Why Traditional Economics Is Precisely Wrong

Richard Thaler received the Nobel Memorial Prize in Economic Sciences on Oct. 9 for his pioneering work in behavioral economics. The month before he won, Thaler sat down with Barry Ritholtz at the Morningstar ETF Conference in Chicago for a conversation ranging from Thaler’s mentors to his movie career. Their talk provided a tour of the field, garnering laughs while touching on key issues for investors today.

Thaler teaches at the University of Chicago Booth School of Business, where he is the Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics.

His books include The Winner’s Curse: Paradoxes and Anomalies of Economic Life; Nudge: Improving Decisions About Health, Wealth, and Happiness (co-written by Cass Sunstein); and most recently Misbehaving: The Making of Behavioral Economics. Thaler also is a principal at Fuller & Thaler, an asset-management firm with $8 billion in assets.

Ritholtz is the chief investment officer of Ritholtz Wealth Management. He also is a columnist with Bloomberg View and hosts the Masters in Business podcast. His conversation with Thaler took place Sept. 7 and has been edited for clarity and length.

Barry Ritholtz: Let’s start with an idea of yours from one of your more recent books that I found fascinating. It’s what you call “econs versus people.” Conventional economics assumes that people are highly rational and unemotional. They can calculate like a computer and have no self-control problems. That leads to two obvious questions. The first is how does this manifest itself in everyday economic choices?

Richard Thaler: Well, the main point is that we're not econs. We have a theory based on fictional characters. Think of Spock in the old Star Trek series. He's an econ.

Ritholtz: Or at least tries to be.

Thaler: Pretty much succeeds.

Ritholtz: Pon farr?(1) If you really want to get wonky….

Thaler: No, no, no, I don't want to go there. But he's close—closer than you or me—versus, say, Homer Simpson. If you were building a model of economic agents, what would be better—a model of Spock or a model of Homer Simpson?

Ritholtz: Certainly, Spock would be desirable, but Homer Simpson is the reality.

Thaler: Yes. So, economics is supposed to be about reality. Economics is not a theory of experts. That's a mistake that lots of people make—that it's built as if everyone knew as much about a subject as the economists studying it.

Ritholtz: So, the second question: How is a social science, such as economics, built on such a fundamentally flawed assumption?

Thaler: It didn't used to be. I would say economics through World War II was behavioral economics. Starting with Adam Smith—especially The Theory of Moral Sentiments, the book before The Wealth of Nations—through Keynes, economics was behavioral.

Then, there was a period of the great mathematization of economics that started with people like Paul Samuelson. If you’re going to write down mathematical models, the easiest models to write are the ones where people are rational, because you just write max and solve, and if you can take a derivative and set it equal to zero, then you’re an economic theorist.

If people are doing something more complicated than that, like buying a stock or a fund because of its ticker symbol, good luck writing that down in a mathematical model.

Ritholtz: Yet the history shows that more memorable ticker names outperform random letters and random names.

Thaler: Right. So, behavioral economics is messy. Traditional economics is precisely wrong.

Nobel Mentors Ritholtz: Let's talk a little bit about your career in academia. You have had a number of mentors who all turned out to be Nobel laureates. How did that happen?

Thaler: Good taste in friends?

Ritholtz: But you don't always get to choose who your advisor is going to be or the person who is reviewing your doctoral thesis.

Thaler: No, but the people closest to me, Daniel Kahneman and Amos Tversky,(2) I stalked them.

Ritholtz: Really?

Thaler: They were at Hebrew University and were scheduled to spend a year at Stanford. This was 1977. I claim my greatest scientific discovery is discovering them.

Ritholtz: Were you at Stanford?

Thaler: No, I was then at the University of Rochester,(3) but I made it my business to be at Stanford that year.

Ritholtz: Stalking them?

Thaler: Stalking them. We got to be friends and spent the year together, and Danny Kahneman is still my best friend.

Ritholtz: So, how does an econ think about a problem differently than a regular person?

Thaler: An econ will basically solve every problem with a spreadsheet. And real people are rarely deciding anything. We spend our lives doing. Every once in a while, there's a moment where we have to decide something, but then we go back to doing. Econs are deciding all the time. They never go into this autopilot phase. Most of us are on autopilot all the time. The other thing—the key thing—is that econs don't have self-control problems.

