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Book review: 'Misbehaving' by Richard Thaler

A revolution in economics

‘I began to have deviant thoughts about economic theory while I was a graduate student.’ So begins Richard Thaler’s account of the history of behavioural economics, a discipline he in large part founded. You can judge the tone of the book from this one sentence: Thaler has a good sense of humour, and a keen eye for the absurd.

Short of something by Michael Lewis, this is one of the most accessible books on economics or finance you can find. Well-chosen anecdotes and examples help to bring otherwise dry subjects to life, perhaps particularly important for a book that touches on so many different areas of economics.

The history of behavioural economics

The book itself largely proceeds chronologically. As Thaler himself acknowledges, he was lucky to bump into two Israeli psychologists at the start of his career, Daniel Kahneman and Amos Tversky, whose work on prospect theory, or describing the way people choose between probabilistic alternatives, was important to jump-starting behavioural economics. You may be familiar with Daniel Kahneman from the bestseller ‘Thinking Fast and Slow’ and of Tversky and Kahneman’s partnership, it being the subject of a good book by Michael Lewis – ‘The Undoing Project’.

The first part of Misbehaving largely deals with the aspects of behavioural economics that people may already be familiar with. The reader encounters common human fallibilities like placing a higher value on something you already own or obsessing over sunk costs. These might be minor inconveniences to you or me, preventing us from living out a truly rational (happier!?) life, but when Thaler set out to incorporate them into economic thinking forty years ago, his ideas were treated as an existential threat to the discipline.

To understand the reaction to Thaler’s mission in Misbehaving, you need to appreciate the two founding tenets of economics, those of optimisation and equilibrium. Optimisation is the idea that people choose the range of goods best suited to them, whereas equilibrium is the idea that prices fluctuate so that supply equals demand in competitive markets. While you can theoretically model human behaviour under these assumptions, you fall prey to a host of problems. The most germane of these for Misbehaving is what Thaler calls ‘supposedly irrelevant factors (SIFs), all the things that influence our decision making, even if they are not apparently relevant in the rational theory of economics.

It’s clear that it was difficult for economists to incorporate SIFs and behavioural quirks into their models when Thaler started out in academia. At one early conference, an unusually candid questioner asked Thaler what he was supposed to do if behavioural economics was right: Thaler’s conclusions would put him, along with many other economists, out of a job.

Nevertheless, Thaler persevered with his approach. Perhaps the fiercest opposition to behavioural economics came from financial economists, those concerned with theories of how financial markets work and often perceived as the most ardent defenders of rationality in economics. Paradoxically though, financial economics has perhaps been the area where a behavioural approach has won the most enthusiasts. After all, financial economists can clearly observe behavioural errors in markets, and there are clear rewards for capitalising on these errors.

From outsider to establishment

While the early part of Misbehaving presents behavioural economics as something of a rebellion, we see the discipline becoming more established by the end of the book. As Thaler himself notes, by the time the book was published in the US, he was in the midst of a one year term as the president of the American Economic Association and one of his close conspirators, Robert Shiller, would be his successor. In his own words, ‘the lunatics are (now) running the asylum!’ Shiller is perhaps most famous for challenging the efficient market hypothesis, one of the most important doctrines for those who believe in rational human behaviour model of economics.

The influence of behavioural economics is not just limited to the US. After reading one of Thaler’s earlier books, Nudge, David Cameron invited him to form the Behavioural Insights Team in Whitehall, tasking Thaler with the job of improving the effectiveness of government policy and its actions. One of the simpler experiments was to change the wording in reminder letters for overdue taxes, which increased the number of taxpayers making payments within 23 days by 5%. While this might not sound significant, it likely resulted in a large saving in terms of letters sent and postage paid.

Thaler is not precious about his field. He acknowledges in Misbehaving that much of the work of groups like the Behavioural Insights Team owes as much to insights from other fields such as psychology. While behavioural economics has made a significant contribution to areas like financial economics, there has been relatively little impact on macroeconomics, or the study of how economies behave. If a government wants to cut taxes to cushion the impact of a recession, for example, how should it present it to make sure people spend the money?

As well as chronicling the rise of behavioural economics, Misbehaving offers a good introduction to many concepts in economics. You won’t emerge as an expert on competition law or supply and demand balances, but you will gain some insight into the theories of value, closed end funds, and the factors that drive markets.

Is there a future for a behavioural approach?

Misbehaving does not read like one of the many books that have poured scorn on economists since the financial crisis. Thaler clearly loves the discipline, is indisputably passionate about what he chose to study, and wants to remedy its shortcomings rather than knock economists off their perch. He pays tribute to recent work by economists who wouldn’t identify themselves as ‘behavioural economists’, but who do take into account human behaviour. You wouldn’t expect a book on economics to have its poignant moments, but Thaler’s hope at the end of the book delivers one, with the aspiration that his behavioural economics, his life’s work, fades away as a separate discipline, ‘leaving economics as behavioural as it needs to be.’

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