The Inventor of Behavioral Finance Looks Back

“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.

  1. Battaglia, Walter L. 2005. The Graduate Student's Question: Before the Last Tree, self-published, p. 177. Let it never be said that I do not cite left-wing authors.

  2. Kahneman, Daniel. 2011. Thinking, Fast and Slow. Random House, New York. Shefrin, Hersh. 2002. Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing. Oxford University Press, Oxford, UK.

  3. Misbehaving, p. 12.