t is possible that
Richard Thaler changed his mind about economic theory and went on to
challenge what had become a hopelessly dry and out-of-touch discipline
because, one day, when a few of his supposedly rational colleagues
were over at his house, he noticed that they were unable to stop
themselves from gorging on some cashew nuts he'd put out. Then again,
it could have been because a friend admitted to Thaler that, although
he mowed his own lawn to save $10, he would never agree to cut the
lawn next door in return for the same $10 or even more. But the moment
that sticks in Thaler's mind occurred back in the 1970's, when he and
another friend, a computer maven named Jeff Lasky, decided to skip a
basketball game in Rochester because of a swirling snowstorm.
"But if we had bought the tickets already, we'd go," Lasky noted.
"True -- and interesting," Thaler replied.
Thaler began to make note of these episodes -- anomalies, he called
them -- and to chalk them up on his blackboard at the University of
Rochester, where he was a young, unheralded and untenured assistant
professor. Each of these stories was at odds with neoclassical
economics as it was taught in graduate schools; indeed, each was a
tiny subversion of the prevailing orthodoxy. According to accepted
economic theory, for instance, a person is always better off with more
rather than fewer choices. So why had Thaler's colleagues roundly
thanked him for removing the tempting cashews from his living room?
The lawn example was even more troubling. Perhaps you dimly remember
from Economics 101 that unlovely term, "opportunity cost." The idea,
as your pointy-headed prof vainly tried to persuade you, is that
forgoing a gain of $10 to mow a neighbor's lawn "costs" just as much
as paying somebody else to mow your own. According to theory, you
either prefer the extra time or the extra money -- it can't be both.
And the basketball tickets refer to "sunk costs." No sense going to
the health club just because we have paid our dues, right? After all,
the money is already paid -- sunk. And yet, Thaler observed, we do.
People, in short, do not behave like the pointy heads say they should.
In the ordered world of economics, this rated as a heresy on the
scale of Galileo. According to the standard or neoclassical school
(essentially a 20th-century updating of Adam Smith), people, in their
economic lives, are everywhere and always rational decision makers;
those who aren't either learn quickly or are punished by markets and
go broke. Among the implications of this view are that market prices
are always right and that people choose the right stocks, the right
career, the right level of savings -- indeed, that they coolly adjust
their rates of spending with each fluctuation in their portfolios, as
though every consumer were a mathematician, too. Since the 1970's,
this orthodoxy has totally dominated the top universities, not to
mention the Nobel Prize committee.
Roger Lowenstein is the author of "When Genius
Failed: The Rise and Fall of Long-Term Capital Management." He
last wrote for the magazine about Sanford I. Weill, the chairman
of Citigroup.
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Thaler spearheaded a simple but devastating dissent. Rejecting the
narrow, mechanical homo economicus that serves as a basis for
neoclassical theory, Thaler proposed that most people actually behave
like . . . people! They are prone to error, irrationality and emotion,
and they act in ways not always consistent with maximizing their own
financial well being. So serious was Thaler's challenge that Merton
Miller, the late Nobelist and neoclassical deity, refused to talk to
him; Thaler's own thesis adviser lamented that he had wasted a
promising career on trivialities like cashews. Most economists simply
ignored him.
But the anomalous behaviors documented by Thaler and a band of
fellow dissenters, including Yale's Robert Shiller and Harvard's
Lawrence Summers, Clinton's last treasury secretary, have grown too
numerous to ignore. And the renegades, though still a minority, have
embarked on a second stage: an attempt to show that anomalies fall
into recognizable and predictable patterns. The hope is that by
illuminating these patterns, behavioral economics, as it has come to
be called, will yield a new understanding of the economy and markets.
Behaviorism, says Daniel McFadden, the recent Nobel laureate, "is a
fundamental re-examination of the field. It's where gravity is pulling
economic science."
haler, after years of
being shunned, is now a popular, highly paid professor at the
University of Chicago Graduate School of Business, the traditional
nerve center of neoclassicism. His increasing following is owed in no
small part to the fact that behaviorism, unlike so much of economics,
is fun. Although prewar economists like John Maynard Keynes were
literary artists, most writing in the field since the 70's has been
obtuse and highly mathematical, all but inaccessible to the lay
person. By contrast, Thaler's papers are rich with intuitive gems
drawn from sports, business and everyday life. In one paper, he
pointed out that people go across town to save $10 on a clock radio
but not to save $10 on a large-screen TV. It's a seemingly obvious
point -- and also a direct contradiction of rationalist theory.