Ritholtz: No self-control problems?

Thaler: No, because they choose the best thing for them all the time. They eat just the right amount of food, they drink just the right amount of alcohol, and they go to sleep at the right time, they wake up at the right time, they never hit that snooze button because they set the alarm for the time they wanted to get up and then they get up. Right? Now, I think there are people like that, but I haven't met any. They're not the people I know.

Anomalies Ritholtz: Let’s talk about the people you know and how they tend to come out in your “anomalies” that you publish on a regular basis. How did that come about— that you started publishing a column, going back a few decades, on things that simply don’t make any sense according to traditional economic theory?

Thaler: There was a new journal that the American Economic Association started called The Journal of Economic Perspectives.

As a past president of the American Economic Association, I’ll take an ad out for that journal. It’s free to anybody. You just go on the American Economic Association website. The articles are written for a nonspecialist—most of them would be accessible to almost everybody in this room.

In the late 1980s, when that journal was starting, I was having dinner with Hal Varian, who’s now…

Ritholtz: …the chief economist at Google.

Thaler: Right, an old friend of mine. This was before he was rich. He was telling me about this journal, and we cooked up the idea at dinner of having a series on anomalies. The first editor was Joe Stiglitz.(4) Joe likes making trouble, which is what this column was going to do, and so he said, "Great idea!" I did that once a quarter for four years and then sporadically after that.

Ritholtz: Some of the things that have come up under the idea of anomalies are really fascinating. We were discussing the other day the issue with health insurance deductibles. What is the problem with how people deal with their own deductibles?

Thaler: There are some recent papers on this. Our best guess is a third of the people who buy health insurance from their employer have a plan that is dominated by another plan offered by that employer. By dominated, I mean regardless of how much healthcare you consume, you'll spend less with the other plan. Typically, that other plan will have a higher deductible.

Ritholtz: Why do people automatically [turn] away from the high deductible?

Thaler: They don't like deductibles. Now, I've discovered that this anomaly existed at my employer only because one of my smart young colleagues explained it to me. So, I've been experimenting this year with a high-deductible plan. It comes with the option of a health savings account…

Ritholtz: …thereby making it a little less high right off the bat.

Thaler: Well, they contribute $1,000, but I put in the max. It's a no-brainer. Everyone in this room should have a high-deductible health insurance plan and max out their HSA.

Ritholtz: Assuming there’s a health savings account and that the monthly cost [of the high-deductible plan] adds up to less than the [other plan’s] low deductible with the higher monthly cost.

Thaler: You won't be guaranteed to pay less every year, but you'll certainly pay less over time. And HSAs, unlike those dreadful flexible spending accounts, are easy to use and are not use-it-or-lose-it.

Ritholtz: Why are we so irrational with numbers? Why do we look at that lower deductible and not think about what the match is on the HSA, what the total annual premiums are? Why do we just see one big number, and it throws us completely off?

Thaler: A lot of this is inertia. At the University of Chicago, the high-deductible plan is new, around three years old. And the default during open enrollment period is, if you don't log on, you get the same healthcare plan [you had] last year, which is better than no healthcare plan. But there's an amusing thing, which is the high-deductible plan is called the "savings plan," and it has a much lower premium. So, my colleagues in the business school look at that and say, "You know, I'm an affluent guy. I don't need the savings plan. I want the good plan. The good plan just costs more, right?" What we have here is two Starbucks. One is 20% off. And they're saying, "No, I want the expensive one." It's the same coffee, right? These are the same networks, the same everything, except do you want to pay more?

Ritholtz: Now, I’d be curious to see if that takes place at other schools, because at Chicago, price contains information.

Thaler: Well, I have a class I'm teaching this year called Choice Architecture in Practice. In fact, we had Morningstar as a client when we did it last year. My students are going to take on this problem. Part of the problem is figuring this all out is really complicated.

Ritholtz: For the average person as well as an economist?

Thaler: Right. Look, here's a trivial thing. Deductibles are quoted in annual dollars. Premiums are quoted monthly, because we get paid monthly.

Ritholtz: Is it that hard to multiply it by 12?

Thaler: Apparently.

