6 Lessons from Misbehaving | Richard H. Thaler
I picked up this book out of my recent curiosity about behavioral economics. The last book I read was Predictably Irrational by Dan Ariely. It was a paradigm shifter for me and allowed me to see the connection between economics and psychology, two fields that I am both interested in. The author of Misbehaving, Richard H. Thaler, is one of the founders of behavioral economics and has won the Nobel Prize of Economics in 2017 and I was hoping to gain some insights into the fundamentals of the field. However, the book was not about that, though it contains some information. It was more about the development of the field, from the initial irregularities in traditional economics to becoming into a new branch of economics. Even though it was not the book I had in mind, I was pleasantly surprised by the book since you don’t often read about how a new field of study comes alive. Overall, I found this book to be a very interesting read from a rebel who is not afraid to challenge the basic premise of economics.
How Should Read It: For anyone who is interested in the history and development of behavioral economics
1. Traditional economics is rational, but people are not.
This is the single key argument of behavioral economics. In traditional economics, people are expected to be perfectly rational and well informed, and always looking to maximize the potential outcomes. However, this is rarely the case: people still buy that expensive designer shirt that could never justify the price, people still value their own stuff way more than its market value. In other words, people act on their emotions and it is nearly impossible to optimize every single decision in life since people’s mental resources are limited. Here is where behavioral economics enters the picture: by introducing a term called Supposedly Irrelevant Factors (SIFs), which includes psychological components such as sunk costs and endowment effects.
Besides the optimization problem, another factor that traditional economists tend to overlook is the fact most of us have a self-control problem. If people have perfect self-control, everyone will be able to save money for retirement instead of spending it all on an impulse purchase. However, this is usually not the case. In addition, people would remove themselves from tempting cues to avoid bad behavior but this behavior would bewilder a traditional economist. As Thaler suggests, traditional economics expect people to be perfectly rational and well informed and have perfect self-control. Behavioral economics fulfills the missing part by adding human psychology into the picture.
2. Some Theories in Mental Accounting
Mental accounting is the mental process people use to evaluate outcomes of a certain transaction. This is where psychology mingles with economics to explain some interesting everyday decisions.
- Transaction Utility: humans don’t just think in terms of numbers but also the perceived quality of the deal (i.e. stores can use high price to mark the quality of the goods but discount it as a sale and therefore increase the transaction utility to the consumers)
- Delayed Consumption: when we buy something for the future, we think of ourselves as investing rather than an expense. But when we actually consume the product, we treat it as free (i.e. business targets this psychology buy providing bundles or annual passes. People would make a big one-time payment to purchase a bundle and think it is a good investment. When they start using it, they would consider it to be free)
- House Money Effect: when people won money, they think of the money as “house money” and takes greater risks (i.e. people tend to act more irrationally and aggressively in gamble when they won money)
- Break-Even Effect: when people are losing but have the chance to break even, they are willing to take greater risks to erase their loss (i.e. another psychology that is common on the gambling table. People would take bad risks simply for the tiny chance to win back their lost money)
3. People Like to Be Fair
People like to be fair and expect others to do the same. A condition where unfairness is perceived is when the business raises prices during high demands, such as Uber surges. Even though this action might make perfect sense in a traditional economist world, people do not like unfairness and therefore decreases the reputation of the business. The only exception to the perceived unfairness is when all the competitors do the same thing. The most noticeable example is the airlines. Airlines could charge all different kinds of fees as long as the whole industry is doing it. Thaler further suggests that people don’t just “not like” unfairness, they “hate ”unfairness and would sacrifice themselves to punish those who are behaving unfairly.
Another interesting fairness phenomenon is donations, where people are willing to sacrifice their self-interests for the good of the public. This does not make any sense in an economist's mind, in fact, if people are perfectly rational economist-minded, donation would not occur. Therefore, Thaler contributes most people as conditional cooperators, meaning they are willing to cooperate as long as others do the same.
4. See the Big Picture
Another common psychological mistake that Thaler notices is that people often fail to see the bigger picture. For example, most people would not take 70% chance of making $150 and 30% of losing $300 only once but would willing to do it if they can do it 100 rounds. This is myopic loss aversion, the tendency to refuse to take a risk once but would play the game several times and use laws of large numbers to take advantage of favorable odds. This often occurs in investment firms. Investors would treat each investment as individuals as may lose out on many good opportunities such as the deal mentioned previously, which Thaler calls “narrow framing”. The best way to counter this instinct is to step outside of each opportunity and see the long term values of this investment by treating investments as a portfolio rather than a single event of win/loss.
5. The Stock Market
The stock market is another place where traditional economists cannot explain: if people are perfectly rational and trade based on the exact value of the stock, no trading would take place because no one would buy a stock that does not have good value and therefore the stock market would be dead. However, the reality is that the stock market constantly has an extremely high trading volume and the price of each stock is constantly changing. The volatility of the market is largely contributed by noise traders, who tend to overreact to news or trade based on Supposedly Irrelevant Factors. Thaler suggests value investing is better than timing the market since it is difficult to predict the market due to people’s irrationality. Combined with narrow framing advice from the previous section, I would highly recommend Index Funds since it is not only value investing but also diverse investing.
6. Nudge: Guidance to the Right Behavior
Thaler coins the term “nudge” as ways to incentivizing humans to solve their own problems in the right way through certain systems and rules. In fact, he wrote an entire book dedicated to this subject and he mentions briefly in this book. He suggests that people often enjoy the right to choose, but can’t often make decisions that are best for them. For example, high school students would always pick pizza or burgers over veggies and fruits in their cafeteria. Therefore, it is important to place healthy foods in places that are obvious to nudge students into picking the right choice for their health. Another example is that startups often face the risk of losing everything if failed. Therefore, the better way to incentivize more startup creations is to mitigate the risks of failure rather than cutting taxes or rates.