Richard Thaler, the father of behavioral economics, has been awarded the 2017 Nobel Memorial Prize in Economic Sciences, it was announced Oct. 9, 2017.
He is currently a professor at the Chicago Booth School of Business and president of the American Economic Association. His career highlights also include co-directing, with Robert Shiller the Behavioral Economics Project at the National Bureau of Economic Research (NBER). Prior to teaching at the University of Chicago, he taught at Cornell University and the University of Rochester.
As a founding economist in the behavioral finance field, he is the author of Nudge (2008) and Misbehaving: The Making of Behavioral Economics (2015), which largely counters the belief of the efficient market hypothesis (EMH), heralded by economists of the neoclassical tradition. He argues that instead of individuals acting in rational and efficient form, there exist deviations where human agents act with fallibility. (For more, see: Behavioral Finance: Introduction.)
Background and History
Richard Thaler grew up in New Jersey and attended Case Western Reserve University for his bachelor’s degree. He later received his masters and Ph.D. at the University of Rochester.
Inspired by papers written by Amos Tversky and Daniel Kahneman in the 1970’s, Thaler was drawn to the emerging field of behavioral finance. He was immediately taken by their finding that claimed people make predictable mistakes in their decision-making. This further propelled his interest in the field.
The area of behavioral finance had only begun to emerge in the mid-80s. Behavioral finance argued there was a descriptive model of rationality. Instead of considering investors acting in a cold, irrational way, Thaler argues that investors act under the influence of behavioral biases often leading to decidedly less than optimal decisions. (For more, see: Understanding Investor Behavior.)
At first, Richard Thaler’s research was viewed with skepticism by his academic peers. In a talk at the London School of Economics, he said the first twenty years of his career were spent primarily facing criticism. Many thought that his research was insignificant. Recalling how Milton Friedman described his work by saying, “We shouldn’t judge a theory by the realism of the assumptions, we should judge it by the validity of its predictions.”
A number of central ideas emerged early in his career that resisted assumptions in economics. For example, he wrote on “the endowment effect” to explain how individuals place a higher value on something they own than if the identical item was someone else's. There has also been evidence of this effect in the brain, as demonstrated by the studies by Brian Knutson of Stanford University. This phenomenon challenges the rational economic view. Moreover, this departure can be explained by our acute aversion to loss.
Thaler also discusses the “confirmation bias,” where individuals will often seek information that supports and affirms their pre-existing beliefs and the “hindsight bias,” where people tend to believe they had predicted an event before it had happened.
Perhaps most strikingly, Thaler’s research on prospect theory offered a new way of understanding how individuals react to the financial markets. Here, he takes a closer look at human decision-making. (For more, see: Behavioral Finance: Key Concepts - Prospect Theory.) Essentially, he shows how individuals make decisions based on framing, or the context that the decisions are placed within. Thaler argues that prospect theory is perhaps one of the most important tools for behavioral economists. One part of prospect theory is loss aversion, where the pain of loss is almost twice as powerful as an equal amount experienced from gains. (For more, see: How does behavioral economics treat risk aversion?) In one example, Thaler looks at the equity risk premium puzzle. When you look at the daily movement of the S&P 500 from 1950-2014, you see losses 46% throughout this time and see 54% gains during this time.
This presents a quandary is for investors who check their portfolios on a daily basis. Thaler’s research showed that the investors who monitor their portfolios less frequently experience significantly less loss or pain. If investors were to check their portfolio on a monthly basis, as opposed to a daily basis from 1927-2014, they would experience 38% less loss. If investors were to check on an extremely disciplined annual basis, this visible loss would drop to 27% of the time. Premised on diminishing feelings of loss to prevent poor decision-making, Thaler’s research is aimed to help individuals make more productive decisions when it applies to their portfolios.
When it comes to retirement savings, Thaler has also conducted research that uses behavioral economics and psychology. Recognizing that the savings rate in the U.S. is declining, through the shift in many employers offering defined contribution plans instead of defined benefit plans, they acknowledged that the middle class will have to bear more weight in planning for retirement. "As we've switched over from defined benefit plans to defined contribution plans, we've turned over responsibility for enrollment and contribution decisions to individuals, many of whom don't have expertise in this area," says Thaler. Thaler and Shlomo Benartzi, co-chair of the Behavioral Decision-Making Group at UCLA Anderson School of Management, created a plan that allows employees to increase their contribution amount as their wages increase over time. In the program’s first implementation, the average savings rate of the participants tripled over 28 months, from 3.5 percent to 11.6 percent.
The Bottom Line
Richard Thaler's work in the behavioral finance field seeks to unpack and explain how individuals can improve their decision making with regards to asset allocation, viewing the financial markets, looking at opportunities for investment, and retirement savings plans. His research seeks to understand the errors entrenched in individuals, and applies a model that reflects the way individuals act on an empirical basis.