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| A Call for Nudges |
| by
John Rekenthaler
| 10-15-09 |
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Richard Thaler believes that financial advisors have a major advantage over most economists: They know that investors are human.
Thaler leads a relatively new area of research, behavioral economics, that attempts to "bound" the notion that financial markets are unfailingly rational. The success of Thaler's efforts in bringing legitimacy to his field may be seen by the University of Chicago's decision in 1995 to recruit him for a chaired position in its business school to become the school's first behavioral economist. Thaler now presides over 15 faculty members in running Chicago's Center for Decision Research.
Thaler's work has always been unfailingly practical, from his Ph.D. dissertation on pricing the value of a human life, to his seminal 1980s research on mean reversion in stock prices and the apparent outperformance of value stocks, to later work on motivating 401(k) participant behavior, which he called Save More for Tomorrow. Recently, he co-wrote the book Nudge (Penguin, 2009), which advocates that regulatory bodies use behaviorally gained knowledge to create policies that "nudge" consumers toward making optimal decisions. Proof that Nudge succeeds in its goal of carving out a philosophical middle ground may be seen in its diverse readership, which includes both President Barack Obama and David Cameron, the leader of Great Britain's Conservative Party.
In this free-ranging interview, Thaler discusses the development of behavioral economics, its influence in the current Obama administration, and what behavior economics can say about several current investment topics.
John Rekenthaler: To start, should we be talking about behavioral finance or behavioral economics? Do you have a preference for which term I should use?
Richard Thaler: I think behavioral economics is broader. It's applying psychology to the principals of economics, and finance is one branch of economics. For Morningstar's readers, behavioral finance is what we should talk about. On the other hand, something like Save More for Tomorrow and principles such as loss aversion and overconfidence are more general than finance.
Rekenthaler: Whether we call it behavioral economics or behavioral finance, where do the roots lie?
Thaler: I can tell you my own roots started when I was a graduate student working on my doctoral dissertation. My dissertation was on the value of a human life. This is not as sexy as it sounds. It was really a question in public finance. If the government is going to do something that will make things safer, like improve a road or an airport, and it's going to save three lives a year for the next 20 years, how much is that worth? Clearly, not an infinite amount, but something more than zero. It was mostly an econometrist exercise of estimating how much you had to pay people to get them to take risky jobs.
In the midst of thinking about this problem, I decided it might be fun to ask people some questions. One of the questions I asked was: Suppose you'd been exposed to a rare disease, with a one in a 1,000 risk of dying; how much would you pay to eliminate that risk? Typically, people would give an answer in the range of $5,000. I'd then ask them: We're running some research on this disease over at the hospital, and we need people to expose themselves to it. How much would you charge to participate in this study? People would typically give answers that were two or three orders of magnitude bigger: $500,000 or $5 million. Some people would say they wouldn't do it at any price.
Economic theory says those answers have to be about the same. This got me started on keeping a list of weird behavior on my blackboard. Eventually, I was introduced to the work of two Israeli psychologists, Daniel Kahneman and Amos Tversky, who were studying how people make decisions and judgments and how those judgments aren't consistent with what economists call rational. The three of us ended up spending a year together at Stanford in 1977-78. They didn't really know anything about economics, and I didn't know anything about psychology, and we spent the year educating one another. That was the beginning.
Rekenthaler: Obviously, when you started, you didn't really have a vision of where this would be 30 years later. Are there parts to the development of behavioral economics that might have seemed predictable to you at the time? And are there branches that have surprised you?
Thaler: I think finance is the biggest surprise. But let me come back to that.
I think that in some ways the things we started working with back then are still very important. I was interested in things like self-control and loss aversion and what came to be called mental accounting. Those have remained big themes today. So in some sense, I think we knew what was important early on.
As for the role of markets, it was clear that a question that needed to be asked was: Well, look, if people do dumb things in the privacy of their homes, like they watch the wrong television show or what have you, that's one thing. What happens in markets?
I think it was clear that there was going to have to be a lot of attention paid to that. I started writing papers about it. The first ones were published in 1985.
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