If you were paired up with a stranger and told that (1) the stranger would decide how to split $100 from a benevolent source between the two of you and (2) that you had the ability to either accept the deal (whereby you each got the money that the stranger proposed) or to reject it (whereby neither of you would get any money), would you accept a split of $95 to the stranger and $5 to you? Despite knowing that accepting the arrangement will increase your wealth, most people would misbehave according to economic standards and reject this arrangement. They would rather forgo the money in order to punish someone who is acting unfairly. This “Ultimatum Game,” is just one of many interesting games, studies, and topics discussed in Richard H. Thaler’s book Misbehaving: The Making of Behavioral Economics. Thaler walks the reader through sort of a Who’s Who of Behavioral Economics as well as the research and papers that created the field that it is today. He does this through amusing anecdotes, examples, and well-explained experiments. It is a very enjoyable read!
Early on in the book, I was delighted to see a reference to an actuary. The author’s father, Alan Thaler, is an actuary who provides the younger Thaler with a Society of Actuaries book on occupational mortality. Using this, Thaler estimated how much people would have to be paid to be willing to accept a higher risk of dying on a job. As part of this analysis, Thaler found that by phrasing questions about the trade-off between money and risk of death differently, people responded differently. Although the expected values were the same in the questions, people showed different risk appetites based on how the question was asked. This was a violation of economic theory, in which people are rational decision makers and their risk-appetites stay consistent for a given situation, regardless of the wording of the question. Thaler begins to see that there is a quite a disconnect between “Econs,” the rational beings that are necessary for standard economic theory to hold true versus “Humans,” the people we all are that “misbehave” by changing our preferences based on wording, by being overconfident at times, by struggling with self-control, and by using rules of thumb, to name a few.
Using rules of thumb will work at times for us Humans, but it will lead to us making predictable errors when the instance we are being asked about isn’t really in our wheelhouse of experience. For instance, we often hear about gun violence through the news. If asked if there are more gun deaths caused by homicide or suicide in the United States, most people respond incorrectly. Gun deaths from suicide are almost double the number of gun deaths by homicide, yet homicide is the common response. This is not a random error that can be cancelled out in a statistical exercise. It is an example of a systematic bias that we “Humans” have.
We Humans know that we aren’t the best decision makers, so shouldn’t we be able to learn from our mistakes or rely on others to help us? Thaler reminds us that in order to learn from experience, we need frequent practice and immediate feedback on our decisions. Unfortunately for us, the big events in life like accepting a job, buying a house, getting married, and saving for retirement are things that we may only do a few times during our lives, at the most. We can get fairly good at the small decisions in our lives, like shopping for a sweater, but for the big decisions, it is likely that we will make mistakes. If we think that we need to rely on an expert to help us figure out the financing for a new home or how to invest our money for retirement, we probably need help knowing how to find the best expert to help us! Despite our flawed decision-making and lack of expertise, we Humans will carry on the best we can. Thaler points out that General Motors has never been regarded as a well-run company, but they have successfully “stumbled along as a badly-run company for decades. For most of this period they were also the largest car company in the world.”
Thaler’s opinion of General Motors was no doubt influenced by a potential consulting gig he had there, which he details in the book. At the time, GM was offering customers a choice between a loan with an interest rate of 2.9% (compared to the going interest rate of 10%) or a rebate to sell the current year’s models before the new models came out. A reporter from the Wall Street Journal had done the calculations and determined that the rebate had more economic value than the lower interest rate. (The rebate applied to the down payment for the car would reduce the amount the customer needed to borrow. This reduced amount at the 10% interest rate was cheaper than borrowing the original amount at the 2.9% interest rate.) Many customers were opting to take the 2.9% loan instead of the rebate though. Thaler found this interesting and thought he might have a simple psychological explanation for the customers’ behavior. Through a friend, Thaler ended up going to GM and speaking with many of the company’s vice-presidents. He learned that the promotional loan amount of 2.9% was decided upon by the CEO because he liked the sound of that number versus 3.9% or 4.9%. There was not much science behind the decision. Additionally, Thaler asked who was going to evaluate the promotion and whether it should be offered again in the future. No one at GM seemed inclined to do the assessment. Thaler ultimately recommended to GM that they figure out why the promotion had worked so well and also to make plans for the future. His ideas were rejected. GM thought it would better plan its production for the following year, and therefore, there wouldn’t be a need for sales of the excess summer inventory. Needless-to-say, there was a sale the following year to get the current year’s models sold prior to the new models coming out. While GM is the company at the center of this particular story, it probably could represent many companies. This example from Thaler reminds us that we have a responsibility to test, evaluate, and learn from our decisions. We should also try not to be so overconfident in our abilities.
As Humans, we can be very risk-averse at times. Thaler explains that the more that we look at our investments, the less willing we are to take on risk because we see losses more frequently. Looking at our retirement plan only once a year may result in us earning more money in the long run, than if we look at it on a monthly basis and re-evaluate our investments. Thaler’s advice to investors is this: “I tell them to buy a diversified portfolio heavily tilted toward stocks, especially if they are young, and then scrupulously avoid reading anything in the newspaper aside from the sports section. Crossword puzzles are acceptable, but watching cable financial news networks is strictly forbidden.”
Thaler’s section of Misbehaving that focuses on anomalies in the financial markets will be very familiar to those of you who have taken Exam 9. He briefly reviews and discusses flaws with CAPM, as well as Fama and French’s 3 Factor Model. (As a bonus, you will get to learn whether Fama finds getting into his high school’s athletic hall of fame more or less valuable than getting a Nobel Prize.) You also learn about arbitrage opportunities like the 3Com/Palm situation. It was a nice refresher to hear the particulars of that circumstance again, but I must admit that I mostly enjoyed hearing that a PhD student at the University of Chicago was actually able to take advantage of the situation and bought a sports car (nicknamed the Palm-mobile) with his profits. For those of you who have yet to take the exam, Misbehaving can be a very nice introduction and/or supplement to the Bodie, Kane, Marcus textbook, Investments.
My favorite parts of the book were the real life examples of improvements companies or governments made through behavioral economics. Hearing how a struggling ski resort was able to entice more business from the locals through a “ten-pack” or how the United Kingdom could speed up the payment of overdue taxes by including the sentence, “You are currently in the very small minority of people who have not paid their taxes on time,” in the letters to the truants makes me realize what a powerful effect some small changes can have. We are “Humans,” not “Econs,” and we will continue misbehaving. I for one, am not planning on assessing the opportunity cost of spending my time reading Misbehaving and writing this post….