“Economics is…a branch of…animal behavior.” – Walter L. Battaglia1
Behavioral finance is one of the great discoveries of our time, and the University of Chicago professor and
investment manager Richard Thaler is one of its principal discoverers. Misbehaving is Thaler’s
personal account of his discoveries, which influence the way assets are managed, policy is conducted and economic
theory is understood and taught.
Behavioral finance is the idea that investors do not act like the rational optimizers and profit maximizers that
neoclassical economics assumes them to be. (Behavioral economics, a related field also closely linked to Thaler,
studies irrational behavior in the real economy.)
Misbehaving is not an exceptional read. Thaler is not Michael Lewis or Peter Bernstein, weaving dry
concepts into magical prose. His book, constructed as a memoir, is workmanlike and informative with much to
recommend it. But the reader is unlikely to come away with a changed view of the world. Those interested in
revolutionizing their thinking on human behavior as it relates to investing should start with Daniel Kahneman’s
Thinking, Fast and Slow – a psychology book – and Hersh Shefrin’s Beyond Greed and
Fear, which delves deeply into the investment issues raised by behavioral finance.2 Read those
and add Thaler’s book as enrichment.
Misbehaving is one part personal history, one part brief against neoclassical economics, one part primer on
behavioral economics and finance and one part guide to practical applications. (The main applications are active
investment management, where investors’ predictable errors provide a framework for beating the market
and “nudge” policies, which are behavioral tricks intended to help people help themselves, for example
by saving more.) While Misbehaving does not hold together as a unitary book, it combines different aspects
of Thaler’s work into a single, accessible volume, and in that regard it succeeds.
A personal victory
Thaler’s journey through the economics profession was a curious one. As a young Ph.D. student, he attacked
head-on one of the most fundamental principles of conventional economics, the assumption that economic agents
(people) act rationally. Others who had taken this path did not get far. The late labor economist Sherwin Rosen,
unimpressed with Thaler, said, “We did not expect much of him.”3 Yet, some decades later,
Thaler ended up as president of the American Economics Association, the field’s most prestigious group. In
that sense behavioral economists have won – it has become socially acceptable to be one – despite the
persistence of the rationality assumption as the foundation of economic analysis.
Cognitive biases
Behavioral economics and behavioral finance are based on the observation that people do not process information
rationally. Instead, they suffer from cognitive biases, imperfections in processing that cause people to believe
things that aren’t true, misunderstand the consequences of even simple decisions and act against their own
interest. Thaler devotes several chapters to documenting these often amusing foibles.
For example, a plurality of people surveyed think that if they paid $20 for a bottle of wine, but it is now worth
$75, drinking the bottle costs them nothing (because they already paid for it), but dropping and breaking the bottle
costs them $75. If that is the best that people can do in assessing the costs and benefits of an action, no wonder
they misprice securities, invest in funds that have already gone up and fail to save enough for retirement! The
behavioral critique of rationality in economics and finance certainly has strong intuitive appeal.
Humans and econs
Thaler draws a sharp distinction between real people, who make mistakes – “humans” – and the
fictional agents of economic models, whom he calls econs.4 Econs are lightning-fast calculators who have
access to complete information about every situation, understand all of the ramifications of their decisions and
make each decision with an eye to maximizing utility, invoking a kind of enlightened selfishness.5 People
don’t behave like that, so it’s sensible to question what would happen to economic theories and
predictions if one drops the assumption that they do. That is the essence of Thaler’s contribution to
economics, and it’s a valuable one.
Yet Thaler overstates the faults of conventional economics. There may have been (and there still may be) economists
who believe that humans act like utility-maximizing genius robots, but I haven’t met one. More realistically,
economists tend to believe that economic models can be constructed as if people behave like econs, and that
such models are much more useful and accurately predictive than they would be if one had to drop the rationality
assumption. Without the rational-agent assumption, economics would be lost at sea, unable to make a prediction or a
policy recommendation – but that doesn’t mean the assumption is, or should be, realistic. A half-century
ago Milton Friedman famously argued that the test of a theory is the accuracy of its predictions, not the realism of
its assumptions, and that principle still holds.6
The “as if” critique, dismissed by Thaler, is actually relevant
Thaler, noting that he encountered the “as if” critique often in his early effort to persuade colleagues
of the behavioral view, is dismissive of it:7
One of the most prominent of the putdowns had only two words: “as if.” [T]he argument is that even if
people are not capable of…solving the complex problems that economists assume they can handle, they
behave “as if” they can… Even today, grunts of “as if” crop up in economics workshops
to dismiss results that do not support standard theoretical predictions.
