Econs and Humans
As many of us know, sometimes it is difficult to bridge theory and practice. In theory, just about everything is relatively easy. In practice, though, we find that things that appear to be quite simple, like eating a healthy diet, exercising consistently, saving money and making time for loved ones can prove to be quite difficult.
When it comes to bridging the gap between economic theory and the reality of human behavior, there is a field called “behavioral economics” that attempts to do just that. Traditional economics argues that we all aim to optimize and that we all act rationally. As we all know, (likely through countless examples!), humans do not always act rationally.
In 2015, Richard Thaler authored a book entitled Misbehaving: The Making of Behavioral Economics where he detailed the differences between the two fields and also discussed, in great detail, how behavioral economics got its start. Over the next several paragraphs I’ll outline some helpful lessons from the book.
Early on in the book, Thaler points out that he has “been preoccupied by these kinds of stories about the myriad ways in which people depart from the fictional creatures that populate economic models.” Thaler doesn’t point the finger at humans for being silly but rather states that, “the problem is with the model being used by economists, a model that replaces homo sapiens with a fictional creature called homo economicus, which I like to call an Econ for short. Compared to this fictional world of Econs, Humans do a lot of misbehaving.”
Further, as Thaler suggests, economists can get themselves in trouble when they make predictions that depend on all individuals being “economically sophisticated.” Assuming everyone will save optimally for retirement or that financial bubbles are theoretically impossible could lead to some dreadful consequences. Behavioral economics is still economics, however, it is economics with “strong injections of good psychology and other social sciences.”
My undergraduate major was psychology and my background in the subject is something for which I am thankful for frequently. In my estimation, it relates to all disciplines and is useful in most human interactions. Italian economist and sociologist, Vilfredo Pareto said it best in his 1906 quote, “The foundation of political economy and, in general, of every social science, is evidently psychology. A day may come when we shall be able to deduce the laws of social science from the principles of psychology.”
As for lessons from Misbehaving that can be applied directly to one’s life, one is that economic theory, which assumes that everyone is rational, will likely differ significantly from reality. We know that every human acts irrationally, at one time or another. And by “one time or another”, I mean very frequently! Because humans have emotions, don’t get enough sleep because they binge watch Netflix until 3:00 a.m., have bad days and lack self-control, etc., etc., behavioral economics is needed to bridge the gap between rationality (aka optimal behavior) and actual human behavior. This bridge is really important when you are navigating the real world.
To improve individual decisions as well as larger policy decisions, Thaler recommends we start paying attention to supposedly irrelevant factors. An Econ would never buy too much food at the grocery story because they went shopping while they were hungry, yet humans make that mistake all the time. An Econ would never drive to Minnesota in a blizzard, risking their life to watch a sporting event, yet humans often do that—and are more likely to do so if the ticket was very expensive (thus disregarding the concept of a sunk cost)!
Some ways to use behavioral concepts from the book that should help all of us make better decisions:
Options aren’t always better; keep in mind most humans have limitations on their willpower. Do not put yourself in a position that may compromise your ability to make an optimal choice.
Example: Thaler used a “cashew” example. He and his wife have friends over for dinner. They are having drinks waiting for something to cook so they can eat. Dr. Thaler brings out a bowl of cashew nuts for everyone to enjoy. After five minutes, half the bowl is gone. Dr. Thaler removes the bowl and hides it in the kitchen. Everyone exhales with joy—their appetites have been saved!
Anything where you may feel as though you cannot act in moderation can be used in place of cashews.
Nudges…for good
Example: Most people realize they need to save for retirement. Most of those same people have great difficulty saving for retirement. It can be lack of discipline, lack of knowledge of the options, lack of knowing how much to save, any number of reasons. One solution to this problem is to “nudge” people to sign up for optional retirement plans. That is, change the default option from having to “opt in” to having to “opt out.” If given the choice to opt in, many employees choose not to sign up at all. If given the choice to opt out, most employees choose to participate on some level. Additionally, have the default contribution rate increase as an employee’s salary increases. This also leads to higher contribution rates.
People look at their money somewhat irrationally
Example: Imagine a casino-goer who arrives with $300 in his pocket only to find himself with $500 in his pocket after an hour of lucky gaming. What does this individual do? If he is like most novice gamblers, he puts the $200 in winnings in one pocket and keeps the other $300 in another pocket. Why? Because the $200 is “house money”, of course! This is quite bizarre as the money in either pocket spends equally well.
As Thaler states, “Every field of economics could benefit from giving greater scrutiny to the role of humans.” Even education could benefit. How do we maximize what children learn in school? Thaler suggests that rewarding inputs (such as doing homework) rather than outputs (such as grades) would be one place to start.
What other areas of society could benefit from running experiments?
Being that schools are some of our oldest institutions, the fact that we haven’t learned to teach our children all that well is telling. Perhaps experiments should be run to provide ideas on how to improve teaching students?
What about corporations…is there any empirical data letting us know that we are running them as optimally as possible? I think we all know the answer to that question. It is time for all of us to realize that Humans make mistakes…lots of them! We should all be open to observing, collecting data and learning.
It sounds straightforward, however, most Humans fall victim to one, or multiple, biases which prevents us from continuing to grow and improve. As Thaler states, “it is time for everyone to adopt the same data-driven approach to their jobs and lives that good scientists use.”
Other notable quotes from Misbehaving
Econs would be perplexed by the whole idea of gifts. An Econ would know that cash is the best possible gift, which allows the recipient to buy whatever is optimal. But unless you are married to an economist, I don’t advise you to give cash on your next anniversary. Come to think of it, even if your spouse is an economist, it’s still not a great idea.
The old joke is that an economist from the University of Chicago would not bother to pick up a $20 bill on the sidewalk because if it were real, someone would have already snagged it. There is no such thing as a free lunch…or a free $20 bill.
Well, hopefully you found the above summary of Richard Thaler’s terrific book, Misbehaving: The Making of Behavioral Economics to be informative and entertaining. And maybe, just maybe, you picked up a trick or two to help you next time you have a dinner party (hide the cashews!) or that the money you brought with you and the money you won is all your money and does not need to be treated differently.
Sincerely,
Charles Verruggio
Chief Investment Officer
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