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.
To start, should we be talking about behavioral finance or behavioral economics? Do you have a preference for which term I should use?
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.
Whether we call it behavioral economics or behavioral finance, where do the roots lie?
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.
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?
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.
But I certainly never would have expected that the branch of behavioral economics that would really take off first was behavioral finance. Our expectation was that finance would be the least likely place that we'd find big anomalies, and the reason is that financial markets are the most efficient markets. They are markets in which many of the traders are professionals. The stakes are huge. So if there's something that's not working right, people can make tons of money exploiting that and making it go away.
It was a surprise that it turned out to be pretty easy to find puzzles in financial markets. Perhaps because they were so surprising, and because the data is so rich in financial markets, this branch of the enterprise really has been the most successful to date--successful in the sense of attracting a fairly large group of academics who consider that's what they do for a living and attracting the interest of practitioners like you.
It's my sense that under the Obama administration, behavioral economics now has an official link into policy-making. It is more directly connected with what goes on in Washington than ever before.
Yes. It's funny. About five years ago, I organized a session at the American Economists Association meeting called "Memos to the Chairman of the Council of Behavioral Economic Advisors." It was meant to be sort of a whimsical title and science fiction. If there were such a group, what would people be thinking about?
Now, here we are, and it's not that there's a Council of Behavioral Economic Advisors, but in some sense, it's even more than that. There are behavioral economists scattered through the administration, including the co-author of Nudge
, Cass Sunstein, who, let's hope, by the time this article is published will be confirmed in his job as the director of the Office of Information and Regulatory Affairs. It's in the Office of Management and Budget, and it's the most important job in Washington that no one's ever heard of. It essentially has to give approval for any new regulation.
So OMB has really become the Council of Behavioral Economic Advisors, because Peter Orszag, the director, has written extensively about behavioral economics. Another guy in the OMB, [executive associate director] Jeff Liebman, from Harvard, has as well. There are other people around the administration, too, most notably Michael Barr, who's an assistant secretary of the Treasury in charge of consumer regulation. Even Larry Summers wrote some early papers on behavioral finance. Neither he nor I would call him a behavioral economist primarily, but he is a very eclectic guy, and he is certainly happy to use behavioral economics when it seems to be the appropriate tool at hand.
Can you give an example of ideas that you and Sunstein worked on that are making their way into policy?
One of the first things that the administration did was announce a carbon emissions inventory. Starting in 2010, firms will have to announce what their emissions are. The idea--and we talk about this in the book--is that simply by having to announce their emissions, companies will be shamed into greening up their act a little bit. If you have the dirtiest factory in town, maybe people will get on your back. This is in preparation for some sort of cap-and-trade system where we'll need those data anyway, but the idea was let's just start with this. In some other fields, this "announcement effect" has been helpful.
Something more finance related is an idea that we talk about in the book that has been picking up a lot of steam. We call it RECAP--Record, Evaluate, and Compare Alternative Prices. The idea is that firms would be required to give two kinds of data to their customers. Let's think about it from the perspective of credit cards.
Once a year, every credit-card holder would get two electronic files from their credit-card company. One would be usage data. The file would list all the ways you've used your credit card in the past year that are capable of incurring charges. The basic principle is that as the user of a service, you should be entitled to know how much you're using it. Right now, it's very hard to get that information. You might have to spend hours with a calculator to figure it out, if you can at all.
The second file would be information on prices. It would be essentially a spreadsheet that would list all the ways that the credit-card company can charge you.
Now, it's not that we expect that very many people would actually look at those files themselves. Instead, with one click, they could upload the files into third-party Web sites that would analyze the files and make suggestions, such as how you might save money by, say, paying your bill on time. Or if you travel and you have a card that charges you a lot for foreign purchases, maybe you should switch to a card that doesn't. Then, it would do the shopping for you, given the way you purchase--here's a card that would be better for you.
That proposal has now made its way into a document that the government released. There is a proposal to create a Consumer Finance Protection Agency. One of the lists of things this agency would do is require electronic, machine-readable disclosures.
It seems to me in reading through Nudge
that a core principle is rather than to take the approach of regulation and telling people and companies what they can and can't do, you're really about disclosure and information design. That properly accessible information will lead to better outcomes than coming up with a particular rule to prohibit a particular practice.
Yes. We wouldn't want to argue that disclosure can solve all the problems. But what's true, of course, is that the existing disclosure rules are really obsolete. For a credit card, you get 30 pages of fine print that no one reads. So, there are a couple of steps one could take.
