Book Review: Misbehaving – The Making of Behavioral Economics…

Book ReviewMisbehaving - Richard Thaler: Misbehaving: The Making of Behavioral Economics

Author: Richard H. Thaler

Publisher: W W Norton & Company

Kindle Price: INR622.25, Hard cover price: INR1397, Pages 432

Originally published: May 11, 2015

Reviewed by: Jainendra Shandilya, CFA, CAIA

Misbehaving is about the journey of behavioural economics from its origin, recognition as an independent discipline, and the growing acceptance of this subject by the policy makers of developed countries. Richard Thaler, the author and Professor of University of Chicago, is a known behavioural economist/scientist who has put in over three decades of his research into this book. Misbehaving was one of the six books shortlisted for McKenzie FT Business book of 2015, and true to its reputation, it mesmerizes readers with umpteen number of experiments/trial conducted to analyse human behaviour. The author promises the readers full of entertainment and excitement, and advises them to stop reading the moment they don’t find it interesting. To a great extent, this claim is true but for somewhere in the middle of book. It is, however, prudent to read the book from the beginning till end; some of the best things are towards the end.

Prof. Thaler set question paper on economics for his class and noticed that the average score was 72 out of 100 marks. This was not well received by the students. Next time, he changes the maximum score to 137, keeping the level of difficulty little tougher, and the average changes to 96 and the class has no complaint about the question paper. The author is perplexed and realizes that to the rational economists this is a case of misbehaving, as the percentage average score is almost the same in both cases. The whole book is a serious attempt in finding out the reasons why humans’ behaviour departs from rational behaviour postulated by economists. Ordinary humans cannot optimize contrary to what economists expect the rational people to do. “Does a family, that have a choice of thousands of options in a grocery store, optimize”, asks the author? Does a manufacturer employ marginal productivity theory when hiring workers?

People don’t want to part with what they already have compared to what they can have with the same amount of money. This is an endowment bias and in large number of experiments conducted by Thaler, his subjects have demonstrated this bias. People show different risk appetite for gain compared to the same amount of loss. They are more risk averse when it comes to gains compared to when they are in loss. The loss hurts more than the same amount of gain gives pleasure and this is what is called loss aversion in behavioural economics. According to Thaler, there are two kinds of utilities when dealing with human behaviour; one is acquisition utility and the other is transaction utility. When you buy something which you value more, this is acquisition utility; when you buy something at a lower price or of higher quality, this is transaction utility. Two cases in points are of Macy’s and JC Penney. Macy’s tried to reduce the use of coupons that allowed customers discount, and it miserably failed in its attempt. It had to return to its previous coupons program by the holiday season of the same year after realizing that its sales had plummeted. JC Penny, on the other hand, abolished coupons and started a scheme called everyday low price. In the process, JC Penny abolished prices ending with .99 and charged full price instead. It was true that customers were not paying different prices under both practices, the sales of JC Penny, like Macy’s, plummeted and it led to ouster of its CEO Johnson. This misbehaviour by the customer is due to transaction utility. The author applied his knowledge of behavioural economics in practical business application. In Ithaca, a little town, there was ski resort known by the name Greek Peak. The resort was in serious financial difficulty and badly needed to increase revenue or decrease debt. The increased revenue could come only at the expense of high price which could lead to customers shifting to some nearby ski resorts, which appeared to provide better amenities. Thaler adopted the practice of gradually increasing the ticket price to resort so as not to create any backlash by the customers. The resort also had a racecourse which was chargeable to customers. Thaler suggested the owner and the manager to make it free as the racecourse was anyway not making much money. The price of ski-lift was also increased but along with other schemes such as ten pack that included five weekend ticket and five weekday tickets at 40% discount to original price if tickets were booked during the month of October. This discount scheme turned out to be hugely popular with the customers and it provided them with transaction utility. After continuing this scheme for three years did they realize that the scheme turned out to be highly profitable as only 60% of the customers redeemed their tickets and the resorts had already got money from 100% from the customers? In reality, tickets were sold at full price to all the visiting customers! Similarly, car companies like Chrysler, Ford and GM were offering rebate on their car sales for the previous year model to clear their old inventories. This scheme turned out to be very popular with customers, though the rebate was not a big deal. Subsequently, GM introduced highly discounted interest rate on car financed from them, and giving the customers the option to choose from rebate on the price or the discounted loan. The loan offer was hugely successful, although an analysis revealed that the customers would be better off taking rebate and then financing it at prevailing full interest rate. Why did the customers do this? Why were they not behaving like a rational economic agent?

