My Overview

• Richard Thaler is one of the greatest behavioural economists ever, he was pivotal in bringing the founding ideas of Daniel Kahnman and Amos Tversky into mainstream Economics. He was also one of the key experts brought in to help formulate the British Behavioural Insights Team (BIT) aka the Nudge Unit in the UK, similar units cannot be found across most Western governments.
• I have been fascinated by behavioural economics since I first started studying economics aged 16. I became frustrated by the restrictions of traditional economic theories and how they were often so bad at explaining real life. I believe this is one of the key drivers to me choosing to study politics with economics at university, as I wanted to apply economics in real life.
• Once I got to university the more I read about behavioural economics and Richard Thaler, the more interested I became. Since then I’ve been applying key lessons to my own life.
• This book is the perfect introduction to behavioural economics and can be read by anyone, regardless of if you have economic training or not. Having studied economics and read about behavioural economics before, some of the points raised by Thaler weren’t new, but his comic and self-deprecating manner still made them highly enjoyable.
• You should be able to tell just how much I loved this book by the sheer volume of notes I’ve captured below. While I hope you’ll read my notes in full, here are the 10 key messages I took away from this terrific book:
  • The importance of SIFs – Behavioural economics fundamentally justifies itself based on highlighting the importance of supposedly irrelevant factors (SIFs), these are often the human fallacies (human nature) which explain why markets aren’t efficient and why we make the same mistakes over and over.
  • People care more about what they already own – Humans are risk-averse for gains, and risk-seeking for losses, therefore we don’t like losing things we already have more than we care about gaining something we don’t already have, about twice as much. This explains why sunk costs are so important in understanding people’s decision, even though the money is gone and can’t be repurposed people will continue to make decisions based on that initial cost, even if the effect does deprecate over time.
  • Debunking the ‘learning’ counter-argument – Traditional economists said behavioural economics lived in a ‘one-shot’ game and that in reality, individuals learned. However, to learn you need (a) frequent practice (b) immediate feedback. This means with the big things: buying a car, saving for retirement, or buying a house, we humans don’t get frequent practice. Therefore, we can’t learn from our own experience. The key message here is that when doing something you will only do once or a hand full of times in your life, do your research and learn from others.
  • The importance of testing things out & experimenting – Learn from others, but on the smaller things which you will be able to repeat lots of times, don’t be afraid to experiment on yourself. Try out different ways to improve your finances, health, knowledge when the potential downside is limited. Don’t think just because something seems ‘obvious’ that it is the best or only way to do something.
  • Appreciating perceived ‘fairness’ – Perception is extremely important to humans, how we perceive the fairness of something will depend on how the situation is framed as well as who it harms or helps, hence by people are much happier to see a discount removed from something instead of a surcharge being added, even if the actual change is the same for the individual/company benefiting.
  • The Prisoners Dilemma isn’t a fall gone conclusion – Around 40% of people don’t act as expected when the Prisoners Dilemma plays out in real life, why? Thaler believes it is because most people can be categorised as ‘conditional co-operators’, therefore willing to cooperate if enough others do. This is why Public Goods are provided, although not at the most efficient level. At the start people are willing to give people the benefit of the doubt, but if cooperation rates fall and are too low these ‘conditional co-operators’ also become free riders.
  • Thaler’s Investment Advise – Don’t look at your investments very often, in fact ‘scrupulously avoid reading anything in the newspaper asides from the sports section.’ Additionally, ‘buying a stock that the Market does not fully appreciate today is fine, as long as the rest of the market comes around to your point of view sooner rather than later!’
  • I could be an NFL Scout – Thaler’s analysis shows that across an entire NFL draft each year a player picked early will only be a better player than a late pick 52% of the time, that is only 2% better than simply flipping a coin!
  • Use Behavioural Economic principles to save for your retirement – If automatic pension enrolment is available to you, you are in a better position than most others. Analysis found that before auto enrolment only 49% of employees joined a plan, after auto enrolment that increased to 86%, a massive change given the very small intervention.
  • Apply Behavioural Economics in the Workplace – To be a good leader in the workplace managers need to create an environment where people are actively encouraged to under-take evidence based decisions, regardless of the outcome. The ideal organisational environment encourages everyone to observe, collect data, and speak up.
• The notes below are focused on the key concepts within the book, however Thaler manages to thread these around extremely interesting, and often funny, stories which really bring the concepts to life, a highly-recommended read. Enjoy!