While Thaler is dismissive of this concept, it deserves a fair hearing.
It is hard to overstate the beauty and power of neoclassical, rationality-based economics as an explanation for the
world as we see it (or “theory of everything”). Once you’ve grasped the importance of tradeoffs,
incentives, competition, cooperation, decision-making on the margin and so forth, you see these principles in
everything, including non-human realms such as biological evolution.8 Yet behavioral economics says that
the founding principles of conventional economics, especially the assumption of rationality, are, in some sense,
wrong. If that is the case, we can’t rely on the intuition provided by conventional economics, about the real
economy, financial markets or much of anything else.
For example, conventional (neoclassical) economics says that companies increase their production until the marginal
cost of a unit of production equals marginal revenue. By asking corporate managers, Thaler found that many companies
don’t even know that their marginal cost varies with the amount produced, nor do they maximize profits by
setting output at the optimal level. Instead, they try to sell the greatest number of units they possibly can.
Does behavioral economics, then, overturn this foundational idea, that companies set marginal cost equal to marginal
revenue? Yes and no. “Sell as much as you can” is a pretty good – not perfect – heuristic
for getting close to the profit-maximizing level of output because of the limits placed on “as much as you can”
by competitors’ production and pricing, alternative uses for the money and consumers’ limited ability to
pay. There will be some waste, some unsold goods, but not a lot! And there will be some waste with the marginal-cost
method, too, because of error in estimating the proper level of output.
At any rate, companies will learn pretty quickly not to make massive, repeated mistakes in determining output
because, if they do, investors will allocate capital elsewhere, driving the poorly-run company’s stock price
down or running the company out of business (which is exactly as it should be; markets are a machine for allocating
capital to its best use, unforgiving of poor management). The economy functions as if conventional
economics is its set of operating instructions, even if that isn’t precisely true.
From behavioral economics to behavioral finance
As Thaler points out, finance is the branch of economics where behavior is most likely to be rational because
financial markets tend to be liquid, transparent, deep, continuous and subject to arbitrage. Thus, it was in finance
that the discovery of behavioral anomalies was most surprising and most vigorously resisted.
Still, the anomalies are there, and there are many of them. Thaler recounts many anecdotes familiar to readers of
other behavioral finance literature. Among them are the stocks of 3Com and Palm, linked by crossholding, which were
priced in such a way that, by using a long-short strategy, 3Com could theoretically be purchased at a negative
price; the inconsistency of the prices of Royal Dutch and Shell, which are claims on the same corporate assets; the
existence and persistence of value and small-cap anomalies that violate the CAPM; and many others. By the time
Thaler is done, you would have to be immune to logical reasoning to believe that market prices, always and
everywhere, reflect fundamental value.
The dogmatism of (some) academics
But today’s investors are unlikely to appreciate the extent to which academics in the 1970s, when Thaler began
his quest, shut out all attempts to show how or why markets might be inefficient. As Thaler notes, most papers that
challenged efficient markets were rejected outright by prestigious journals, and the few that were accepted were
accompanied by “abject apologies [from the authors] for the results.”9 It was as though the
authors had announced to their preachers that they had ceased to believe in God.
It is right for the proponents of a good theory to defend it from flaky, flat-Earth attackers. But, in the case of
efficient versus inefficient markets, there were good arguments on both sides. The academic community should be
embarrassed by the long delay between Fama’s groundbreaking 1964 study showing that markets are likely to be
efficient and the wide acceptance of market efficiencies in the 1990s; it was one of the worst examples of
groupthink ever.10
Thaler and his behavioral compatriots, of course, had much to do with this shift in attitudes. Part of the shift
came from the persistence of well-trained academics, such as Thaler, in poking holes in efficient markets –
and part of it came from the obvious success of practitioners in exploiting inefficiencies, culminating in the
hedge-fund craze of the last 20 years.11 Readers interested in the history of financial thinking will
find Thaler’s account of this transition, and of his role in it, valuable.
