Richard Thaler is a professor at the University of Chicago’s Booth School of Business and the author of several books. He was recently awarded the 2017 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. I spoke with him about behavioral economics in September at the Morningstar ETF Conference.

—Charles Rotblut, CFA

Charles Rotblut: There are two words that I hear most associated with you: humans and econs. Can you explain what they are and how they differ, for those unfamiliar with the terminology?

Richard Thaler: Humans are the people we deal with every day.

Econs are the people that we read about in economics textbooks. They are really smart. They are as smart as the smartest economist, or possibly even as smart as the smartest economist thinks he is, which is really smart.

Econs also have no self-control problems. They always do exactly what they intend to do, when they intend to do it. They don’t procrastinate. They don’t have a problem with obesity. They save just the right amount for retirement. They’re perfect.

They’d be perfectly boring people, but these idealized creatures only appear in economics textbooks and academic journals. Econs don’t exist in the world. Behavioral economics has been an attempt to introduce humans to the economics literature.

You wrote a lot in your book, “Misbehaving: The Making of Behavioral Economics” (W.W. Norton & Company, 2015), about—for a lack of better word—“arguments” in the 1970s and 1980s between traditional economists and the proponents of the then-emerging field of what we describe now as behavioral economics.

Oh, there were plenty of arguments as the field was getting started.

One of the things you brought forward were “supposedly irrelevant factors” (SIFs). The SIFs, from what I understand, were a big thorn in the traditional economists’ side at the time.

That term is relatively new. It’s a term I coined in “Misbehaving.” You’re right though, I’ve been using them forever just without a name. To take a simple example, one of the things I talked about early in my career was the so-called sunk cost fallacy.

In economics, we teach that money you’ve already spent should not be a factor in future decisions. Say you bought tickets to a concert—a currently popular artist like The Weeknd. Then a friend of yours that you haven’t seen for years calls you from O’Hare Airport and says that her flight has been cancelled and she’s got one evening available in Chicago. If you stipulate that you’d rather see your friend, then the amount you paid for the tickets shouldn’t matter. To most people, the money spent on the tickets would matter. This is the kind of thinking that gets us to finish what’s on our plate even when we’re no longer hungry.

So a sunk cost is a good example of a supposedly irrelevant factor, because the theory says it’s irrelevant, but people treat it as relevant. To the extent that you can find which of the supposedly irrelevant factors are relevant, you can build economic models that have more explanatory power—in other words, models that describe the world better.

This seems to go back to the point you made earlier during the Morningstar ETF Conference about the traditional economic models treating people as always acting rationally, because the math was easier to calculate that way.

Yes. Think about writing down a model of rationality. We all know the formula for the circumference of a circle, right (2πr)?

Right.

If we tried to write down what you would guess is the circumference of the circle, we wouldn’t know where to start. The standard economic approach would be to start with that formula because we know that, and if estimates are unbiased then that formula will be pretty good.

This is where the work of psychologists Daniel Kahneman and Amos Tversky came in. They showed that when we make judgments, we make predictable errors, so a model based on people choosing optimally will also make predictable errors.

Well, that leads to a discussion of coffee mugs.

Doesn’t everything?

In your discussion in “Misbehaving” about testing for the endowment effect, I thought it was interesting that just by happenstance you chose coffee mugs. I say this because coffee mugs are now very much associated with the endowment effect. Even just doing an online search for “coffee mug experiment” finds references to the endowment effect.

In your study, you found a disparity in terms of what students who were given coffee mugs were willing to sell them for and what students who didn’t receive them were willing to pay for those mugs. The experiment seemed to show how both loss aversion and the endowment effect are examples of how economic theory can be flawed.

In the experiment you’re talking about, we went into a classroom and we gave every other person a coffee mug. Some owned a mug and some didn’t, and then we conducted a market for mugs.

Mug owners could say at what price they would sell. Mug non-owners could say at what price they would buy. Economic theory says half of the mugs should trade because the half of the people who like mugs the most should end up with them at the end. But we thought this prediction of the theory was incorrect and we were right.

What happened is the people who got mugs wanted to keep them, and the people who didn’t get mugs weren’t that interested in buying them. Selling prices were about twice as much as the buying prices, and that’s an indication of what we call loss aversion or the endowment effect. Once you own something, you don’t want to get rid of it, even though you would not buy it if you did not have it.