Does sunk costs matter? Not to the economists, but definitely to humans. A man buys a pair of shoes that hurt when it is put on. He removes it and wears it again hoping that it would fit properly and it does not. How many more times the man will wear this before retiring the shoes and how long will he keep it in his house before gifting it to somebody? The answer, says Thaler, depends on how much you have paid for it. The more you have paid for it, the more you would wear it and the longer you would keep it in your closet before gifting it to somebody. The reason, the brain does mental accounting and it tries to recoup losses incurred in any transaction, even if one has to take extra pains to do so. In order to break even, mutual fund managers indulge in a more risk seeking behaviour when they are faced with a loss in the last quarter of the year. Gamblers are more risk seeking when they have initial successes in the casino, a phenomenon called house money effect.

Three distinguished economists, namely, John M. Keynes, Milton Friedman, and Franco Modigliani have defined the behaviour of human beings the way they perceived human consumption behaviour. Keynes, while defining consumption function, assumed that individuals consume a proportion of their yearly incremental income – a term her called marginal propensity to consume (MPC). In 1957, in a book, Milton Friedman came out with permanent income hypothesis – a situation where households try to smoothen their consumption on their expected income over short time period, maybe for three years or so. Franco Modigliani, with his student Richard Brumberg, moved from income to wealth and came out with ‘life cycle hypothesis’. Modigliani’s model assumed that individuals distribute their lifetime wealth over their expected life span and allocate to consumptions accordingly. The three models each tried to explain behaviour of humans in allocating to consumption, the Modigliani model was a clear winner as it was cleverer of all, feels the author. In yet another model of Robert Barro, an economist at Harvard, there is a paradigm shift in terms of how an economist can think. In Barro’s model, an individual not only thinks of his own lifetime but also thinks about bequeath. She is also concerned about her children and grandchildren and, accordingly, allocates consumption over her lifetime. If an individual gets a small amount of money from lottery, she is more likely to be consuming like the Modigliani model. In case, however, the windfall is coming from a temporary tax cut financed by government through market, consumers are likely to increase their bequests by the same amount as they can sense increased tax liabilities in future. “Barro’s insight is ingenious”, feels Thaler. Continuing this argument further, Richard Thaler along with Hersh Shefrin proposed behavioural life-cycle hypothesis. In this model they assumed that consumption in a given year will not depend just on its lifetime wealth, but also on the mental accounts in which that wealth is kept. Humans don’t have the brain of Einstein, nor do they have the self-control of a Buddhist monk.

When it comes to self-control problem over consumption, the author classifies the problem as principal agent problem. The agent is a doer, who wants to satisfy her immediate greed and therefore wants to consume immediately, whatever is available for consumption. The principal -the planner, is a long time thinker and wants to save for future. This is everyday problem and the planner has limited control over the doer-agent that is aroused by food, sex, alcohol or whatever that attracts her. The planner is residing in prefrontal cortex region of the brain and can be described as system 2 of Kahneman’s ‘Thinking, Fast and Slow’, while the doer is the fast, impulsive, intuitive system 1.

Some companies, when hit by recession, reduce the number of workers rather than cutting the wages of workers. Cutting wages makes workers angry and those who are laid off are not around to complain, hence this strategy finds more favour. It is also possible to reduce real wages with the help of inflation and still keep workers happy. Another interesting example in point is sale of Whitney Houston’s album after her death in 2012. The price of her 1997 album ‘The Ultimate Collection’ increased on the UK’s iTunes site from $7.86 to $12.58 – a 60% increase despite the fact that the supply of soft copy-the music sold on iTunes, is unlimited at the same price. Do customers punish this kind of unfair practice by business? The experience of Chicago First – a bank that started charging for teller use, shows that such practices are dangerous if competitors don’t adopt the same strategy. These are not the good times to be greedy, feels the author. One company that does not heed this warning is Uber, it increases charges substantially during peak hour. The author suggests capping the prices charged to passengers during peak hours to something like a multiple of 3 rather than 10!