Thaler loves pointing out that not even economics professors are as
rational as the guys in their models. For instance, a bottle of wine
that sells for $50 might seem far too expensive to buy for a casual
dinner at home. But if you already owned that bottle of wine, having
purchased it earlier for far less, you'd be more likely to uncork it
for the same meal. To an economist (a sober one, anyway) this makes no
sense. But Thaler culled the anecdote from Richard Rosett, a prominent
neoclassicist.
No sense going to the health club
just because we have paid our dues, right? After all, the money
is already paid-sunk. And yet we do. People do not behave the
way that the pointy heads say they should.
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A thickset man of 55, Thaler has a sharp wit and a voluble ego.
Many assume that his years in the academic wilderness have made him
defensive; Thaler denies it. "The last thing I want to do is to sound
embittered about having to struggle," he told me, easing his Audi
around Lake Michigan toward the Gothic stone campus. But Thaler
doesn't so much debate opponents; he skewers them. The British
economist Ken Binmore once proclaimed at a seminar that people evolve
toward rationality by learning from mistakes. Thaler retorted that
people may learn how to shop for groceries sensibly because they do it
every week, but the big decisions -- marriage, career, retirement --
don't come up that often. So Binmore's highbrow theories, he
concluded, were good for "buying milk."
I met Thaler two days after the election, and he was already
predicting that the country would be willing to accept Bush as the
winner, because "people have a bias toward the status quo." I asked
how "status-quo bias" affects economics, and Thaler observed that
workers save more when they are automatically enrolled in savings
programs than when they have to choose to participate by, say,
returning a form. Standard theory holds that workers would make the
most rational decision regardless.
Savings is an area where Thaler thinks he can have a big impact.
Along with Shlomo Benartzi, a collaborator at U.C.L.A., Thaler cooked
up a plan called Save More Tomorrow. The idea is to persuade employees
to commit a big share of future salary increases to their retirement
accounts. People find it less painful to make future concessions
because pain deferred is, to an extent, pain denied. Therein lies the
logic for New Year's resolutions. Save More Tomorrow was tried with a
Chicago company, and workers tripled their savings within a year and a
half -- an astounding result. "This is big stuff," Thaler says. He is
shopping the plan around to other employers and predicts that
eventually it could help raise the country's low savings rate.
Though Thaler, who comes across as a middling, Robert Rubin-style
Democrat, plays down the connection, such results could provide
ammunition to liberals who think government bashing has gone too far.
Since the Reagan era, a mantra for office seekers is that people know
what is best for themselves. Generally, yes; but what if not always,
and what if they err in predictable ways? For instance, Thaler has
found that the number of options on a 401(k) menu can affect the
employees' selections. Those with a choice of a stock fund and bond
fund tend to invest half in each. Those with a choice of three stock
funds and one bond fund are likely to sprinkle an equal amount of
their savings in each, and thus put 75 percent of the total in stocks.
Such behavior illustrates "framing" -- decisions being affected by how
choices are positioned. Political pollsters and advertisers have known
this for years, though economists are just coming around.
Framing has big implications for the debate on privatizing Social
Security. Neoclassicists say that people should manage their own
retirement accounts, and that the more choices they have the better.
Thalerites are not so sure. "If Thaler is right, it makes the current
dogmatic antipaternalism really doubtful," says Cass Sunstein, a
prominent legal scholar at the University of Chicago.
Thaler, who grew up in Chatham, N.J., the son of an actuary, wrote
his doctoral thesis at the University of Rochester on the economic
"worth" of a human life (public planners tackle this morbid theme
frequently, for instance, in determining speed limits). Thaler
conceived a clever method of calculation: measuring the difference in
pay between life-threatening jobs like logging and safer lines of
work. He came up with a figure of $200 a year (in 1967 dollars) for
each 1-in-1,000 chance of dying.
