Why is traditional economics outdated? Why are behavioral economics important in everyday life?
In Misbehaving, Richard H. Thaler says that the theories of traditional economics rest on a faulty foundation. Traditional economics assumes that consumers act rationally and that financial markets reflect securities’ true values.
Read below for a brief overview of Misbehaving.
Misbehaving by Richard H. Thaler
In his 2016 book, Misbehaving, Richard H. Thaler instead argues that consumers frequently behave irrationally by the standards of traditional economics, making suboptimal economic decisions, and financial markets may under- or over-value securities such as stocks and bonds. To show as much, he traces the historical development of behavioral economics, which explores how consumers actually behave in economic situations, not just how they should behave.
Thaler is the 2017 recipient of the Nobel Prize in economics and one of the founding fathers of behavioral economics. He coauthored the 2009 bestseller Nudge, which recommends practical applications from behavioral science.
The Foundations of Traditional Economics
Before discussing the arguments that Thaler marshals against traditional economics, it’s helpful to understand the foundations of traditional economic theory. To that end, we’ll begin by discussing the two key components of traditional economics: the premise of constrained optimization and the efficient market hypothesis.
The Premise of Constrained Optimization
Thaler explains that the first foundational principle of traditional economics is the premise of constrained optimization, which contends that consumers with a limited budget always make decisions that optimize it. In other words, they act rationally, and their decisions always maximize economic value based on their available budget.
To see how this works in practice, imagine that you were purchasing groceries on a $100 budget. According to the premise of constrained optimization, every item that you purchase will guarantee that you’re getting the most bang for your buck. For example, if you were choosing between a $10 name-brand item and an $8 value-brand item with identical nutritional values and flavor profiles, you would always choose the $8 item to maximize your budget.
Thaler explains that the premise of constrained optimization implies that noneconomic factors are irrelevant to consumers’ decision-making process. For example, the fact that one brand of bread has more aesthetic branding than another won’t influence your decision, since the factor is economically irrelevant. But, as we’ll see later, Thaler argues that many purportedly irrelevant factors are, in fact, very relevant.
The Efficient Market Hypothesis
While constrained optimization concerns individual consumers, the next foundational component of traditional economics—the efficient market hypothesis (EMH)—concerns financial markets on the whole. As Thaler relates, the efficient market hypothesis consists of two claims: Financial markets always accurately price securities, and it’s impossible to consistently earn above-market returns.
As for the first claim, Thaler explains that the EMH dictates that financial markets always price securities according to their intrinsic value—roughly, the fair value that a given security is worth. According to EMH advocates, markets accurately price securities because they immediately incorporate all publicly available information into securities’ prices, meaning these prices fairly reflect all relevant information. For example, as soon as Tesla releases a quarterly earnings report, the relevant information from this report is factored into Tesla’s share price.
As for the second claim, Thaler clarifies that it follows from the first: If securities are always fairly priced, then financial markets will never include the bargains necessary to consistently beat the market. In other words, while investors could accurately predict that bargain securities typically increase in price, they cannot reliably predict what will happen to fairly priced securities since these securities are already trading at their fair value.
Arguments Against the Premise of Constrained Optimization
Having examined the foundation of traditional economic theory, Thaler discusses the arguments from behavioral economics that undermine this foundation. He focuses on arguments against the premise of constrained optimization, highlighting three types of counterexamples to this premise that show the salience of noneconomic factors in our decision-making process—namely, examples of mental accounting, examples of the importance of fairness, and examples of present bias.
Argument #2: People Care About Fairness and Cooperation
While Thaler’s examples from mental accounting show more mundane ways that consumers often act irrationally according to traditional economic theory, other experiments reveal more specific situations in which we consider allegedly irrelevant factors in our economic decision-making. Thaler’s second argument against the premise of constrained optimization is that consumers are concerned with fairness and cooperation, even when these concerns conflict with budget optimization—as shown by two experiments: the ultimatum game and the prisoner’s dilemma.
Argument #3: People Exhibit Present Bias
Thaler’s third argument holds that we exhibit a present bias—a preference toward smaller immediate rewards over larger future rewards—that conflicts with the premise of constrained optimization because it decreases our long-term economic utility. To show as much, he examines how this bias manifests itself in children as well as adults.
Thaler first examines psychologist Walter Mischel’s famous experiment testing children’s willpower in a laboratory setting. In Mischel’s experiment, children are given the choice between one marshmallow now and two marshmallows in 15 minutes, with the caveat that they have to spend these 15 minutes in a room with access to the single marshmallow. Thaler relates that, on average, children couldn’t last the 15 minutes: They lasted an average of 11 minutes before eating the single marshmallow. If children rationally maximized economic utility, however, they would wait 15 minutes, since two marshmallows are clearly worth more than one.
According to Thaler, adults likewise exhibit present bias—that is, they irrationally place more weight on short-term economic gains than equivalent long-term gains. He argues that adults often fall victim to a specific form of present bias known as hyperbolic discounting, in which they prefer immediate rewards to future rewards, but they don’t differentiate between comparable rewards at different dates in the far future. For example, if you’re offered tickets to the Superbowl either for this year or 10 years in the future, you’ll likely prefer the tickets to this year’s Super Bowl. By contrast, if you’re offered the choice between tickets to the Super Bowl 10 years in the future or 11 years in the future, you’ll likely lack the strong preference for the earlier tickets.
Arguments Against the Efficient Market Hypothesis
Having seen how consumers often take noneconomic factors into account when making decisions, contrary to the premise of constrained optimization, we’ll now proceed to Thaler’s arguments against the other key thesis of traditional economics—the EMH. And while Thaler agrees with the EMH’s claim that it’s impossible to consistently beat the market, he disagrees with its claim that securities’ prices always reflect their intrinsic value. In this section, we’ll consider three arguments against the thesis that securities are always accurately priced: that investment opportunities from closed-end funds violate the EMH, that stock market overreaction violates the EMH, and that the stock market is too volatile to be perfectly efficient.