Book Notes

Supposedly Irrelevant Factors (SIFs)

• Misbehaving…’behaviour inconsistent with the idealised model of behaviour that that is at the heart is what we call economic theory.’
• Behavioural Economics is all about the fallacy of replacing Homo sapiens with Homi economicus (Econs) in economic models.
• Optimisation + Equilibrium = Economics
• ‘We don’t have to stop inventing abstract models that describe the behaviour of imaginary Econs. We do, however, have to stop assuming that those models are accurate descriptions of behaviour, and stop basing policy decisions on such flaws analyses. And we have to start paying attention to those supposedly irrelevant factors.’ (SIFs)

The Endowment Effect

• ‘Giving up the opportunity to sell something does not hurt as much as taking the money out of your wallet to pay for it. Opportunity costs are vague and abstract when compared to handing over actual cash.’
• ‘The stuff you own is part of your endowment, and I had stumbled upon a finding that suggested people valued things that were already part of their endowment more highly than things that could be part of their endowment, that were available but not yet owned.’

Value Theory

• ‘With prospect theory, Kahneman and Tversky set out to offer an alternative to expected utility theory that had no pretender of being a useful guide to rational choice; instead, it would be a good prediction of the actual choices real people make. It is a theory about the behaviour of Humans’
• ‘People think about life in terms of changes, not levels. They can be changes from the status quo or changes from what was expected, but whatever form they take, it is changes that make us happy or miserable.’
• ‘People will be risk-averse for gains, but risk-seeking for losses’
• ‘Roughly speaking, losses hut about twice as much as gains make you feel good.’
• ‘So, we experience life in terms of changes, we feel diminishing sensitivity to both gains and losses, and losses sting more than equivalently-sized gains feel good.’

The Gauntlet

• List of key retorts traditional economists gave the behavioural economics back in the day:
  • ‘As If’ – Traditional economic theory says that Individuals may not fully understand the dynamics behind a decision, but they act ‘as if’ they did. Behaviour counter-argument: Experts may act as if they do but economics is supposed to be about everyone, and from survey evidence most people aren’t expert.
  • ‘Incentives’ – Traditional economic theory says we understand our preferences, if we like A more than B we can never prefer B over A. Grether & Plott (1973) proved otherwise, the more the stakes raise the more severe preference reversals are.
  • ‘Learning’ – Traditional economists said behavioural economics lived in a ‘one-shot’ game but in reality, individuals learned. However, to learn you need (a) frequent practice (b) immediate feedback. This means with the big things; buying car, saving for retirement you don’t get frequent practice, so we can’t learn.
  • ‘The Market’ – Traditional economists say that ‘markets somehow discipline people who are misbehaving.’ But all too often the market doesn’t force you to be rationale, you can still muddle through getting by, like most people do.

Mental Accounting: 1979 – 85

• Mental accounting is how people think about money

Bargains & Rip-Offs

• Econs believe that ‘acquisition utility’ is king, but Thaler introduces ‘transaction utility’. Therefore, people don’t just get consumer surplus (acquisition utility) they also get transaction utility, ‘the difference between the price actually paid for the object and the price one would normally expect to pay, the reference price.’ It is a bargain or a rip-off.
• ‘For consumers, there is nothing wrong with being on the lookout for a bargain. Saving money on one purchase makes another purchase possible. But we don’t want to get caught buying something we won’t use just because the deal is too good to pass up.’

