We Are Not Rational

Here are some questions to ponder:

• Why would someone drive 10 minutes to a get a $10 discount on a $45 clock radio but not do the same for a $10 discount on a $495 television? 

• Why would someone refuse to pay an exorbitant $10 to get his lawn mowed but refuse to mow someone else’s lawn for $20? 

• Why do we feel it’s perfectly acceptable to buy a beer at a fancy resort for $7 but feel outraged if we see the same beer for $7 at a local bar? 

• Why can car companies sell more by offering $300 cash rebates than by simply discounting the car price by $300? 

• Why would someone who has paid $1000 to play at a tennis club continue playing after developing painful tennis elbow, even though it makes him worse off in every way?

These and many other like questions are what behavioral economist Richard Thaler asks in his new book, Misbehaving: The Making of Behavioral Economics. They are the kind of questions that could never appear in traditional economics because irrational behavior doesn’t exist in the traditional economist’s world – but they also are the kind of questions that make us laugh because we know they arise in the real world all the time.

Thaler is an economist who has been studying real-world behavioral phenomena for four decades. His fascination started as a grad student, and after meeting behavioral science greats Daniel Kahneman and Amos Tversky, he never looked back. Misbehaving is his account of his four decades in this rising field – a look at his own work, the work of respected colleagues, and some entertaining accounts of their battles with the economics establishment (some big names do get named). 

What we learn over and over is that we are not rational creatures. Contrary to what traditional economics says, we do not always calculate optimal solutions. In real life, we make suboptimal decisions. We do things that are silly or downright idiotic. Sometimes we even know we’re doing something silly and still choose to do it. The point is that understanding our behavior might help us to do better – save more for retirement, invest smarter, motivate troubled students, or get people to pay their taxes on time. Thaler even covers how NFL teams could improve their draft picks if they used a little smart behavioral knowledge.

In the humorous spirit of the book, Thaler also shares how he applies behavioral science in his own life. For instance, he receives endless complaints from his students about how difficult his economics exams are. The average score is 72. In response, Thaler simply reframes the situation by announcing he will grade exams on a scale of 137. Suddenly, students who receive a 96 are over the moon with happiness. Surely they know 96 out of 137 is 70%, but he never gets complaints again. Go figure.

One interesting thing to come out of the book is that the field of behavioral economics has had its greatest impact where it was least expected: finance. In 1980, this was unimaginable because if there was any place believed to be the pinnacle of rational economic behavior, it was financial markets. Surely, market participants were using all available information to calculate correct stock prices, right? Hardly. It turns out that there is pretty damning evidence that financial market participants are as irrational as everyone else.

As one example, take a look at the chart below that Thaler borrows from his friend Robert Shiller. The blue line shows the theoretically correct price of stocks (using a dividend discount model), while the other line shows actual stock prices. Together, they suggest that investors are over- or under-reacting in a big way to news or sentiment that ends up being irrelevant.  They at times push prices below their intrinsic value – creating great opportunities for value investors – or they become as over the moon as those students who got 96 out of 137 on their exams.