PDF Summary:Misbehaving, by Richard H. Thaler

The theories of traditional economics—which assume that consumers act rationally and that financial markets reflect securities’ true values—rest on a faulty foundation, according to behavioral economist Richard H. Thaler. In his 2016 book, Misbehaving, Thaler instead argues that consumers frequently behave irrationally, making sub-optimal economic decisions, and that markets may price securities incorrectly. To show as much, he traces the historical development of behavioral economics, which explores how consumers actually behave in economic situations, not just how they should behave.

We’ll discuss the foundations of traditional economics and Thaler’s arguments against them. We’ll examine examples from behavioral economics that undermine the premise that consumers always optimize their budget, and we’ll assess arguments that challenge the claim that financial assets are always accurately priced. To conclude, we’ll discuss real-world cases of behavioral economics helping consumers make better decisions. We’ll also discuss counterarguments from traditional economists and consider updates to Thaler’s arguments since Misbehaving’s publication.

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(Shortform note: Experts note that situations analogous to the prisoner’s dilemma often occur in business contexts when companies compete against one another. To illustrate, imagine that two companies sell a similar product, such as two airline companies selling tickets for the same flights. In this case, both companies are dependent on each other to keep prices high, because if one company cuts prices attempting to gain a larger market share, then the other company would cut prices as well to prevent this. Thus, both companies’ profit margins would decrease, while cooperating would have kept profit margins higher. For this reason, cutting prices is functionally similar to informing on your collaborator in the prisoner’s dilemma.)

As Thaler relates, if the traditional economic assumption that individuals maximize their own well-being were true, both prisoners would inform on each other. To see why, imagine that you’re one of the two prisoners. Logically, there are two options: Either your collaborator will inform on you, or they won’t. If they do inform on you, you should likewise inform on them, since doing so would reduce your sentence from 10 years to five years. If they don’t inform on you, you should still inform on them, since doing so would reduce your sentence from one year to zero years. Regardless, standard economic theory dictates that you should inform.

(Shortform note: Using vocabulary from game theory, informing on your collaborator is the dominant strategy, meaning that it yields the best outcome for you regardless of how the other player acts. According to standard economic theory, you should always utilize the dominant strategy if one exists, since doing so seems to maximize your own self-interest.)

However, Thaler says, when variants of the prisoner’s dilemma are performed in the laboratory, we find a different result: 40-50% of prisoners (that is, those playing the role of prisoners) refuse to inform on each other, instead remaining silent even if it means spending a year in jail. Thus, it seems that prisoners are interested in cooperating with each other, even though standard economic theory says that cooperation is irrelevant.

(Shortform note: In 1980, political scientist Robert Axelrod held a tournament pitting various prisoner’s dilemma strategies against one another via computer programs that played successive rounds of the game. The most successful strategy, he found, was known as the “tit for tat” strategy: It cooperated on the first move, then did whatever its opponent did the previous move. For example, if the opponent cooperated on the first move, it would cooperate on the second move, whereas if the opponent informed on the first move, it would inform on the second. Thus, the “tit for tat” strategy benefited through cooperation with a collaborative opponent, but avoided exploitation by informing against adversarial opponents.)

Argument #3: People Exhibit Present Bias

Thaler’s third argument holds that we exhibit a present bias—a preference toward smaller immediate rewards over larger future rewards—that conflicts with the premise of constrained optimization because it decreases our long-term economic utility. To show as much, he examines how this bias manifests itself in children as well as adults.

Thaler first examines psychologist Walter Mischel’s famous experiment testing children’s willpower in a laboratory setting. In Mischel’s experiment, children are given the choice between one marshmallow now and two marshmallows in 15 minutes, with the caveat that they have to spend these 15 minutes in a room with access to the single marshmallow. Thaler relates that, on average, children couldn’t last the 15 minutes: They lasted an average of 11 minutes before eating the single marshmallow. If children rationally maximized economic utility, however, they would wait 15 minutes, since two marshmallows are clearly worth more than one.

(Shortform note: In Calling Bullshit, Carl Bergstrom and Jevin D. West point out that although results of the marshmallow experiments measured children’s capacity for delayed gratification, this capacity was itself related to another factor—parental socioeconomic status. They report that, according to later researchers, children from higher-income families could consistently wait longer to earn the second marshmallow compared with children from lower-income families, possibly because they had more trust in adults or simply didn’t consider one marshmallow to be as good of a reward.)

