When Richard Thaler, today a distinguished professor in behavioral science and economics at the University of Chicago, was still in college and heard that renowned psychologists Daniel Kahneman and Amos Tversky would be at Stanford for a year, he made his way out there to “stalk them,” he told a Morningstar ETF conference luncheon crowd. “We became good friends,” he said, and today he and Kahneman are still best friends.
Thaler is widely known as the “father of behavioral finance” and was instrumental in Michael Lewis’ writing of “The Undoing Project,” which is about Kahneman and Tversky’s psychological impact on the world. After reading Lewis’ book “Moneyball,” Thaler and friend and legal scholar Cass Sunstein wrote a review of it in the New Republic, stating the method Lewis described was founded by Kahneman and Tversky. The rest is history, as Lewis then met with the two psychologists and wrote the book.
But Thaler believes the two’s impact on his own studies, and his move to behavioral economics, helped give the area rebirth. He pointed out that behavioral economics isn’t new and was followed by Adam Smith and John Maynard Keynes, until the “period of the great ‘mathemazation'” came in with economists like Paul Samuelson. But he believes theoretical economics is flawed.
“If you’re going to write down mathematical models, the easiest ones to write are that people are rational … but people are doing something more complicated than that,” he said.
For example, history has shown people are more apt to purchase stocks with more memorable ticker symbols than those with random symbols or names, even though the later may perform better. Another example is when deciding which credit card balance to pay, people typically will opt to pay more on the one with the higher balance, as opposed to the one with the higher APR.
“Behavioral economics is messy,” he said. “Traditional economics is precisely wrong.”
Thaler said that an “econ” — someone like an emotionless Mr. Spock from the TV show "Star Trek" — will solve every problem with a spreadsheet. “But real people are rarely deciding anything,” he said. “We spend our lives doing, and sometimes we have to decide. Also, econs have no self-control problems. They choose the best thing for them all the time … now there may be people like that, but I don’t know any.”
“The main point is we are not econs, [but] we have [economic theories] based on fictional characters like Mr. Spock,” he said. “Economics is supposed to be about reality, it’s not a theory of experts.”
He added that he’s not against conventional economic theory, stating that “EMH [efficient market hypothesis], like many economic theories, is an idealized view of the world. In a world of econs, EMH is true. It’s a useful theory to know but not what real markets do. I would teach it to say this is a normative model, or how the world should be, and then go into what actually happens.”
Speaking of today’s markets, he admitted to being very “worried.” He has something he calls the exuberance delta, “and it is at a record high right now.” He added his colleague Robert Shiller, a Nobel Prize winner, also is worried, especially with the combination of high prices and infinitesimal volatility. “But you guys keep buying,” said Thaler, who had a cameo in the movie “The Big Short,” where he explained synthetic collateralized debt obligations.
When asked where he saw the next bubble, he said, “we should have learned our lesson about the dangers of debt and leverage. I would say where we see a lot of leverage is where I would be most worried.”
--- Check out Michael Lewis’ Portrait of Two Men Who Changed the World on ThinkAdvisor.