July 26, 2017

Reading Uncertainly? ‘Misbehaving: The Making of Behavioral Economics’ by Richard Thaler

This is the engaging story of the development and rise to practical significance of “behavioral economics,” the recognition that we “Humans” (as Professor Thaler calls us) are inevitably flawed in our dealing with finance and the market. It is also the personal biography of the author, along with many of the most important thinkers of the past 50 years.

The idea that our financial markets are “efficient,” as suggested by the “Econs,” the gurus we followed for many years, is destroyed by the realities of the human brain. First came Daniel Kahneman and Amos Tversky, who discovered our innate aversion to loss. Thaler notes that “ … losses hurt about twice as much as gains make you feel good,” noting, “Loss aversion has become the single-most powerful tool in the behavioral economist’s arsenal.”

But, Thaler also warns that, “… people who are threatened with big losses and have a chance to break even will be unusually willing to take risks, even if they are normally risk averse. Watch out!”

We need to be far more aware of the vagaries of the human mind when trying to guide ourselves and others toward the best balance of risk and reward: “The bottom line is that in many situations in which agents are making poor choices, the person who is misbehaving is often the principal, not the agent. The misbehavior is in failing to create an environment in which employees feel that they can take good risks and not be punished if the risks do not pay off.”

Unfortunately, we all tend to follow the herd: “It is better for reputation to fail conventionally than to succeed unconventionally.” Many years ago, IBM tried a better idea: it created a “Skunk Works” (from Al Capp’s L’il Abner cartoon) where employees with new and uncommon ideas could use corporate funds and help to work them out. If they succeeded, glory. If not, they could return, without blame, to their former employment.

Thaler’s sense of humor is always evident. Instead of watching our investment portfolios too closely, a uniformly bad habit, he suggests doing a crossword puzzle instead. He made a correct prediction about the collapse of the market in 2008: “Having made that one correct prediction, I am resolving not to make any more.”

And in American football, he urges teams to do the unexpected, such as “going for it” on fourth down. It changes the psychology on both sides echoing the, “And now for something completely different,” from Monty Python.

Thaler’s language is distinctly non-academic, a pleasure to read. He quotes Douglas Bernheim (2002): “As an economist, one cannot review the voluminous literature on taxation and saving without being somewhat humbled by the enormous difficulty of learning anything useful about even the most basic empirical questions.”

The last third of the book details the writing and reception of Nudge, the 2008 book he co-authored with Cass Sunstein. Their original title was “libertarian paternalism,” abbreviated, thank goodness, to “nudge,” the idea that we can encourage someone to do something that is in their best interests, by making it slightly easier.

At the end, Thaler asks “What Is Next?” He answers: “the only sensible prediction is to say what happens will surely surprise us.” Behavioral economics, the role of humans in what we do and how we live, is critical to both strategic and tactical planning.

And I did find a word I’ve never seen before: “corybantic.” It means frenzied, agitated, unrestrained: exactly how some human respond when their traditional beliefs and ideals are challenged.

Editor’s Note: ‘Misbehaving: The Making of Behavioral Economics’ by Richard Thaler is published by W. W. Norton & Co., New York 2015

Felix Kloman

About the Author: Felix Kloman is a sailor, rower, husband, father, grandfather, retired management consultant and, above all, a curious reader and writer. He’s explored how we as human beings and organizations respond to ever-present uncertainty in two books, ‘Mumpsimus Revisited’ (2005) and ‘The Fantods of Risk’ (2008). A 20-year-resident of Lyme, he now writes book reviews, mostly of non-fiction that explores our minds, our behavior, our politics and our history. But he does throw in a novel here and there. For more than 50 years, he’s put together the 17 syllables that comprise haiku, the traditional Japanese poetry, and now serves as the self-appointed “poet laureate” of Ashlawn Farms Coffee. His wife, Ann, is also a writer, but of mystery novels, all of which begin in a bubbling village in midcoast Maine, strangely reminiscent of the town she and her husband visit every summer.

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