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What Richard Thaler Has Taught Us About Economics… and Markets

On October 9, this year’s economics Nobel winner was announced: Richard Thaler of the University of Chicago.  

Mostly, the advances made by economists who win the Nobel can seem a little abstruse, but Mr Thaler’s contribution is different.  To understand why needs a little history.  Forgive us for this digression — we promise you’ll understand its relevance to the markets by the time we’re through.

Chicago’s Richard Thaler:  Making the Dismal Science Less Dismal

Source:  Xinhua

Economics: Where It Came From

The discipline we know as “economics” began as a branch of moral philosophy at the end of the 18th century.  Adam Smith, author of The Wealth of Nations, one of the earliest “economics” texts, was a moral philosopher by training.  The discipline he helped give birth to was called “political economy,” and for most of the 19th century, it existed squarely in the realm of qualitative social sciences.  People thought of “political economy” mostly as akin to history or politics, not math or physics.

Toward the end of the 19th century, though, as ever-huger strides were being made in the physical sciences, political economists began to get a bit of an inferiority complex.  A few brilliant theoreticians, particularly Alfred Marshall, started to lay the foundations for an economic science that would be much more rigorous and mathematically based.  It was thanks to his work that we stopped calling the discipline “political economy” and began calling it “economics.”

There were some heretics.  Joseph Schumpeter, and more broadly the so-called “Austrian School” of scholars like Ludwig von Mises, maintained a view of economics which explicitly recognized that it was rooted in human behavior, human intention, and human desire.  But by and large, economics got more and more “mathy,” so that it could take its place at the table of “real” sciences and get the respect of “real” scientists.

In order to do this, economics had to create mathematical models, and those models were inevitably great simplifications of reality.  Unlike a physics lab, where scientists can carefully hold all variables constant except the one they want to study, the world which economists study has thousands (maybe millions) of important variables that can’t be controlled.  So instead of controlling them, economists simply assumed that they were constant.  We all know that magic incantations have to be in Latin, so economists used one: ceteris paribus, “all other things being equal.”  That way, the messy, impossibly complex reality of human economic activity can be reduced to a system of elegant equations, principles, and high-level abstractions.  Some of those elegant equations proved to be extremely useful and insightful.

Source:  Wikipedia

However, it’s easy to forget that these simplifying assumptions have been made.  And pretty soon the majority of the economics profession was functioning as if their mathematical models were a straightforward representation of reality… rather than a very tentative attempt at an extreme approximation.  And then the tendency was to keep assuming the model was real, even when there were observable phenomena that didn’t fit the model’s predictions and assumptions.  

Of course, one of the biggest of these unexamined assumptions that made the micro-economic models work is that human beings are rational value maximizers.  (None of us, especially those of us who are married, would ever operate with this assumption in real life.  If our spouses were rational, clearly they would do everything our way.)

Enter a Troublemaker

Richard Thaler was the boy who shouted that the emperor had no clothes.

Even in graduate school, when he noticed that the realities of observable human economic behavior deviated from the models’ assumptions, he didn’t ignore that; he took a puckish interest.  He was willing to talk about the uncomfortable facts and pursue a deeper, more complete, and more satisfying explanation.

In one of his early papers, written when he was still an untenured professor at Cornell University, he wrote:

“The economic theory of the consumer is a combination of positive and normative theories.” (That is, theories that purport to say what is the case as well as what ought to be the case.)  “Since it is based on a rational maximizing model it describes how consumers should choose, but it is alleged to also describe how they do choose.  This paper argues that in certain well-defined situations many consumers act in a manner that is inconsistent with economic theory.  In these situations, economic theory will make systematic errors in predicting behavior.”

That was a gauntlet thrown down in front of the whole economics profession.  Thaler went on to develop these insights, refine them, and test them with ingenious experiments throughout his career.  In doing so, he founded a new branch of economics, “behavioral economics,” that studies how human beings actually behave in economic activities and tries to base its theories on those observations, rather than on a set of plausible assumptions.  And of course, as we all knew but economists wanted to ignore for the sake of having simpler models, humans are not just rational value maximizers.  

In a way, behavioral economics brings the science back to its origins as a human science, without throwing away the insights brought by a century of “mathiness.”

Bringing the Humanity Back Into Economics

Here are a few of Thaler’s main discoveries.

First, humans are not immune to ignorance or stupidity, and their economic actions prove it.  In more polite terms, humans have the problem of “bounded rationality” or “cognitive limitations.”  They may be rational, but that’s not all they are.  For example, Thaler observed that individuals are more averse to losses than they are enthusiastic about gains.  (This means, among other things, that they weigh out-of-pocket costs more heavily than opportunity costs.)  He coined the phrase “endowment effect,” which means that individuals assign greater value to things they possess than to similar things they don’t own.  (In one experiment, people given a mug and then offered the chance to sell it valued the mug on average four times more highly than they did when they were bidding on other people’s mugs.)  And he developed a theory of “mental accounting,” where individuals fail to consider their economic life as a whole, and compartmentalize it in a way that prevents them from maximizing the value of their resources.  All of these distort “fully rational” behavior in a variety of ways, and help explain systematic deviations from the value-maximizing behavior that mainstream economic theory predicted.

Second, humans can’t control themselves very well a lot of the time.  Thaler developed a model of humans called the “planner/doer” model.  Rather than just assume that humans are perfectly knowledgeable, far-sighted planners, he suggests that while we have that planner within us, we also have a “doer” who is much more focused on immediate gratification.  The uneasy coexistence of these two “inner people” can explain a lot of the irrational savings behavior of households.  Thaler has seen some of these insights confirmed by neuroscientists.

Third, “social preferences” matter.  Humans actually do care about fairness and equity in economic transactions, which helps explain a variety of anomalies in labor markets.  Some of Thaler’s experiments in this area, such as the so-called “dictator game,” are fascinating.

All of these tendencies are probably rooted in deep evolutionary hard-wiring… which is why overcoming them can be so difficult.

These insights don’t just concern individual consumers and workers; Thaler also demonstrated that they do not disappear when many individuals act together in a firm or in a market.  This led to the development of a new field of finance — behavioral finance — which examines the impact of the behaviors Thaler studied on finance and investment.

Efficient Markets?  Not All the Time

Are markets “efficient”?  It’s a never-ending argument, often between the more scientifically minded theoreticians of finance, and the more pragmatically minded investors and traders.  Thaler’s insights, though, have allowed a new generation of behavioral finance practitioners to give scientific explanations of some of the irrational market behaviors that traders observe and work with.  Investors, even when they come together in large markets, exhibit the same kind of limited cognition, lack of self-control, and social preferences that consumers do — and therefore systematic inefficiencies can persist in markets without being arbitraged away.  At least one can say that in its strongest forms, the “efficient markets hypothesis” has been put in serious question by Thaler’s work.

For example, mental accounting, the “endowment effect,” and loss aversion combined can explain why investors can tend to hold onto losing stocks and sell their winning stocks.  It takes considerable mental discipline to overcome this tendency… and en masse, investors will continue to fall into it, affording opportunities to those who are able to overcome it.

Investment implications:  One of the reasons that active management persists through its seasons of decline and renaissance is that it recognizes and tries to exploit some of the real-world human behaviors which Richard Thaler studied and integrated into the new disciplines of behavioral economics and behavioral finance.  Traders and active managers always recognized some anomalous market phenomena for which Thaler helped develop a systematic theoretical framework.  His work is worth studying for anyone who wants deeper insight into their own cognitive shortcomings, and where their own tendencies lead them to make sub-optimal investment decisions.

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