You can see this in everyday life. If you go to any kind of major sporting event, let’s say a Chicago Cubs World Series game—if lightning should strike twice in the same century—you’ll find people who have somehow come into tickets. They know somebody who knows somebody, and they have these tickets. The ticket holders know the tickets are selling for $3,000 on StubHub, but they’re not selling, and they would not be buying at those prices if they did not happen to luck out.

Economic theory says that at a given price you’re either a buyer or a seller. Either the game is worth $3,000 to you, in which case you should be willing to buy a ticket, or it isn’t, in which case you should be selling instead of going to the game. But that is not how people think.

There was something I saw on the web somewhere recently. There was a big Powerball jackpot a couple of weeks ago. [Editor’s note: The Powerball jackpot reached $758 million in late August 2017.] Somebody was interviewing people who had just purchased lottery tickets and then offering to buy the tickets back for twice the price. I don’t know what those tickets cost, but let’s say $2.00. So they would offer to buy them for $4.00. Nobody was selling.

The Relationship Between Coffee Mugs and Investing

An oft-cited study published by Daniel Kahneman, Jack Knetsch and Richard Thaler (“Experimental Tests of the Endowment Effect and the Coase Theorem,” The Journal of Political Economy, December 1990) found empirical evidence of the endowment effect. The endowment effect is the tendency of humans to demand much more to give up an object than they would be willing to pay for the very same object. Parting with an endowed item would result in feelings of loss.

One of the experiments used to prove the existence of the endowment effect involved coffee mugs. Half of the participants in the study were given coffee mugs and the other half of the participants were not. A market was then created for the participants to buy and sell the mugs. Actual trades were few in number, because those who were given the mugs (“sellers”) asked twice as much as those who did not receive the mugs (“buyers”) were willing to pay.

What the endowment effect shows is human’s bias toward placing a higher value on what they own over what they don’t own. Merely taking ownership of a stock, a bond, exchange-traded fund (ETF) or any other investment asset does not alter its economic value. The asset is only worth what the prevailing market price is. Yet, the endowment effect can cause us to be averse to selling the object by making us view the investment as being more valuable than it really is merely because we already own it.

—Charles Rotblut, CFA

I guess it’s a case where people weren’t considering their expected outcomes.

Well, they didn’t want to give up the tickets. The amusing thing is that I think most people who buy those tickets have the numbers picked at random. So, it’s not like these are their lucky numbers. If I bought a ticket for $2.00 and somebody offered me $4.00, I could take the $4.00 and buy two tickets. That would definitely double my chances of winning.

This would also seem to tie into loss aversion, and obviously the whole concept of feeling more pain from a loss than deriving pleasure from a gain. Is there an evolutionary aspect at work here, going back to maybe what our ancestors experienced?

Amos Tversky, one of my mentors, used to say as a joke that there once were species that didn’t exhibit loss aversion, but they’re now extinct. The idea was that if you are living at a subsistence level, then it’s rational to be loss averse. If I have this bone and that’s what I’m going to eat, I’m dead if I lose it.

These evolutionary arguments are very appealing, but they’re not testable without a time machine. The point is that we’re not at subsistence now. Nobody needs to go to a Cubs game.

But we still feel the same pain.

Yes. There’s no doubt that much of what we do is because we’re hard-wired. Nobody has to tell us to breathe.

Is that the same with people being risk-seeking when they think they could actually gain back a loss and get back to breakeven after losing?

It could be. Again, that could have some ancient explanation, but whether or not it does, it’s true now.

How much do you think this explains what people do with their brokerage accounts in terms of the decisions they make? Does it explain half of their decisions, most of their decisions or is it hard to quantify?

It is impossible to quantify, and modeling the choices of individual investors would be quite hard. Consider people who are trading on their own accounts and decide to invest in some company’s stock. How did they decide to pick that particular stock among the thousands available? Any model would have to start with some theory of attention. What was it that caught the investor’s eye?

One feature of many individual investors is that they tend to buy stocks in companies whose products they know and like. Apple has lots of individual investors because people love their iPhones.

We know that’s not a great way of investing. Many people loved their BlackBerry phones too. And people loved Kodak film. I do not think that most individual investors trading on their own account are “beating the market.” My guess is that they persist because they either don’t know how to compute their rate of return, or don’t want to find out how they did.