According to Thaler, adults likewise exhibit present bias—that is, they irrationally place more weight on short-term economic gains than equivalent long-term gains. He argues that adults often fall victim to a specific form of present bias known as hyperbolic discounting, in which they prefer immediate rewards to future rewards, but they don’t differentiate between comparable rewards at different dates in the far future. For example, if you’re offered tickets to the Superbowl either for this year or 10 years in the future, you’ll likely prefer the tickets to this year’s Super Bowl. By contrast, if you’re offered the choice between tickets to the Super Bowl 10 years in the future or 11 years in the future, you’ll likely lack the strong preference for the earlier tickets.

(Shortform note: Experts point out that, just as individuals display hyperbolic discounting, the same is true of larger institutions that prefer present gratification at the expense of larger future rewards. For example, corporations might take actions to bolster their quarterly earnings reports now, even if such actions aren’t in the corporation’s best interest in the long term.)

Arguments Against the Efficient Market Hypothesis

Having seen how consumers often take noneconomic factors into account when making decisions, contrary to the premise of constrained optimization, we’ll now proceed to Thaler’s arguments against the other key thesis of traditional economics—the EMH. And while Thaler agrees with the EMH’s claim that it’s impossible to consistently beat the market, he disagrees with its claim that securities’ prices always reflect their intrinsic value. In this section, we’ll consider three arguments against the thesis that securities are always accurately priced: that investment opportunities from closed-end funds violate the EMH, that stock market overreaction violates the EMH, and that the stock market is too volatile to be perfectly efficient.

Argument #1: Closed-End Funds Violate the Law of One Price

According to Thaler, one argument against the EMH is the violation of the law of one price—the thesis from traditional economics that a security should never sell at two different prices at the same time. Thaler explains that the law of one price follows directly from the EMH’s assumption that securities are always accurately priced. Under this assumption, it’s logically impossible for the same security to have two different prices, since that means at least one of the prices is different from the security’s intrinsic value.

(Shortform note: According to a slightly different understanding of the law of one price, this law admits that there can briefly exist price disparities of a security in different markets, but this disparity will quickly be eliminated by savvy traders. These traders, the argument runs, will exploit the price disparity by purchasing the security at the lower price in the first market and selling it at the higher price in the other market to earn a guaranteed profit. Consequently, they should drive the security’s prices to an equilibrium because buying the security at the lower price will drive its price up while selling it at the higher price will drive its price down.)

However, Thaler argues that closed-end funds violate the law of one price and therefore are inconsistent with the EMH. Closed-end funds, he explains, are investing funds—that is, pools of money from investors that money managers invest on their behalf—that raise money via an initial public offering (IPO) in which investors can purchase shares of the closed-end fund. The fund managers then use the money raised through this IPO to purchase stocks. For example, if the IPO raised $10 million, then the fund managers would invest this $10 million in the stock market as they see fit. Crucially, investors can then also buy and sell shares of the closed-end fund itself, although they cannot invest money directly into the fund after the IPO.

(Shortform note: Experts note that the largest closed-end fund—that is, the closed-end fund with the greatest assets—is the municipal bond fund, which invests in bonds issued by state and local governments. Such funds are advantageous to investors because they not only include only highly rated bonds (in other words, bonds with the lowest likelihood of defaulting) but also because the interest payments from these bonds are often tax-deductible.)

Thaler notes that, if the law of one price were true, the market price of closed-end funds should be equivalent to their net asset value—that is, the value of the assets that the fund owns. For example, imagine that after the IPO raised $10 million, the fund’s managers invested $5 million in Netflix which rose 20% (yielding $6 million in value) and $5 million in Google which rose 10% (yielding $5.5 million in value). Then, the IPO’s net asset value would be $11.5 million, and because investing in the closed-end fund is functionally equivalent to investing in its underlying assets, the law of one price states that the market price of the closed-end fund (its share price multiplied by its total number of shares) should also equal $11.5 million.

In practice, however, closed-end funds’ market prices are rarely equivalent to their net asset value. On the contrary, Thaler points out that closed-end funds typically trade at a 10-20% discount of their net asset value (though, occasionally, they also trade above net asset value), meaning that investors are essentially purchasing shares of the closed-end funds’ underlying assets for less (or occasionally more) than their market price. Either way, closed-end funds represent a violation of the law of one price.