Sherwin Rosen, his thesis adviser, loved it. Thaler did not. He had
been asking friends about it, and most insisted that they would not
accept a 1-in-1,000 mortality risk for anything less than a million
dollars. Paradoxically, the same friends said they would not be
willing to forgo any income to eliminate the risks that their jobs
already entailed. Thaler decided that rather than rationally pricing
mortality, people had a cognitive disconnect; they put a premium on
new risks and casually discounted familiar ones.
For a while, Thaler regarded such anomalies as mere cocktail-party
fodder. But in 1976 he happened upon the work of two psychologists,
Daniel Kahneman and the now-deceased Amos Tversky, who had been
studying many of the same behaviors as Thaler. The two had noticed a
key pattern: people are more concerned with changes in wealth than
with their absolute level -- a violation of standard theory that
explained many of Thaler's anomalies. Moreover, most people are "loss
averse," meaning they experience more pain from losses than pleasure
from gains. This explains why investors hate to sell losers. For
Thaler, their work was an epiphany. He wrote to Tversky, who plainly
encouraged him. "He took me seriously," Thaler recalled, "and because
of that, I started taking it seriously."
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Drawings by Gary Baseman
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Thaler began designing experiments to test his ideas. In one,
Thaler told lab subjects to imagine they are stranded on a beach on a
sweltering day and that someone offers to go for their favorite brand
of beer. How much would they be willing to pay? Invariably, Thaler
found, subjects agree to pay more if they are told that the beer is
being purchased from an exclusive hotel rather than from a rundown
grocery. It strikes them as unfair to pay the same. This violates the
bedrock principle that one Budweiser is worth the same as another, and
it suggests that people care as much about being treated fairly as
they do about the actual value of what they're paying for. Although
"fairness" is generally ignored by neoclassicists, it's probably a
reason why companies do not lower salaries when they encounter tough
times -- perversely, laying off workers is considered more fair.
Thaler's first paper on anomalies was rejected by the leading
economic journals. But in 1980, a new publication, The Journal of
Economic Behavior and Organization, was desperate for copy, and
Thaler's "Toward a Positive Theory of Consumer Choice" saw the light
of day. "I didn't have any data," he admits. "It was stuff that was
just true."
The response from fellow economists was zero. But the article
eventually caught the eye of Eric Wanner, a psychologist at the Alfred
P. Sloan Foundation in New York. Wanner was itching to get economists
and psychologists talking to one another, and Thaler took the bait.
"He was the first economist who thought hard about the implications
for economics," Wanner says. "The reaction of mainstream economists
was defensive and hostile. They considered it an attack -- an
apostasy." Wanner, who became president of the Russell Sage
Foundation, started financing behavioral economics, and Thaler became
the informal leader, organizing seminars and summer workshops. In
effect, he turned an idea into a movement.
"Dick was like a taxonomist who goes out and collects embarrassing
specimens," Wanner says. "He learned that to get anyone to pay
attention to him he had to develop a portfolio of facts that he could
be entertaining about and that economists couldn't sweep under the
rug."
Thaler's most original contribution was "mental accounting" -- an
extension of Kahneman and Tversky's "framing" principle. "Framing"
says the positioning of choices prejudices the outcome. "Mental
accounting" says people draw their own frames, and that where they
place the boundaries subtly affects their decisions. For instance, a
poker player who accounts for each day separately may become bolder at
the end of a winning night because he feels he is playing with "house
money." If he accounted for each hand separately, he would play the
first and last hands the same.
Most people sort their money into accounts like "current income"
and "savings" and justify different expenditures from each. They'll
gladly blow their winnings from the office football pool, a
"frivolous" account, even while scrupulously salting away every penny
of their salaries.
haler and a trio of
colleagues went on to document that cabdrivers stop working for the
day when they reach a target level of income. (Each day's "account" is
separate.) This means that -- quite nonsensically -- they work shorter
hours on more lucrative days, like when it's raining, and longer hours
on days when fares are scarce! In a sense, investors who pay attention
to short-term fluctuations are like those cabbies; if they toted up
their stocks less frequently, they would be better investors. Thaler
went so far as to suggest to an audience at Stanford that investors
should be barred from seeing their portfolios more than once every
five years.