Daniel Kahneman once told me that he thought everybody should work with an adviser because the behavioral errors are just uncorrectable. Any thoughts on that?

Well, of course an adviser can be quite helpful, but as in any profession, there is variability in both the prices charged and the quality of the advice.

I think it’s certainly a reasonable question as to whether anybody should be buying and selling individual securities when we know most active mutual fund managers don’t beat their benchmarks, and they’re professionals. Given that, what are the chances for an amateur to succeed?

I don’t own a single stock. I own stocks, but they’re in mutual funds—either index funds or funds managed by my company.

What about the concept of nudging? You and Cass Sunstein wrote a separate book on the subject (“Nudge: Improving Decisions About Health, Wealth, and Happiness,” Yale University Press, 2008), but if somebody’s working for themselves and/or trying to invest by themselves, is there something they could do to try and nudge themselves to make good decisions or at least avoid some of the bad decisions?

The best thing is to keep track of how you are doing as a decision maker. For individual investors, the biggest problem is overconfidence. You read something on the web and you think it’s private information, or you hear Jim Cramer talking about some stock and you forget there are millions of other people listening to that information. If the information did have value, would it still have value by the time you acted?

So my advice is to keep track of all the investment decisions you make. Buy software that will allow you to see how your performance compares to some reasonable benchmark, because this is really hard to do by yourself. That’s my recommendation because we have bad memories, especially about our mistakes.

What about the concept of “Save More Tomorrow?” Many of our members may not be aware that you’re responsible for coming up with the idea of automatically escalating how much workers contribute to 401(k) plans at predetermined intervals (such as when a raise is given).

Any suggestions as to how somebody might be able to do this with their IRA? How can they commit to automatically increasing their savings rates if it’s not automated through their workplace plan?

I think the most important thing we can do is help people who don’t have a good retirement savings plan at work. The only way most people successfully save is through payroll deductions. That’s because the money gets taken out before you have a chance to spend it, and then it gets hidden over there in some account that’s labeled retirement.

One of the groups of people I worry about are those working in the gig economy: Uber drivers have no employer other than themselves. Ideally, you create your own retirement account and automatically contribute to it. Any bank can set up a system where you take money out periodically. There’s all these fintech (financial technology) companies. There are lots of people ready to help people doing that, but the individuals have to save. It would be good for them to implement their own versions of “Save More Tomorrow.”

Start by saving 3% of your income with a plan to make it 5% next year and 7% the next year. Gradually, as you start to make money, you’ll be able to save more and you’ll get yourself up to saving 10% to 15%, which is something closer to what you’re going to need if you want to have a comfortable retirement.

There’s an interesting chapter in “Misbehaving” about football. When you looked at the National Football League’s draft, you found teams not only overvaluing certain players but also exhibiting overconfidence. They also tend to believe other teams have the same opinions of and desire to pick the same players as they do. Could you talk about the research a little bit?

This is research I did with a former student of mine, Cade Massey, who now teaches at Wharton. We made two main findings.

One is that the picks at the top of the draft, especially the top half of the first round, are overvalued. It’s because teams think they’re really good at predicting who’s going to be the next superstar, and the evidence is that the teams are not so good at it.

The quarterback last year who had the most successful season, Dak Prescott, was picked by the Dallas Cowboys in the third or fourth round. He was the eighth quarterback selected in that draft. If you have the first pick and you traded for the fifth pick and the 10th pick, you have two chances to be right. So trading out of the top is the first lesson.

The second is that teams are impatient. You can essentially trade a second-round pick this year for a first-round pick next year.

So the really smart strategy is to trade for future picks and then trade those for more picks. If teams followed this strategy, they could double the number of early-round picks they have. Picks are like lottery tickets: The more you have, the better chance you have to win.

And so the second-round pick, or the third-round pick, is worth as much as the first-round pick?

To be clear, the players in the first round are, on average, better than those taken in the second round—but not by a huge amount—and the first round players get paid much more. We find that the second-round picks provide the biggest bang for the buck because they’re almost as good, but they cost one-fifth as much.

We were talking about Dak Prescott. If he turns out to be the quarterback he seemed to be last year, the Cowboys are going to have a huge advantage of having a high-performing quarterback that they’re paying almost nothing. That’s what the Patriots had for five years because they lucked into Tom Brady who was picked in the sixth round.

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