Violations of the Law of One Price in Cryptocurrency Markets

In addition to closed-end funds, other violations of the law of one price can occur in cryptocurrency markets, which experts typically consider less efficient because they’re younger than more established markets such as the US stock market. According to Michael Lewis, the author of Going Infinite, these violations of the law of one price helped drive the rise of former cryptocurrency mogul Sam Bankman-Fried.

Lewis writes that, when Bankman-Fried first opened his quantitative cryptocurrency trading firm, Alameda Research, he employed a program known as Modelbot to exploit price disparities in international Bitcoin markets. In essence, Modelbot identified Bitcoin price disparities in different markets—for example, it might find that Bitcoin was trading at $9,500 in South Korea and $9,550 in Japan—and automatically purchase Bitcoin at the lower price then sell it instantly at the higher price to net a profit. Through this program, Bankman-Fried earned upwards of a million dollars daily at one point.

However, financial experts note that as Bitcoin markets became more efficient, these violations of the law of one price largely vanished by the end of 2018.

Argument #2: Overreaction in the Stock Market

Thaler argues that, much like closed-end funds demonstrate inefficiencies by violating the law of one price, the stock market also demonstrates inefficiencies by overreacting. In other words, he argues that stocks that recently outperformed the market tend to underperform it in the future. His research demonstrates that significant past overperformance is predictive of significant future underperformance, and vice versa. This contradicts the EMH’s prediction that past market performance cannot predict future performance.

Thaler explains that if stocks were always accurately priced like the EMH claims, there would be no way to determine whether a stock will increase or decrease in value. After all, if you knew that a stock would increase in value, that would illustrate that it’s currently undervalued and therefore not accurately priced. By contrast, if you knew that a stock would decrease in value, that would illustrate that it’s currently overvalued and therefore not accurately priced.

(Shortform note: Because EMH proponents maintain that there’s no way to know whether a stock’s price will increase or decrease, many of these proponents liken the stock market to a random walk in which securities’ prices fluctuate entirely at random. According to this random walk hypothesis, neither technical analysis nor analysis of a company’s business fundamentals will yield any insight into the future direction of its share price.)

However, the occurrence of overreaction suggests that some stocks are undervalued or overvalued, contrary to the EMH’s prediction. To show as much, Thaler conducted a study comparing the most successful and unsuccessful stocks on the New York Stock Exchange (NYSE) over various three- to five-year periods—that is, those that outperformed the market by the largest margin and those that underperformed the market by the largest margin. Across various portfolios, his results were consistent: In the subsequent three- to five-year periods, the previously least successful stocks outperformed the market by an average of 30%, and the previously most successful stocks underperformed the market by an average of 10%.

(Shortform note: Since the publication of Thaler’s original work examining stock market overreaction in 1985, there’s been evidence that stock market overreaction has persisted well into the 21st century. For instance, researchers examining the Dow Jones Industrial Index found that, between 1990 and 2017, below-market returns during one period of time were predictive of subsequent above-market returns, and vice versa. Further, these researchers agree with Thaler’s claim that this overreaction constitutes strong evidence against the EMH, since it implies you could beat the market by purchasing stocks that have recently underperformed.)

The Counterargument: Higher Risk Justifies Higher Rewards

Thaler acknowledges that EMH proponents offered an initially plausible response to his argument: Previously underperforming stocks beat the market because they are significantly riskier than successful stocks, and vice versa. In other words, the reason underperforming stocks subsequently beat the market was because they were riskier, not because they were undervalued. And the EMH allows that riskier investments can yield higher returns, since investors require higher returns to compensate for the risk they incur.

(Shortform note: In The Most Important Thing, Howard Marks clarifies that the higher expected return of a riskier investment is known as a risk premium. More specifically, he explains that a risk premium is the difference between a stock’s expected return and the risk-free rate of return—that is, the lending interest rate set by the US Federal Reserve.)