Such irreverence reinforced the view among economists that Thaler
could be safely ignored. His anecdotes were fuzzy science, they said,
and examples like the cabbies were easy pickings. Since there is no
way for a third party to profit from a cabbie's mistake, it's not
surprising that he would make one. Thaler knew the criticism had
merit, and that to be taken seriously, he had to demonstrate
irrationalities in financial markets, which are the purest embodiment
of neoclassicism. In the markets, one person's bad decision can be
offset by someone else's smart one. Across the markets, rationality
should reign.
Thaler set out to prove that it did not. His first effort, a 1985
paper with Werner De Bondt, his doctoral student, showed that stocks
tend to revert to the mean -- that is, stocks that have outperformed
for a sustained period are likely to lag in the future and vice versa.
This was a finding that Chicago School types couldn't ignore --
according to their theory, no pattern can be sustained, since if it
did, canny traders would try to profit from it, correcting prices
until the pattern disappeared.
Then, in 1987, Thaler was hired to write a regular Anomalies column
for a new economics journal, giving him a widespread audience among
his peers. That same year, the stock market crashed 23 percent on a
single day. Thaler could hardly have imagined better proof that the
market was not, well, perfectly rational. More economists began to
mine the data, and by the 90's there was a rich literature of market
anomalies, documenting, for example, that people can consistently make
money on stocks that trade at low multiples of earnings, or on
companies that signal changes by doing things like hiking dividends.
Documenting anomalies became a popular pastime from Berkeley to
Harvard.
haler still has plenty
of critics. The harshest one is right upstairs from his office at
Chicago, the curmudgeonly Eugene Fama, a longtime advocate of the
efficient-market school. "What Thaler does is basically a curiosity
item," Fama snipes. "Would you be surprised that every shopper doesn't
shop at the lowest prices? Not really. Does that mean that prices
aren't competitive?"
Thaler periodically invites Fama in to his class to present the
other side, but Fama has not returned the gesture and, indeed, sounds
bitter that behavioral finance is getting so much attention. "One
question that occurs to me," Fama says, "is, 'How did some of this
stuff ever get published?"' The objection raised most often, from Fama
and others, is that if Thaler is right and the market is so screwy,
why wouldn't more fund managers be able to beat it? A variation of
this theme is that if behavioral economics, for all its intuitive
appeal, can't help people make money, what good is it?
Thaler, actually, is a director in a California money management
firm, Fuller & Thaler Asset Management, which, according to
figures it provided, has been beating the market handily since 1992.
The firm tries to exploit various behavioral patterns, like
"categorization": when Lucent Technologies was riding high, people
categorized it as a "good stock" and mentally coded news about it in a
favorable way. Lately, Lucent has become a "bad stock." But Thaler,
who does not get involved in picking stocks, stops short of suggesting
that investors versed in his research can beat the market. Mispricings
that spring from anomalies are hard to spot, he says, particularly
when the people looking for them are prone to their own behavioral
quirks.
If this sounds muted, it may be because Thaler is ready to declare
victory and join the establishment. The neoclassical model, he admits,
is a fine starting point; it's misleading only when regarded as a
perfect or all-encompassing description. People aren't crazy, he adds,
but their rationality is "bounded" by the tendencies that Kahneman,
Tversky, himself and others have studied. What he hopes is that a
future generation will resolve the schism by building behavioral
tendencies into a new, more flexible model.
For now, Thaler is still looking for new miniature applications
wherever he can find them, like on the basketball court recently.
Thaler studied games in which a team trails by 2 points, with time
left for just one shot. What to go for, 2 points or 3? A 2-point shot
succeeds about half the time, a 3-pointer about 33 percent of the
time. But since a 2-point basket would only tie the game (and force an
overtime, in which the team has a 50-50 chance of winning), going for
a 3-pointer is a superior strategy. Still, most coaches go for 2. Why?
Because it lowers the risk of sudden loss. Coaches, like the rest of
us, do more to avoid losing than they do to win. You won't find an
explanation for that in the mechanical homo economicus of
theory. But it has everything to do with folks Thaler thinks are much
more relevant to the economy -- Homo sapiens.