For much of the 20th century, many economists assumed people behaved rationally and in their own self-interest. If a person goes to the store and is deciding between two otherwise identical kinds of toilet paper? They’ll buy the cheaper one. If someone makes an offer to buy your house? You’ll do the math to figure out if the price is enough to justify the cost of a move, and take or reject the offer. Right?
Well, maybe not. These assumptions never sat right with University of Chicago economist Richard Thaler, who on Monday was granted the Nobel Memorial Prize in Economic Sciences (note: somewhat confusingly, this “economic Nobel” is not technically in the same category as other Nobel Prizes, since it was established after Alfred Nobel’s death, in his memory).
For one, if people are so economically rational, Thaler once wrote, why do we give one another gifts?
Publishing key research in the early 1980s, Thaler and his ideas at first seemed radical — so much so that much of the economics faculty at the University of Chicago reportedly tried to block his appointment. Eventually, Thaler’s ideas helped give rise to the modern field of behavioral economics, which combines elements of economics and psychology in an attempt to figure out why people make the decisions they make. Some of his findings have had huge ramifications, particularly for anyone trying to save money.
If you have a company retirement account, for example, Thaler’s research may have influenced how you were enrolled. In one experiment on retirement savers, Thaler showed that when plans were automated, workers more than tripled the percentage of each paycheck they saved. One of Thaler’s peers estimates that his suggestions about how to structure retirement accounts have added some $29.6 billion to people’s savings.
Here are some more of Thaler’s most celebrated — and useful — pieces of wisdom.
1. Auction “winners” are often money losers
One of Thaler’s most popular early papers was about a concept called the “winner’s curse,” which was based on the idea that people who “win” auctions tend to overpay for whatever it is they purchased.
The winner’s curse can happen in two ways: Paying more for something than it’s worth intrinsically, or having something turn out to be worth less than you thought it would when you decided what to pay for it. That the winner’s curse happens at all, Thaler writes, is proof bidders are not behaving rationally.
The winner’s curse happens often, he explained, because people tend make mistakes when they’re trying to figure out what to bid. Large groups of bidders also tend to encourage people to bid more aggressively, driving an item up to a higher price, and making it less likely the “winner” is getting a good deal.
One key takeaway? Stick with lotteries — especially the free kind.
2. You tend to think your own stuff is more valuable than it is
Another one of the ideas Thaler helped popularize was something called the “endowment effect,” which is another way of saying that people tend to overvalue their own possessions, all other elements being equal.
In one often-cited experiment, Thaler took a group of economics students and gave half of them college coffee mugs and instructed them to assign a value to the mugs. Those who had mugs perceived the mugs as being more valuable than those who did not.
The reason for this may have to do with something called loss aversion, which holds that people tend to overestimate the pain of losing something and underestimate the pleasure of acquiring it. In one of his papers, the endowment effect is used to explain why so few people who have their pictures developed request refunds for pictures that turn out poorly.
3. Taking a long view pays off
One of the main reasons the committee decided to give the Nobel award to Thaler was his work on the topic of self-control. Everyone knows they’re supposed to save for retirement, but comparatively few people actually save enough — and the reason is because people have a hard time balancing long-term preparations with everyday demands and temptations.
Thaler’s framework for analyzing this tension, called the planner-doer model, is widely used by psychologists and neuroscientists. This tension explains why so many people still opt to have that morning coffee, despite the fact that a lifetime of coffee savings could save you a solid chunk of change over time.
That simple finding paved the way for one of the most surefire ways to save more money: Take five minutes right now and automate your account deposits.
4. It’s smart to pay attention to the invisible design choices steering decision-making
Automatically enrolling people into retirement accounts is an example of something Thaler and one of his research partners, Cass Sunstein, call a “nudge,” a slight tweak to the process which leads to substantially better outcomes. Public policy makers have increasingly looked for other ways to “nudge” individuals in the direction of better long-term choices.
One of the best examples? Thaler’s arguments for automatic enrollment are often credited with a nationwide push to automatically enroll children for free school-lunch benefits. A similar plan that’s underway in New York City public schools is expected to expand access to an additional 200,000 children.
5. You tend to overreact to bad news — and underreact to good news
It should come as no surprise that Thaler’s ideas have also influenced investing strategy. The Nobel Prize-winner sub-advises one fund that makes stock picks by applying his principles — like the idea that people tend to overreact to bad news and underreact to good news — by examining which company insiders seem to be buying or selling lots of stock.
Thaler’s Undiscovered Managers Behavioral Value Fund has about $6 billion under management, according to Bloomberg. It has also done relatively well, returning about 16% annually on average, better than 97% of its peers.
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