Beating the market
The beginnings of behavioral finance, and of Thaler’s story, rely heavily on Shiller’s [1981] finding
that stock indices fluctuate much more than can be justified by subsequent changes in fundamental
value.12 (See Exhibit 1, created by Shiller but reprinted in Misbehaving, comparing actual
levels of the S&P 500 with hypothetical fair values calculated by discounting all future dividend payments,
where the calculation is done as if those future dividends had been known with perfect foresight.13)
Do Stock Prices Move Too Much? Comparison of Detrended Real Stock Prices with Hypothetical Perfect-Foresight Prices
Based on Future Dividends, 1871-1979
Source: Shiller (1981), p. 422.
I believe that stocks fluctuate more than is justified by changes in fundamentals – the crash of 1987 is a
case in point – but Shiller’s argument is not a fully convincing one. Stock prices are present values
and, as such, are exquisitely sensitive to changes in both the discount rate (which Shiller’s study takes into
account) and the expected long-term growth rate (which it does not take into account). In the 1930s and, to
some extent, the 1970s, it looked as though economic and earnings growth would be permanently much lower than
before. In the 1960s and 1990s, growth was expected to be much higher than before. Nobody had perfect forecasts or
even tolerably good ones. Of course stock prices fluctuated more than they would have if good long-term growth
forecasts had been available!
Today, stock prices are fairly high while growth is widely expected to be slow. Should equity owners sell? I did,
prior to the crash of 2008, and I now regret my decision every time the market hits a new high. I’m also
afraid to get back in. It’s difficult to time the market, even if behavioral finance teaches us that the price
is not always right.
Value versus growth
If stock prices overreact to changes in information – a hypothesis strongly supported by Thaler – then
one should be a value investor. Good news causes a stock to become overpriced, even after taking into account the
increase in fundamental value caused by the news, and you should sell the stock; likewise, bad news causes a stock
to become underpriced and you should buy it. A value strategy will take advantage of this effect.
But Thaler also indicates that stock prices can underreact. If that is the case, then you should be a momentum
investor! The reason is that good news, not fully incorporated in the stock price, will cause the stock to rise
further after you’ve bought it.
So…which is it? The verdict seems to be that stock prices both overreact and underreact, and it’s hard
to tell which is which in any given situation. Stock prices, instead of being right all the time (the efficient
market hypothesis), will be wrong much of the time. If that is the case, you should mostly be a value investor since
wrong prices are a mixture of too high and too low, and value strategies overweight the low ones. This intuition has
been vindicated by decades of value-stock outperformance although the value effect is highly variable and cannot be
relied on in any short or even medium-length time period. Nor is there any assurance that the value advantage will
not be arbitraged away as more capital flows into such strategies.
Nudge
The last chapters of Misbehaving recap Thaler’s effort, with co-author Cass Sunstein, to help people
achieve their savings goals and otherwise improve their lives.14 This effort, labeled “libertarian
paternalism” by the authors, has begun to transform defined-contribution retirement savings. The idea is
counter to the top-down, regulatory impulse of government and seeks to improve people’s behavior as judged
according to their own criteria. This last part is important.
Behavioral scientists have discovered that small influences or “nudges” can have big results. An example
is Thaler and Benartzi’s [2004] “Save More TomorrowTM” plan which, in a test site, increased
employee savings for retirement from 3.5% to 13.6% in just four years by asking employees to commit to save part of
their future raises.15 Since the normal cost of a traditional pension is only 15% of payroll, this plan
could achieve the savings needed to help make DC plans work as well as DB plans (although the needed investment
return at a savings rate of 15% is higher than one can reasonably expect under current market conditions).
Other “nudges” are having similar success in other areas, such as getting taxpayers in the U.K. to pay
their taxes more promptly to avoid penalties. The idea is not new; the speed limit is basically a nudge, rarely
enforced but widely followed within a standard error of about 9 miles per hour. But libertarian paternalism, in an
era when government is not widely trusted but people desperately need help in achieving many different goals, is a
concept with promise.
Conclusion
Misbehaving is a welcome addition to the literature on behavioral economics and finance. Its benefit to
investors is indirect because it is a book on economic concepts, not investment strategy. Moreover, as a memoirist
telling a tale of scientific discovery, it helps to be a natural raconteur like the great Richard
Feynman.16 Thaler’s storytelling is drier and more matter-of-fact. But those wishing to round out
their general knowledge of important topics that affect investors will benefit from reading Misbehaving.
Read more articles by Laurence Siegel