Exuberance Is Rational

Or at least human. Richard Thaler has led a revolution in the study of economics by understanding the strange ways people behave with their money. By ROGER LOWENSTEIN

Drawings by Gary Baseman

It 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.

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."

Thaler, 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.

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."

Drawings by Gary Baseman

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.

Thaler 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.

Thaler 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.


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