Argument #1: Closed-End Funds Violate the Law of One Price
According to Thaler, one argument against the EMH is the violation of the law of one price—the thesis from traditional economics that a security should never sell at two different prices at the same time. Thaler explains that the law of one price follows directly from the EMH’s assumption that securities are always accurately priced. Under this assumption, it’s logically impossible for the same security to have two different prices, since that means at least one of the prices is different from the security’s intrinsic value.
However, Thaler argues that closed-end funds violate the law of one price and therefore are inconsistent with the EMH. Closed-end funds, he explains, are investing funds—that is, pools of money from investors that money managers invest on their behalf—that raise money via an initial public offering (IPO) in which investors can purchase shares of the closed-end fund. The fund managers then use the money raised through this IPO to purchase stocks. For example, if the IPO raised $10 million, then the fund managers would invest this $10 million in the stock market as they see fit. Crucially, investors can then also buy and sell shares of the closed-end fund itself, although they cannot invest money directly into the fund after the IPO.
Thaler notes that, if the law of one price were true, the market price of closed-end funds should be equivalent to their net asset value—that is, the value of the assets that the fund owns. For example, imagine that after the IPO raised $10 million, the fund’s managers invested $5 million in Netflix which rose 20% (yielding $6 million in value) and $5 million in Google which rose 10% (yielding $5.5 million in value). Then, the IPO’s net asset value would be $11.5 million, and because investing in the closed-end fund is functionally equivalent to investing in its underlying assets, the law of one price states that the market price of the closed-end fund (its share price multiplied by its total number of shares) should also equal $11.5 million.
In practice, however, closed-end funds’ market prices are rarely equivalent to their net asset value. On the contrary, Thaler points out that closed-end funds typically trade at a 10-20% discount of their net asset value (though, occasionally, they also trade above net asset value), meaning that investors are essentially purchasing shares of the closed-end funds’ underlying assets for less (or occasionally more) than their market price. Either way, closed-end funds represent a violation of the law of one price.
Argument #2: Overreaction in the Stock Market
Thaler argues that, much like closed-end funds demonstrate inefficiencies by violating the law of one price, the stock market also demonstrates inefficiencies by overreacting. In other words, he argues that stocks that recently outperformed the market tend to underperform it in the future. His research demonstrates that significant past overperformance is predictive of significant future underperformance, and vice versa. This contradicts the EMH’s prediction that past market performance cannot predict future performance.
Thaler explains that if stocks were always accurately priced like the EMH claims, there would be no way to determine whether a stock will increase or decrease in value. After all, if you knew that a stock would increase in value, that would illustrate that it’s currently undervalued and therefore not accurately priced. By contrast, if you knew that a stock would decrease in value, that would illustrate that it’s currently overvalued and therefore not accurately priced.
However, the occurrence of overreaction suggests that some stocks are undervalued or overvalued, contrary to the EMH’s prediction. To show as much, Thaler conducted a study comparing the most successful and unsuccessful stocks on the New York Stock Exchange (NYSE) over various three- to five-year periods—that is, those that outperformed the market by the largest margin and those that underperformed the market by the largest margin. Across various portfolios, his results were consistent: In the subsequent three- to five-year periods, the previously least successful stocks outperformed the market by an average of 30%, and the previously most successful stocks underperformed the market by an average of 10%.
Argument #3: Shiller’s Case Against Rational Pricing
While Thaler uses violations of the law of one price and overreaction as arguments against EMH, he also cites the ideas of Nobel laureate Robert Shiller. Shiller argued that the US stock market is more volatile than it should be if it were perfectly efficient.
Shiller’s argument is based on the assumption that a stock’s dividends are a proxy for its intrinsic value. To see why, Thaler asks us to imagine we own a stock that we’ll never sell—then, the value of this stock would be equal to the present value of its future dividends (that is, the total dividend payments over the stock’s life discounted at an appropriate rate). However, he points out that we don’t know exactly what a stock’s future dividend payments will be. Thus, the current stock price is effectively a prediction of net future dividend payments, at the appropriate discount rate.
Thaler then relates Shiller’s argument that, because stock prices are a prediction of future dividends, we should expect the volatility of stock prices to match those of dividends. To take an analogous example, imagine that you’re predicting how a set of 10 counties will vote in the upcoming election. If these counties have historically had similar voting patterns (say, voting on an average 60% Republican plus or minus five percent), then your prediction should reflect this similarity—you shouldn’t predict that one county will vote 20% Republican while another will vote 90% Republican, since this volatility doesn’t reflect the historical data.
However, when it comes to stock prices, these prices exhibit far more volatility than future dividend payments—whereas future dividends are remarkably consistent over time, with slight-but-steady increases, stock prices exhibit erratic swings in prices. Thus, assuming that dividends are a proxy for intrinsic value, Shiller concludes that stock prices must often depart from intrinsic value, contrary to the EMH.
Real-World Applications of Behavioral Economics
Though Thaler’s work may seem to be of primarily theoretical interest, he also clarifies that behavioral economics has important practical implications in everyday life. In this section, we’ll examine how behavioral economics can help influence consumers for good by discussing specific “nudges” that Thaler and other behavioral economists have used to effect change in society.
How “Nudging” Can Improve Consumers’ Decisions
Thaler explains that in his book Nudge, coauthored with Harvard Law professor Cass Sunstein, he argued that insights from behavioral economics can help us “nudge” consumers toward better choices, as measured by their preferences. In other words, behavioral economics can teach us how to help consumers make decisions that they want to make, but struggle to.