One is that you can regulate the form of the disclosure. You might say, "Look, there are three numbers that everybody ought to know and they ought to be on the first page in 20-point font."
The step that we've taken is to say, "Wherever possible, let's make the move toward machine-readable disclosure." Let's remember we're in the 21st century. Once you make things machine readable, then all kinds of Web sites can emerge to essentially do, on other domains, what Morningstar does for mutual funds. Have a simple place where you can get all the basic facts, what the expense ratios are and what the returns have been, and then, perhaps, proprietary evaluations of the sort that Morningstar does.
We imagined that that would be true for mortgages, credit cards, and mobile calling plans. I'm about to take a trip to Asia, and I'm trying to figure out which international calling plan I need, and I need to know how many megabytes of data I use. How the hell am I supposed to know that? We want to make that type of information more available.
Now, that's not to say there are no activities that one would ban. Fraud, for example, needs to be against the law. Nobody's proposing that we eliminate that. But if we think about Bernie Madoff, just a little bit of disclosure would have prevented that. Suppose he had to show were all the money was. I suppose one could say that the SEC already should have done it, but they didn't. So we need to figure out how we can require financial firms to disclose enough that the regulators can make sure that they're not ripping people off--but not so much that they can no longer make a living. I wouldn't propose that hedge funds have to reveal what their secret sauce is. But maybe they have to tell us what their leverage ratio is, and certainly they have to tell us where they keep the money.
We should probably move from behavioral economics in general to how it can help advisors. Any advice?
Well, one thing I would say is that the advisor community was very quick to pick up on behavioral finance. I think the reason is that they know that their job is at least as much like a clinical psychologist as it is like an accountant.
They know their clients are nuts?
Well, that's what John Rekenthaler says.
I've heard it from few advisors, as well.
Let's just say they're human.
Same thing, right?
Yes, exactly. I think it's fair to say that many clinical psychologists spend a lot of time talking to their clients about money and that many advisors think that they're more of a shrink than anything else.
Another thing I would say is that the big problem going forward--especially as I'm the tip of the baby-boom generation and as our generation starts to retire--is that nobody really thinks that they found the solution to how we should handle decumulation.
And what's the right role for annuities? Part of this is behavioral. Most people don't like annuities. One reason is they don't like the idea that if they die too young, then the insurance company makes a lot of money. New products need to be invented and new marketing schemes created that will make people comfortable with at least putting some of their portfolio into products like that.
One other thing that obviously jumps to mind is, what will be the long-term implications of 2008? I suppose that will depend on how quickly the market recovers. The bear market of 2000-03 seemed to have been forgotten pretty quickly. I think maybe it's because the money that people made came in so fast that it was "easy come, easy go."
Or another way of putting it is a lot of the people didn't really lose money in a sense, they just lost what they had made in 1999 and early 2000.
Right. We sometimes call that the house money effect. You win $1,000 at a casino and then lose it back; you don't really feel like you've lost anything. It was their money.
Obviously, the market's fall in 2000 was concentrated. Nasdaq fell by two thirds, but the rest of the market didn't get hit so badly. Here, everything got crushed, including real estate. So, I don't know what the longrun effect is going to be. The next time I talk to a group of financial advisors I'll be interested in hearing their war stories about this.
I'd say in the short term, from what we're hearing from the advisor community, which, of course, is a reflection from what they hear from their customers, is skepticism about the fundamental notion of Modern Portfolio Theory. Because it seemed like everything fell at the same time, people are questioning the point of diversification. And they have an increased desire to find what I would call market-timing strategies. The notion of long-term strategic asset allocation got rocked a bit.
I think that's true. Of course, the sad truth is that nobody has ever had much success with tactical asset allocation or market-timing. Even my dear friend Bob Shiller, who was prescient about the Internet and the real estate bubbles, in both cases was early.
I remember when I came out to meet with Kahneman and Tversky in '77, my impression was California real estate was a bubble. I was happy I didn't have to buy into it then. You can see how smart that was.
Nobody has really figured out how to do timing. I remember in the 1990s, advisors told me that they were having a hard time talking clients out of investing everything in technology stocks. It was hard to convince anybody that real estate wasn't a sure thing.
But in some ways, individual investors have come out looking pretty good in all of this. There's no sense in the data that I've seen--at least in 401(k) plans--that there's been a massive move away from equities. The biggest mistakes and the biggest losses were all made by the professionals. We've had entire companies blow up. I think the observation that diversification "ain't what it used to be" is quite profound, and one that the pros didn't get. Let's hope they've gotten it going forward.