Sunk Cost

• Econs say ignore sunk costs
• In reality people all too often can’t help including sunk costs in their decisions, ‘you have paid some money, and when you consume the product you will get the pleasure of the acquisition utility and the account will be clear; your earlier cost is cancelled out by your later gain’… e.g. Willing to drive through a blizzard to get to a football game if you’ve paid $100 for a ticket, but not going if you got the ticket for free
• Payment Depreciation: Effect of sunk cost wears off over time, either because people think they’ve gotten their money’s worth or forgotten the original purchase price completely.

At the Poker Table

• Continuation of the fact that people are risk-seeking when it concerns losses…’players who were behind were attracted to small bets that offered a slim chance for a big win…but dislike big bets that risked a substantial increase to the size of their loss, even though they offered a high probability of breaking even.’ = Break Even Effect
• House Money Effect = If $200 up at a casino you are willing to gamble that money more because you don’t see it as your money, therefore more willing to gamble it.
• ‘A good rule to remember is that people who are threatened with big losses and have a chance to break even will be unusually willing to take risks, even if they are normally quite risk averse. Watch out!’

Self-Control: 1975 – 88

• ‘Although it is never stated explicitly as an assumption in an economics textbook, in practice economic theory presumes that self-control problems do not exist’

Willpower? No Problem

• ‘Modigliani’s life-cycle hypothesis, in which people decide how much of their lifetime wealth to consume each period, does not just assume that people are smart enough to make all the necessary calculations (with rational expectations) about how much they will make, how long they will live, and so forth, but also that they have enough self-control to implement the resulting optimal plan.’

The Planner & the Doer

• Understanding self-control problems…’We propose that any point in time an individual consists of two selves. There is the forward looking ‘planner’ who has good intentions and cares about the future, and the devil-may-care ‘doer’ who lives for the present’
• ‘The Planner has two sets of tools she can use to influence the actions of the doers. She can either try to influence the decisions that the doers make through rewards or penalties (financial or otherwise) that still allow them discretion, or she can impose rules, such as commitment strategies, which limit the doers’ options.’

Misbehaving in the Real World

• ‘The reluctance to experiment, test, evaluate, and learn that I experienced at General Motors is all too common…over-confidence is a powerful force.’

Working with Danny: 1984-85

What Seems Fair?

• ‘In many situations, the perceived fairness of an action depends not only on who it helps or harms, but also on how it is framed.’ (E.g. ‘Removing a discount is not nearly as objectionable as adding a surcharge.’
• ‘Any large first mover who takes an action that violates the norms of fairness runs considerable risks if competitors do not follow suit.’

Fairness Games

• ‘There is clear evidence that people dislike unfair offers and are willing to take a financial hit to punish those who make them.’ – Ultimatum Game: ‘Proposers make offers of close to half the pie, and Responders tend to reject offers of less than 20%.’
• Prisoner’s Dilemma: ‘The game theoretic prediction is that both players will confess because, no matter what the other player does, it is in the selfish best interest of each player to do so. Yet when this game is played in the laboratory, 40-50% of the players cooperate, which means that about half the players either do not understand the logic of the game or feel that cooperating is the just thing to do.’
• ‘The standard economics prediction that no one will cooperate in the Public Goods Game turns out to be false. On average, people contribute about half their stake to the public good. There is still a public good problem, meaning that public goods are not supplied in as great a quantity as people would wan if they could all somehow agree to be cooperative, bit the under-supply is about half as severe as the rational selfish model predicts.’
• ‘A large proportion of people can be categorised as conditional co-operators, meaning that they are willing to cooperate if enough others do. People start out these [Public Good] games willing to give their fellow players the benefit of the doubt, but if cooperation rates are low, these conditional co-operators turn into free riders.’

Mugs

• Endowment effort in reality…’Those who start out with an object will tend to keep it, while those who don’t have such an object won’t be that keen to buy one.’
• ‘Again we see that losses are roughly twice as painful as gains are pleasurable, a finding that has been replicated numerous times over the years.’
• ‘The endowment effect experiments show that people have a tendency to stick with what they have, at least in part because of loss aversion.’