Michael Lewis Ritholtz: Let’s talk a little bit about baseball. Michael Lewis publishes Moneyball, and it really is about a different way to look at statistics. You and Cass Sunstein write a review of the book essentially saying, “By the way, this is all based on the work of Danny Kahneman and Amos Tversky, and Mike, you should check this out.”(5) You don’t exactly say it in the review, but it’s pretty clear—hey, you missed what this book is actually about.

Thaler: I'll tell you a quick story that tells you about Cass Sunstein. Friday afternoon, we're having lunch, which we did regularly, and we wander into the Seminary Bookstore, which was down at the university next to where we would have lunch. I said, "Cass, I read a book this week that was great." I showed him Moneyball. He starts looking at it. "Oh, this is great. This is great," he says. "Oh, we should review this." Now, he hasn't read anything yet, right? I don't think that way— that if I read something, I should write about it. I was just getting to know Cass at the time. So, he buys the book. Monday, I get a six-page, single-spaced review. This is how we ended up writing the book. He would write a first draft and then I would painfully…

Ritholtz: …clean it up.

Thaler: Well, Thalerize it. So, I wrote it up, and I put in a lot more baseball. We [submit it to] The New Republic back in the good old days of The New Republic. And he says, "Oh, no, there's too much baseball. They won't take it." I said, "Look, leave it in. Let them take it out." So, we get it back from the editor, and the guy says this is great but more baseball! Then, Cass started taking me seriously.

But back to Michael. He and I got to know one another after that. That got him interested in behavioral economics and eventually led him to write his most recent book, about Kahneman and Tversky.

Ritholtz: The Undoing Project.

Thaler: I kept saying, "You're kidding, right? You're going to write a book about these two psychologists who just spend their time talking to one another?"

Ritholtz: And apparently laughing.

Thaler: And laughing. I'm one of the few people that actually saw them working together, because that year I was stalking them, I would wander up the hill. Danny's office was about 100 yards up the hill from me. And sometimes I'd wander in, and he and Amos would be working. So, I saw it in action. The way they wrote was to argue over every word.

Ritholtz: Every word?

Thaler: Every word—several times. I've written papers with each of them, and we more or less used the same method.

Ritholtz: You had a cameo in the movie version of Lewis’ book The Big Short.

Thaler: You finally got to my crowning achievement.

Ritholtz: First, are you and Selena Gomez still dating? I have to ask that question.

Thaler: No, you know, my granddaughter keeps me posted on Selena Gomez, and apparently she's dating somebody whose name is The Weeknd. That's all I know about it.

Ritholtz: What was the experience like doing The Big Short? That had to be a lot of fun.

Thaler: Well, it was fun. They called me on a Monday. They're filming the following Monday. We don't know how many people had said no at that point. They sent me the script, and I said, no, I can't do this. Because if you remember that scene [with Selena Gomez], it's at a blackjack table, and it's trying to explain the idea of a collateralized debt obligation. And I can tell you Selena Gomez is delightful but does not know what any of those three words mean.

Ritholtz: She would not have been a derivatives trader had the acting or singing thing not worked out?

Thaler: No. Amusingly enough, she didn't know the rules of blackjack. So, in the script, the first hand, she gets dealt 21, and she doesn't react. Afterwards I said, "No, Selena, this is good. You win." So, I should get partial directing credit. So, Friday at noon, I had said no, at which point the producers are all freaking out because they're paying Selena a lot of money—not me. In the end, Adam McKay, the writer-director, and I agreed that we would rewrite the script Sunday night. And then it turns out I'm not capable of memorizing lines, but he comes from an improv background.

Ritholtz: So, just wing it?

Thaler: Everything you heard me say in that movie is stuff I made up.

Bubbles and Busts Ritholtz: Let’s talk a little bit about EMH. You had previously said we don’t want to throw away the efficient market hypothesis. We just don’t want to believe it’s true. Explain that.

Thaler: The efficient market hypothesis, like many economic theories, is an idealized view of the world. In a world of econs, the efficient market hypothesis would be true. So, it's useful— just like the theory of the firm is the right formula for how to maximize profits. It's good to know that. It doesn't really explain what real firms do. The efficient market hypothesis doesn't explain what markets do. But I would certainly teach it. If somebody was foolish enough to have me teach a basic course in finance, I would teach them the efficient market hypothesis, and then I would say this is what I call a normative model— a model of the way the world should be. Then, I'd go into what actually happens—stuff like we were talking about before, weird things like ticker symbols mattering.