In various experiments conducted by the author, he has come across endowment bias – a tendency to stick with whatever people have, and status quo bias- a behaviour which is very much like inertia in physics. The book has quoted Merton Miller as saying, “If you take a ten dollar bill from one pocket and put it into a different pocket, your wealth does not change”. The dividend irrelevance theory of Miller and Modigliani is no longer valid in a taxable world, and it is puzzling why companies pay dividends when it is taxed heavily in jurisdictions like the USA. The answer to this puzzle has been provided by Shefrin and Statman, who justified this as a combination of self-control and mental accounting. Pensioners, when they receive dividend money, consider dividend as income and don’t feel guilty of spending their investments.

Many of the experiments in the book are based on games, one such game is illustrated below:

You are presented with four cards lying on the table before you. The cards appear as shown:
A       B       2        3

Your task is to turn over as few cards as possible to verify whether the following statement is true: Every card with a vowel on one side has an even number on the other side. You must decide in advance which cards you will examine. Try it before reading further and note down your preferences.

The typical ranking of the cards in terms of most to least often turned over is A, 2, 3, B. These may not be the ideal choices, yet large number of participants go for this, why? People have a natural tendency to search for confirming evidence rather than disconfirming evidence – a bias called confirmation bias.

Managers of firms turn out to be risk averse if there is penalty for failure. Thaler suggests that managers should be rewarded for risk taking if ex-ante the strategy was value maximizing. In most situations, however, when agents are making poor choices, the person who is misbehaving is the principal and, not the agent.

The author is also puzzled by equity premium. Why is the equity premium as high as 6% per year? Equity premium puzzle was studied by Raj Mehra and Edward Prescot and they found that during 1889-1978 the equity premium was about 6% per year. The puzzle is Mehra and Prescot concluded that the largest equity premium that could be predicted from their model is 0.35% per year, much less than the 6%. Why investors are so risk averse to have such a high equity risk premium? The answer is they are myopic and have short sighted view. When subject are shown long term equity returns, most of them prefer stocks over bonds. Repeated view of investors’ portfolios make them more risk averse. The efficient market hypothesis has two components: the rationality of prices and beating the market. In a paper by Michael Jensen, he showed that professional money managers perform no better than simple market averages. In yet another game played by subjects of the author a very surprising results have come to fore. The game takes cue from the Keynes’ ‘Beauty Contest’. The most important thing in market is to guess what others are doing, if you can do it you are a winner. Here is the game.

Try out a number from 0 to 100 with the goal of making your guess as close as possible to two-thirds of the average guess of all those participating in the contest. Think about your answer before reading further. In 1997, the author happened to hold a contest in the Financial Times newspaper for this puzzle and he expected the answer to be close to Nash equilibrium, but what was the answer that won the return ticket from London to US as prize? Hold your breath, the winning guess was 13. If you rightly guessed the Nash equilibrium, you ought to read the book to know why the answer is not a Nash equilibrium. In case you are not familiar with game theory, my sympathy is with you.