Engaging with the Economics Profession: 1986-94

Anomalies

• Confirmation bias: ‘people have a natural tendency to search for confirming rather than disconfirming evidence.’

Forming a team 

• ‘The idea, initially proposed by George Akerlof, that employment contracts could be viewed partially as a gift exchange. The theory is that if the employer treats the worker well, in terms of pay and working conditions, that gift will be reciprocated with higher effort levels and lower turnover, thus making the payment of above-market wages economically profitable.’

Narrow Framing

• ‘The ‘timid choices’ part of the Kahneman and Lovallo story is based on loss aversion. Each manager is loss averse regarding any outcomes that will be attributed to him. In an organisation setting, the natural feeling of loss aversion can be exacerbated by the system of rewards and punishment. In many companies, creating a large gain will lead to modest rewards, while creating an equal-sized loss will get you fired. Under those terms, even a manager who starts out risk neutral, willing to take any bet that will make money on average, will become highly risk averse.’
• ‘As predicted by my myopic loss aversion [The only way you can ever take 100 attractive bets is by first taking the first one, and it is not only thinking about the bet in isolation that fools you into turning it down]…looking at the returns on your portfolio more often can make you less willing to take risk.’
• ‘The implication of our analysis is that the equity premium – or the required rate of return on stocks – is so high because investors look at their portfolios too often. Whenever anyone asks me for investment advice, 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 asides from the sport section.’

Finance: 1983 – 2003

The Beauty Contest

• ‘Keynes thought that professional money managers were playing an intricate guessing game. He likened picking the best stocks to a common competition in the male-dominated London financial scene in the 1930s: picking out the prettiest faces from a set of photographs.’
• ‘So what are all these [money] managers really trying to do? They are trying to buy stocks that will go up in value or, in other words, stocks they think other investors will later decide should be worth more. And these investors in turn, are making their own bets on others future valuations.
• ‘Buying a Stock that the Market does not fully appreciate today is fine, as long as the rest of the market comes around to your point of view sooner rather than later!’

Does the Stock Market Overreact?

• ‘We call the best performing stocks ‘Winners’ and the worst performers ‘Losers’ [in NY Stock Exchange]…We tested for overreaction in various ways, but as long as the period we looked back at to create the portfolios was long enough, say three years, then the Loser portfolio did better than the Winner portfolio…the Losers outperformed the market by about 30% while the winners did worse than the market by about 10%’
• Confirming that value investing (Benjamin Graham) works because people tend to over-react to the short term good or bad news about companies

The Reaction to Overreaction

• ‘…the debate has continued for years as to whether value stocks are mispriced, as behaviourists argue, or risky, as rationalists claim.’

The Price is Not Right

• ‘When prices diverge strongly from historical levels, in either direction, there is some predictive value in these signals. And the further prices diverge from historical levels, the more seriously the signals should be taken. Investors should be wary of pouring money into markets that are showing signs of being overheated, but also should not expect to be able to get rich by successfully timing the market. It is much easier to detect that we may be in a bubble than it is to say when it will pop, and investors who attempt to make money by timing market turns are rarely successful.’

The Battle of Closed-End Funds

• ‘The term ‘open-end’ means that the assets managed by the fund can grow or shrink depending on the preferences of its investors.’
• ‘The average discount on closed-end funds was correlated with the difference in returns between small and large company stocks; the great the discount, the larger the difference in true story between those two types of stocks.’