Ritholtz: You’re at essentially ground zero for EMH. Are you considered a heretic at University of Chicago? I think at this point they know you’re not going to burn the place down, but early on, there had to be some pushback to your critical work.

Thaler: Yeah, but it's changed a lot. I've been here 21 years. When I arrived, Merton Miller took behavioral finance personally.(6) He basically wouldn't speak to me. He wouldn't look at me. But he was the only one. Gene Fama's always been friendly.(7) If we could estimate the median opinion of the people in the finance group, the median would be closer to me than to Merton Miller or John Cochrane.

Ritholtz: Every time I open The Wall Street Journal, I see an article about how expensive stocks are. How do we deal with bubbles and busts? Is it something we just have to accept as inevitable, or are we ever going to get past the boom-bust cycle?

Thaler: No, I don't think we will. If you need something to make you even more scared than you are now, during the tech bubble, when I would speak to a conference like this—I probably did this at some Morningstar conference 20 years ago—I'd give people a list of five tech stocks and ask, "What do you think the intrinsic value of that portfolio is?" The average answer was "50 cents on the dollar." Then I'd ask, "What do you predict will happen over the next six months?" The average answer was "up 20%." Now, that's a bubble. Right? If people think stocks are priced at 2 times and are going to go up. My buddy Bob Shiller has been asking a version of that question for 25 years: Is the market fairly priced, and what's going to happen? I call it the exuberance delta, and the exuberance delta is at a record high.

Ritholtz: What about Shiller’s CAPE? It’s been saying the market is overvalued, but it’s been mostly saying the market’s overvalued since 1993.

Thaler: Yes. So, Bob is a pessimist.

Ritholtz: As opposed to Siegel.

Thaler: As opposed to Jeremy Siegel, who's an optimist. Bob is a worrier. That's constant. But he worries more at some times than others, and I would say he's more worried now. I think we all should be worried that the combination of the high prices and the infinitesimal volatility, given what we see in the news every day, is just a little hard to understand. You would think that we're in a risky period, wouldn't you?

Endnotes

1 Vulcan mating ritual. 2 Kahneman received the Nobel Memorial Prize in Economic Sciences in 2002, six years after Tversky died, for his and Tversky's work on prospect theory. Kahneman and Tversky's paper "Prospect Theory: An Analysis of Decision Under Risk" (Econometrica, Vol. 47, No. 2, pp. 263–291, March 1979) is often regarded as the groundbreaking work of behavioral economics. But Kahneman credits Thaler. In his Nobel biographical, he wrote, "[T]he founding text of behavioral economics was the first article in which Thaler (1980) presented a series of vignettes that challenged fundamental tenets of consumer theory." He is referring to Thaler's paper "Toward a Positive Theory of Consumer Choice" (Journal of Economic Behavior & Organization, Vol. 1, No. 1, pp. 36–90, March 1980). 3 Thaler received a master's degree in 1970 and a doctorate in 1974 from the University of Rochester. His dissertation was titled "The Value of Saving a Life: A Market Estimate."

4 Stiglitz won the Nobel Memorial Prize in Economic Sciences in 2001.

5 Thaler, R.H. & Sunstein, C.R. 2003. “Who’s on First,” The New Republic,” Sept. 3.

6 Merton Miller won the Nobel Memorial Prize in Economic Sciences in 1990. Wrote Cass Sunstein in his review of Thaler’s book Misbehaving: The Making of Behavioral Economics, “When [Thaler] was appointed at the University of Chicago, Nobel laureate Merton Miller, one of the university’s great figures, did not conceal his displeasure. Asked why he did not block the appointment, Merton could only respond, ‘Each generation has got to make its own mistakes.’” (Sunstein, C.R. 2015. “The Mischievous Science of Richard Thaler,” The New Rambler.)

7 Gene Fama won the Nobel economic prize in 2013 with Robert Shiller and Lars Peter Hansen. Says Thaler, “Gene and I know enough to mostly not talk about finance on the golf course. In academia, you learn to get along with people who have different beliefs. It’s just like getting along with somebody with a different religion. It’s possible.”

This article originally appeared in the December/January 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.