Summary/notes on the Misbehaving by Richard Thaler Econs: the perfect economic agent, unlike humans that misbehave Econs chose by optimizing, they are unbiased, they are not overconfident. Adams Smith - The wealth of nations, fathre of modern economic thinking We need to pay attention to "Supposedly irrelevant factors" (SIF) instead of assuming that people acts as Econs. 2 - The endowment effect We are more sensitive to "individual lives" (a young girl dying) than "statistical lives" (many people dying due to lack of clean water or so). Shelling thought experiment: a medical procedure with small benefit but extreme pain, and a drug that erase all memory of the event. Do you take this procedure? *Endowment effect*: people value things that are already part of their endowment, more than things that could be part of it (that were available but not yet own). 3 - The list Econs ignore "*sunk costs*", that is money already spent. For Econs more choices is always good. The *hindsight bias*: after the fact, we think that we always knew the outcome was likely From the paper "Judgement uner uncertainty: heuristic and biases" (by Kahneman and Tversky): humans have limited brainpower so they use simple rule of thumbs, heuristics, to help them making judgement. An example is availibility (we look in our brain to see what's available and derive generalities out of it). Having a gun in your house increase the risk that a member will commit suicide. 4 - Value theory Two kind of theories: *normative* (tell you the right way to think about a problem) and *descriptive* (describe how people think and answer a problem) It is known since Bernouilli, that people have risk aversion, and an increase in wealth when you are poor result in more utility than a same increase if you are already rich (*diminishing marginal utility of wealth*). - *Expected utility theory* by John von Neumann: the right way to make decision (i.e. a normative theory) - *Prospect theory* (or *Value theory*) by Kahneman and Tversky: a good prediction of how people actually make decision. Change the focus it's "changes of wealth" that matters instead of "level of wealths". Changes are the way human experience life, what makes us happy or miserable. - People have diminishing sensitivity to gain and losses - This make them risk-averse for gains but risk seeking for losses - *Loss aversion*: Losses hurt more than gains. People like gains, but hate losses more (about twice as much). 6 - The Gaunlet *Marginal analyses*: a firm striving to maximize profits will set price and output at the point where marginal cost equals marginal revenue. The same applies to hiring workers. Keep hiring workers until the cost of the last worker equals the increase in revenue that the worker produce *Incentives*: if the stakes are raised, it's a great intensity for people to think harder To learn from experience you need: frequent practice and immediate feedback > we are likely to get things rights at small stakes because we usually have more practice there, and get things wrong with high stakes (buying a house), since it happens less to us Part II - How do people think about money? 7 - Bargains and rip-offs Economic decisions are made through the lens of *opportunity costs*: the cost of something (e.g. dinner) also depends on alternative uses of that time and money Two kind of utility: *acquisition utility* (surplus remaining: utility of the object - opportunity cost of what has to be given up) and *transaction utility* (price paid - price expected to be paid). Transaction utility: Paying a 7 dollar beer in a resort is expected, paying that price in a bodega is an outrage Negative transaction utility can prevent uss from buying special experiences that will provide a lifetime of happy memories (where the amount by which an item was overpriced will long be forgotten). Good deals (positive transaction utility) lure us into making purchases of objects of little value. Some shops keeps products (that we don't buy that often) always on sale. Getting a great deal is more fun than saing a bit on every items 8 - Sunk costs Sunk costs: money spent that cannot be retrieved Sunk cost fallacy: sticking to things you have bought Bad shoes: the more you paid the longer you'll wear them and the longer you'll keep them in your closet 10 - At the pokey table The *house money effect*: if you already have gained some money for free, you'll be more likely to take a gamble that otherwise you would not take (since you are risk averse for gains) People who are threatened with big losses and have a chance to break even will be unusually willing to take risks, even if they are normally quite risk adverse. Part III - self control 11 - Willpower? no problem *Discount of future consumption*: Consumption is worth more to you now than later. A great dinner this week or one year from now, we prefer it sooner. We discount hyperbolically and animals too. 12 - the planner and the doer Odysseus got advice from goddess Circe to be able to listen to mermaids: put wax in his crew ears, and get attached to the mast. Experiment of kids and Oreos. The amount of time a kid waited in this experiment is a good predictor on how they scored for there SAT test ten years after. 14 - what seems fair Should snow shovels increase in price after a snowstorm? 