However, Thaler points out that according to traditional economics’ account of risk, given by the capital asset pricing model, underperforming stocks were actually less risky than exceptionally successful ones. In this model, a stock’s risk is called its beta, where beta is a function of how volatile the stock is—that is, how large its swings in value typically are in either direction. But, as Thaler relates, the stocks that previously underperformed the market actually had lower betas than those that previously outperformed the market, on average. So, Thaler says, the response from traditional economists that the underperforming stocks later outperformed the market because they were riskier doesn’t hold water.

(Shortform note: In The Warren Buffett Way, Hagstrom points out that the reason why traditional economists have historically equated risk with volatility is because of their reliance on the EMH. He notes that, because proponents of the EMH hold that investing success is solely a matter of luck, they conclude that portfolios that are more volatile are simply more likely to lose money, and hence more risky. By contrast, investors who reject the EMH might invest in more volatile securities if they believe these securities are underpriced relative to their intrinsic value.)

Argument #3: Shiller’s Case Against Rational Pricing

While Thaler uses violations of the law of one price and overreaction as arguments against EMH, he also cites the ideas of Nobel laureate Robert Shiller. Shiller argued that the US stock market is more volatile than it should be if it were perfectly efficient.

Shiller’s argument is based on the assumption that a stock’s dividends are a proxy for its intrinsic value. To see why, Thaler asks us to imagine we own a stock that we’ll never sell—then, the value of this stock would be equal to the present value of its future dividends (that is, the total dividend payments over the stock’s life discounted at an appropriate rate). However, he points out that we don’t know exactly what a stock’s future dividend payments will be. Thus, the current stock price is effectively a prediction of net future dividend payments, at the appropriate discount rate.

(Shortform note: Experts note that, although dividends can function as a proxy for intrinsic value, not all companies issue dividend payments in the first place. For instance, while established companies typically issue consistent dividends, the same is often untrue of start-up companies, which normally lack the capital to issue dividends to shareholders. Consequently, it can be more difficult to estimate the intrinsic value of these fledgling companies.)

Thaler then relates Shiller’s argument that, because stock prices are a prediction of future dividends, we should expect the volatility of stock prices to match those of dividends. To take an analogous example, imagine that you’re predicting how a set of 10 counties will vote in the upcoming election. If these counties have historically had similar voting patterns (say, voting on an average 60% Republican plus or minus five percent), then your prediction should reflect this similarity—you shouldn’t predict that one county will vote 20% Republican while another will vote 90% Republican, since this volatility doesn’t reflect the historical data.

However, when it comes to stock prices, these prices exhibit far more volatility than future dividend payments—whereas future dividends are remarkably consistent over time, with slight-but-steady increases, stock prices exhibit erratic swings in prices. Thus, assuming that dividends are a proxy for intrinsic value, Shiller concludes that stock prices must often depart from intrinsic value, contrary to the EMH.

The Primary Counterargument to Shiller’s Argument

Shiller’s argument against the EMH spawned an array of counterarguments from economists reluctant to abandon the EMH. In his book on the nature of speculative bubbles, Irrational Exuberance, Shiller discusses the most prominent of these counterarguments, according to which the stock market is currently efficient, even though it wasn’t efficient when he first published his volatility argument in 1985. As Shiller relates, these EMH defenders contend that contemporary investors have realized the true value of stocks by seeing their historical performance, and thus have accurately priced these stocks in the stock market.

However, he points out that for this response to be viable, EMH defenders must also admit that currently inflated price-earnings (P/E) ratios—that is, the ratio of a company’s share price to its annual earnings—are rational (otherwise this inflation would suggest that investors are irrationally overpaying, meaning that the stocks are mispriced). Consequently, EMH defenders argue that the inflated ratios are justified because stocks have historically yielded superior returns compared to other securities, meaning it’s rational to pay more for them.

However, Shiller maintains that this argument is flawed. He points out that, in the 10 years after two previous peaks in P/E ratios (September 1929 and January 1966), corporate bonds actually outperformed the S&P 500. Likewise, he notes that the same was true in the 30-year periods leading up to 2010 and 2011. So, he concludes that we have no reason to believe currently inflated P/E ratios are justified, and in turn have no reason to think that the stock market has recently become any more efficient than it was historically.

Real-World Applications of Behavioral Economics

Though Thaler’s work may seem to be of primarily theoretical interest, he also clarifies that behavioral economics has important practical implications in everyday life. In this section, we’ll examine how behavioral economics can help influence consumers for good by discussing specific “nudges” that Thaler and other behavioral economists have used to effect change in society.