To prove efficient market hypothesis, a.k.a, price is right hypothesis, the author took all the stocks listed on NYSE and examined for any inconsistency in efficient market hypothesis. He divided the best performing stocks as winner, and the worst performing stocks as Losers. He examined the performance of biggest winners vis-à-vis the biggest losers and he found that over the next five years the winners did worse than the market, however, the losers outperformed the market by 30%. If the price was right, how could this happen? Also, according to CAPM the only risk that is rewarded by market is beta. In this case the losers stock had a beta of 1.03 and the winners had a beta of 1.37. His conclusion, the value stocks outperformed the growth stock and they were also less risky, much against the premise of Efficient Market Hypothesis. The next strategy worth examination is, “Can you beat the market by buying stocks whey they are cheap and avoiding them when they are relatively expensive”? “Yes, but……” feels Thaler. He agrees that there is some predictive power in Robert Shiller’s long term Price/Earning ratio. Another violation of efficient market hypothesis or the law of one price is, if you will, cited by the author. Owen Lamont, a colleague at University of Chicago, found the price of 3Com on the Australian stock exchange. 3Com’s main business was networking and communication and it had acquired a company called Palm that was engaged in a project called Palm Pilot. On March 2, 2000, 3Com sold a fraction (4%) of its stake in Palm in the IPO and retained ownership of 95% of the firm, rest 1% was sold to some designated investors. At the time of this announcement on December 3, 1999, the price of 3Com was $40 a share, which rose to $100 a share on March 1, 2000. The investors of 3Com, as part of the spin-off, would receive 1.5 shares of Palm. In the IPO, the price of Palm was set at $38 a share, but when the stock opened for trading the price soared to little over $95. Around this time, the price of 3Com fell to $82. How this could happen, when one share of 3Com was entitled to 1.5 of Palm and also interest in the profitable venture of 3Com? The market was valuing the stub at minus $61 per share and the entire 3Com at minus $23 billion. How could this happen and happen over a period of several months despite the news widely publicized in popular media? Benjamin Graham exploited the price anomaly between DuPont and General Motors when the GM’s price was the same as the DuPont despite the fact that DuPont held a large number of GM’s share. Price is right was also violated when Royal Dutch merged with Shell and two kinds of shares were created. As part of the agreement 60% of the profit would go to Royal Dutch shareholders and 40% to Shell Shareholder. The ratio of their prices, which should have been 60/40, was never close to this. Sometimes the Royal Dutch Shares traded as much as 30% below the Shell shares.

Critics say that behavioural biases go away when stakes are high enough. Gary Becker believed that in a competitive market only people who are hired are the ones who are able to perform their jobs like Economists.

One question that bothered the author constantly is why people save less for their retirement. Many people suffer from inertia, which is what behavioural economists call as status quo bias. The second reason is loss aversion and, the third important reason is self-control. This self-control is a problem related to present but not of future. When it comes to allocating money towards saving for retirement, individuals show better commitment in saving income earned in future. Keeping this in mind, the author devised Save More Tomorrow and the program turned out to be highly successful. To capitalize on this bias, a company started default option as automatic enrolment in pension plan. The result was phenomenal. Before the automatic enrolment, only 49% of the employees joined the plan, however, after this option the figure soared to 86%. The next question is, and a very logical one, whether this increase is savings by plan participants leads to decrease in their other savings. This was a difficult question that the author has no answer for due to lack of data in USA in this regards. One great economist, Prof Raj Chetty of Harvard University, has an answer for this. Prof Chetty along with a team of Danish and American economists, using Danish data, concluded that when someone moves to automatic plans like this one there is neither a decrease in his other savings, nor is there any increase in debt. Whether tax incentives to this kind of contribution have any role in the increased contribution towards retirement savings, the author has answer for this also. Only 1% of the new savings come due to tax incentives, the rest 99% comes from automatic features. Default options have been very successful in organ donation. When this feature was added while renewing drivers’ licenses and verbally asking for the same in Alaska and Montana, the approach led to organ donations exceeding 80%. In yet another area where the author was able to use his knowledge of Behavioural Finance was in tax payment in UK. In the UK, a team by the name BIT (Behavioural Insight Team) was formed to suggest recommendations on improving tax compliance. The team drafted a letter to all those potential tax evaders who could have been persuaded to pay more taxes. The strategy worked out and there was quick improvement in tax receipt in the next twenty three days.

The message that the author wants to send to various governments is to launch their own Behavioural Insights Team that can work on improving compliance in various areas ranging from health care, education, tax compliance etc. whether the same insights of behavioural finance can be used to encourage US Companies to bring the monies stashed abroad is the question that keeps the author pondering over. There is a need to incorporate all these behavioural variables in Economics and probably that will make behavioural economics redundant, but whether the Economists, who call these deviations from rational behaviour a supposedly irrelevant factor (SIF), will be happy to do so. Only time will tell.



















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India Association of Investment Professionals (IAIP), which is established April 2005 and located in Mumbai, is an association of local investment professionals. As one of the 136 CFA Institute member societies, IAIP connects members to a global network of investment professionals. Consisting of portfolio managers, security analysts, investment advisors, and other financial professionals, IAIP promotes ethical and professional standards within the investment industry, facilitates the exchange of information and opinions among people within the local investment community and beyond, and works to further the public’s understanding of the CFA designation and investment industry.
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