off a portion of the stock holdings periodically, and live off those proceeds while paying less in taxes.” He goes on to describe a preference for stocks paying high dividends as “silly.”

Given a chance to take a fair coin flip to win $200 or lose $100, many people who would not do this once say they’d be happy to do it 100 times. Thaler explains why this is irrational, but notes that people think this way anyway.

Other research shows that people become less willing to take on risk if they see frequent losses. Combining this fact with the up-and-down nature of the stock market, we find “that the more often people look at their portfolios, the less willing they are to take on risk, because if you look more often, you will see more losses.”

Thaler explains a number of problems with strong forms of the efficient markets hypothesis, but notes that despite mispricings, “investors who attempt to make money by timing market turns are rarely successful.” This seems to be a common theme in the stock market. We can find anomalies, but it’s hard to profit from them.

The book contains humour as well. In a section analyzing the value of NFL draft picks, Thaler tells the story of the Redskins trading away several picks over multiple years to the Rams to get quarterback RG3. At the beginning of a game between the two teams, “the Ram’s coach sent out all the players they had chosen with the bonus picks to serve as team captains for the coin toss that began the game. The Rams won the game 24-0 and RG3 was sitting on the bench due to poor play.”

Thaler discusses the importance of “nudges,” which are ways to make it easier for people to do the right thing. Translating to the Canadian tax system, he suggests that RRSP contributions would increase if people could direct their tax refunds to their RRSPs and have the contribution count “for the return being filed (for the previous year’s income).”

Another amusing and likely effective nudge is when people need to “leave for higher ground before a storm strikes ... offer those who opt to stay a permanent marker and suggest they use it to write their Social Security number on their body, to aid in the identification of victims after the storm.”

It’s tempting to laugh at the kinds of mistakes people make and feel confident that we don’t make such mistakes. Of course, this isn’t true. It makes sense to try to make the choices an Econ would make, but we are doomed to fail sometimes. Hopefully, by pointing out the ways we make mistakes, Thaler is helping us make better choices.