Welcome to Chicago: 1995 – Present

Football

• ‘Five findings from the psychology of decision-making supported our hypothesis that early picks [in NFL draft] will be too expensive: 1. People are overconfident…2. People make forecasts that are too expensive [scouts are too willing to say a player is a superstar]…3. The winner’s curse…4. The false consensus Effect…when a team falls in love with a certain player they are just sure that every other team shares their view…5. Present bias…teams want to win now’
• ‘Across the entire draft, the chance that the earlier player will be better is only 52%. In the first round, it is a bit higher, 56%’ — 50% would be flipping a coin to decide who will be better
• ‘The trade market curve [efficient market view] says you can trade the first pick for five early second round picks, but we are finding that each of those second-round picks yields more surplus to the team than the first round pick they are together traded for!’
• ‘So our research yielded two simple pieces of advice to teams. First, trade down. Trade away high first-round picks for additional picks later in the draft, especially second-round picks. Second, be a draft-pick banker. Lend picks this year for better picks next year.’
• ‘the famous Peter Principle: people keep getting promoted until they reach their level of incompetence.’
• ‘my hunch is that as the importance of a decision grows, the tendency to rely on quantitative analyses done by others tends to shrink. When the championship or the future of the company is on the line, managers tend to rely on their gut instincts’

Game Shows

• Deal or No Deal: ‘strong support for path dependence. Contestants clearly reacted not just to the gambles they were facing, but also to the gains and losses along the way.’
• Golden Balls: ‘the cooperation rates do fall, but they fall to about the same level observed on lavatory experiments played hypothetically or for small amounts of money, namely 40-50%.’

Helping Out: 2004 – Present

Save More Tomorrow

• ‘Before automatic [pension] enrolment, only 49% of employees joined the plan during their first year of eligibility; after automatic enrolment, that number jumped to 86%! Only 14% opted out. That is a pretty impressive change in behaviour produced by a supposedly irrelevant factor.’
• ‘I would say saving 10% of income [for pension] would be a bare minimum for those without other sources of wealth, and 15% would be better.’
• ‘When someone moves to a company with a more generous retirement saving plan and automatically starts saving more via that plan, there is neither a discernible decrease in savings in other categories nor an increase in debt.’

Going Public

• Libertarian Paternalism // Optimal paternalism // Asymmetric Paternalism — ‘if it creates large benefits for those who make errors, while imposing little or no harm on those who are fully rational.’
• ‘We want to help them achieve their own goals. Readers who manage to reach the fifth page of Nudge find that we define our objective as trying to ”influence choices in a way that will make choosers better off, as judged by themselves”
• ‘A nudge is some small feature in the environment that attracts our attention and influences behaviour. Nudges are effective for Humans, but not for Econs, since Econs are already doing the right thing. Nudges are supposedly irrelevant factors that influence our choices in ways the make us better off.’

Nudging in the UK

• Mantra’s of the British Behavioural Insights Team (BIT) aka Nudge Unit: (1) ‘If you want to encourage someone to do something, make it easy’ (2)…We can’t do evidence-based policy with your evidence’
• ‘The whole point of forming a Behavioural Insights Team is to utilise the findings of other social sciences to augment the usual advice being provided by economists.’
• ‘Nudge for good…People can be nudged to save for retirement, to get more exercise, and to pay their taxes on time, but they can also be nudged to take out a second mortgage on their home and use the money on a spending binge. Businesses and governments with bad intentions can use findings of the Behavioural sciences for self-serving purposes, at the expense of people who have been nudged.’

Conclusion: What Is Next? 

• ‘One important macroeconomic policy begging for a Behavioural analysis is how to fashion a tax cut aimed at stimulating the economy. Behavioural analysis would help, regardless of whether the motive for tax cut is Keynesian – to increase demand for jobs – or supple side – aimed at getting ‘job creators’ to create even more jobs.’
• Key lessons from Thaler: (1) Observe — be evidence based, observe the anomalies around you (2) Collect Data — ‘Stories are powerful and memorable’, always write down results, even if negative because otherwise fall victim to ‘the dreaded confirmation bias -they only look for evidence that confirms their preconceived hypothesis.’ (3) Speak Up — ‘sometimes, even when you are talking to the boss, you need to warn of the treat of an impending disaster’
• ‘Good leaders must create environments in which employees feel that making evidence-based decisions will always be rewarded, no matter what outcome occurs. The ideal organisational environment encourages everyone to observe, collect data, and speak up.’