How “Nudging” Can Improve Consumers’ Decisions

Thaler explains that in his book Nudge, coauthored with Harvard Law professor Cass Sunstein, he argued that insights from behavioral economics can help us “nudge” consumers toward better choices, as measured by their preferences. In other words, behavioral economics can teach us how to help consumers make decisions that they want to make, but struggle to. In this section, we’ll examine two such “nudges” that have been implemented in the real world: Thaler’s Save More Tomorrow plan and his reformulated letters to delinquent taxpayers in the UK.

Nudge #1: The Save More Tomorrow Plan

Thaler’s first nudge addressed a widespread problem in the US in the mid-1990s: Consumers were saving less for retirement than they wished to, by their own reports. The normal individual retirement accounts (IRAs), Thaler explains, had several problems. First, they required employees to fill out byzantine forms, selecting their interest rate and stock-to-bond allocations to opt into these retirement accounts. Second, they forced employees to see their retirement money taken out of their paycheck. And finally, they required employees to dedicate money to their retirement funds in the present, when humans have the weakest self-control, rather than deciding to add more to their retirement funds in the distant future.

(Shortform note: Perhaps as a result of these IRAs in the 1990s and 2000s, personal savings rates in the US reached a low of around 1% of disposable income in July 2005. And although these rates rose consistently in the 2010s, averaging around 9% of disposable income, data suggest that as of 2023, Americans are saving below 4% of their disposable income. Thus, because experts generally recommend saving 10-15% of disposable income, it seems that Americans are again saving too little for retirement.)

Consequently, Thaler developed the Save More Tomorrow plan to address these three problems. Rather than requiring employees to fill out elaborate forms, Save More Tomorrow included an automatic enrollment. Rather than forcing employees to see the money leave their paycheck, Save More Tomorrow allowed them to increase their retirement rates after receiving a raise, making it feel like they weren’t losing money. And rather than requiring employees to change their retirement rates now, the plan allowed them to automatically increase their rates in the future. Though it took time for Save More Tomorrow to catch on, Thaler reports that by 2011, 51% of employers offered some variation of it, and by 2013, it was estimated to help US employees save an additional $7.6 billion annually.

(Shortform note: According to some experts, automatic enrollment plans such as Save More Tomorrow have yielded mixed results for low-income employees in particular. For example, one researcher found that while automatic enrollment plans increase lower-income employees’ savings, it also causes them to incur more debt to cover expenses in the meantime. Consequently, it’s possible that automatic enrollment plans actually cause these employees to oversave, as they might be better off relying on Social Security benefits for retirement.)

Nudge #2: Letters to Delinquent Taxpayers

Thaler’s second nudge occurred in the UK, as the British government reached out to a team of behavioral scientists asking for assistance drafting letters to delinquent taxpayers. Thaler’s goal was to draft a letter that was more effective at soliciting payments from delinquent taxpayers, thus saving the British government the expense of using a collection agency. So, along with his fellow behavioral scientists, Thaler used a key insight from behavioral economics: If you’re trying to increase individuals’ compliance with a rule, the best strategy is reminding them that most other people comply with the rule.

(Shortform note: The insight that people are more likely to comply with a rule if they know others comply with it stems from a 2008 experiment, in which researchers tested the effectiveness of different messages to get guests to reuse their towels in hotel bathrooms. These researchers found that the most effective message simply informed guests that the vast majority (about 75%) of other guests who had stayed in the same room had reused their towels. By contrast, messages that exhorted guests to reuse their towels because of the environmental benefits alone were significantly less effective.)

Through several experiments, the team discovered that the most effective letters relayed two facts to delinquent taxpayers: The vast majority of British citizens pay their taxes on time, and you haven’t paid yours on time. As Thaler relates, in the three weeks after this reformulated letter was sent to taxpayers, it increased tax revenue for the British government by around ￡9 million (around $14.3 million using the average exchange rate for 2012, when the letter was first introduced).

(Shortform note: According to experts, Thaler’s straightforward letter is representative of a broader movement toward using simplified language in tax forms. In so doing, tax officials believe that the crucial aspects of tax forms—in this case, that delinquent taxpayers need to pay their taxes—will be made clearer and thus more understandable for taxpayers.)