Book of the Week: Misbehaving
26 Sep 2015
I’m reading Misbehaving: The Making of Behavioral Economics this week, because Thaler is a buddy of Robert Schiller, the author of Irrational Exuberance. The book is a chronological journal of Thaler’s adventures in behavioral economics. The book doesn’t linger too long on a subject. It feels like you’re taking a nice stroll with a friend. Supposedly Irrelevant Factors Thaler abbreviates supposedly irrelevant factors as SIFs throughout the book. Traditional economist based their work on the assumption that there is type of person who behaves completely rational,homo economicus. They call this person an Econ for short. SIFs are things that are not supposed to affect decisions an Econ would make. This book is about all of those SIFs and how they do affect how real people make decisions. Real people don’t behave like Econs. The Endowment Effect People value things they already have more than things they could have. This leads to irrational decisions. AcquisitionUtility vs TransactionUtility Acquisition utility is the traditional utility gained minus the opportunity cost. Transactional utility is the perceived quality of the deal, which is is different between price paid and a reference price. It something looks like it is on sale, it will provide utility in addition to the acquisition utility. This leads to people buying stuff they don’t need, because it is on sale. Sunk Cost Money you already spent shouldn’t affect your future decisions. Your gym membership and Amazon Prime membership are sunk costs. They should not factor into whether or not you should go to the gym or buy stuff from Amazon. House Money Effect
The house money effect—along with a tendency to extrapolate recent returns into the future—facilities financial bubbles.
The house money effect is when people who are already up take more risks. If they have recent gains, they don’t treat it as money in their pocket. They treat it as the house money and are willing to be more risk taking. A homo economicus would make a decision regardless of where the money came from. If people are down, they are less willing to take risks, unless it gives them a chance to breakeven. You should treat any gains as things in your bank account, not the house’s money that you won for free. Knowing Versus Doing
A huge company had spent hundreds of millions of dollars on a promotion and did not bother to figure out how and why it worked. Michael Cobb at tiny Greek Peak was thinking more analytically than the industrial behemoth General Motors.
General Motors was able to sell excess inventory by offering cheaper loans rather than rebates. It actually cost them less to do the loans. People act without doing the math. These are cases when people don’t act as homo economicus. Thaler found that early NFL draft picks were overvalued, because
- People are overconfident
- People make forecasts that are too extreme
- The winner’s curse
- The false consensus
- Present bias
He talked with the Washington Redskins about how early draft picks are overvalued, but on draft day, they did the exact opposite of what the data says. The traded up for RG3, sacrificing future draft picks. RG3 is not even a the starting quarterback now. Stars are overvalued.
Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally. - John Maynard Keynes
If you do what everyone is doing and fail, then it’s alright. If you try to do something different, something that may actually be more promising, and fail, then you are ostracized. Even if you know what the data shows and what you’re supposed to do, it takes courage to do it. Those who don’t have the courage, don’t do as well. Narrow Framing
Narrow framing prevents the CEO from getting the twenty-three projects he would like, and instead getting only three. When broadly considering the twenty-three projects as a portfolio, it is clear that the firm would find the collection of investments highly attractive, but when narrowly considering them one at a time, managers will be reluctant to bear the risks.
Because individual managers are risk adverse, the company as a whole suffers, because no one is willing to take the risk and fail. Individual risks may be high, but taken as a whole, the risks can be managed. The CEO needs to make the environment on where failure is not punished. Resources