82% of people say it's unfair. Removing a discount is always better than adding a surcharge for the eyes of the consumer. In difficult times, companies avoid reducing salaries to avoid pushback from employers (they can freeze them ignoring inflation). In general, temporary spikes from demand (e.g. snowstorm) is a bad time for any business to appear greedy. It is badly seen by people. Note: Uber still does it 15 - fairness game People dislike unfair offers and are willing to take a financial hit to punish those who make them. In games where people have to split a price but one is doing an offer, usually 20% is about the lowest percentage you can offer to someone without him not rejecting it. Prisoner's dilemma. The theory says that both player will defect. Though in practice about 40-50% of the time people cooperate. But as the stakes increases (see chapter 30), people cooperate less and less. 16 - Mugs Endowment effect: people who are randomly assigned chocolare bars tend to value them more than those who don't (less trade happening) People tend to stick to what they have because of loss aversion. Buyers are willing to pay about hald of what sellers would demand: losses are twice as painful as gains are pleasurable Part V - Economics profession 17 - debate begins There is a long-standing notion that it is prudent to spend the income and leave the principal alone. We are nice who people that treat us nicely and mean to people who treat us badly. 20 - narrow framing *Narrow framing*: taking different decisions based on the hat I'm wearing. Inside view and outside view: inside view thinking of an issue when you are part of team (caught in some optimism). Outside view, you are more objective and compare to other projects. In order to get managers to be willing to take risks, it is necessary to create an environment in which they will be rewarded for decisions that were value-maximizing at the time of the decision *equity premiums*: difference in returns between equities (stocks) and some risk-free asset such a short-term government bond. Since stocks are risky, investors will demand a premium over a risk-free asset in order to be induced to bear the risk. Samuelson: if you don't like one bet, you shouldn't take many. But is it true? Why do people hold so many bonds if they expect the return on stocks to be 6% per year higher. They take too short term view of the investments. Over 20 or 30 years, the changes for stocks doing worse than bond is small. The more often people look at your portfolio, the less willing you'll be to take on risk, because if you look more often you see more losses. Equitity premiums are so high because people look at their portfolio too often. Investment advice: diversify, use a lot of stocks, especially if they are young, and avoid reading anything in the newspaper. The higher the wage on that day, the less taxi drivers worked. Part VI - Finance 21 - beauty contest If prices are right, there can never be bubbles *no free lunch* principle: there is no way to beat the market. All publicly available information is reflected in current stock prices, it is impossible to reliable predict future prices and make a profit. Professional money managers perform no better than simple market averages. 22 - stock market overreact? *Groucho Marx theorem* : I would never want to belong to any club that would have me as a member. No rational agent will want to buy a stock that some other rational agent is willing to sell With overconfidence, you can explain why high trading volumes arise. *Value investing*: find securities that are priced below their intrinsic long-run value When is a stock cheap? You can look at the price/earnings ratio (P/E). A high PE ratio forecast that earnings will grow quickly to justify the current high price. You want stocks with low PE ratio since likely the price will stay the same of rise. Some kind of regression towards the mean is likely to happen. Cheap stocks are unpopular and out of favor while expensive stocks are fashionable. Sometimes buying cheap stocks you can beat the market. 23 - reaction to overreaction To this day there is no evidence that a portfolio of small firms or value firms is riskier than a portfolio of large growth stocks 25 - Closed-end funds Buying funds with the biggest discounts earned superior returns PART VII 29 - football - People are overconfident - People make forecasts that are too extreme - Winner's curse: the best is usually over estimated - The false consensus effect: people tend to think that other people share their preferences - Present bias: everyone wants to win now *Peter Principle*: People keeps getting promoted until they reach their level of incompetence. As the importance of a decision grows, the tendency to rely on quantitative analyses done by others tends to shrink, people follow their gut instinct. 30 - Game show Big winners and big losers become more risk-seeking People are more risk averse in front of a crowd. 31 - save more tomorrow Present biased: we want everything now. Fly in the urinal: reduce spillage by 80% Book: Robert Cialdini, Influence If you want to encourage someone to do something, make it easy Rewards: It is more effective to reward based on inputs (e.g. doing your homework) rather than outputs (e.g. grades). Nudging parents, by sending them text messages 3 days before children test increased test performances