Misbehaving Book Summary

Standard economic theory assumes that people make rational decisions based only on relevant factors. However, behavioral economics recognizes that in the real world, many supposedly irrelevant factors (SIFs) heavily influence behavior. Examples include:

• Framing effects (e.g. 70/100 feels much worse than 96/137 even if the percentage is the same)
• Anchoring (being influenced by arbitrary reference points)
• Availability bias (judging frequency by how easily examples come to mind) SIFs make behavior deviate from what rational models predict. Identifying SIFs and how they impact decisions is a key aim of behavioral economics.

Section: 1, Chapter: 1

Early in his career, Richard Thaler started collecting examples of anomalies - human behaviors that deviated from the predictions of standard economic models. Some examples from his list:

• Paying more attention to sunk costs than rational models say we should
• Refusing to buy or sell items based on apparently irrelevant factors like recent ownership
• Failing to ignore past costs when making decisions
• Avoiding options to constrain our future behavior

At the time, these anomalies were seen as quirks or mistakes, not fundamentally important. But Thaler saw them as clues that the rational models were flawed and needed to be revised to incorporate human psychology.

Section: 1, Chapter: 3

In the late 1970s, Richard Thaler was a young professor trying to apply psychology to economics, but with a hard time getting others to take his ideas seriously. A few key moments:

• On a drive to Stanford, he pondered how to convince skeptical economists that psychological factors really do affect economic decisions
• He discovered the work of Kahneman and Tversky on heuristics, biases and prospect theory, which provided an academic foundation for his ideas
• At Stanford, he met Baruch Fischhoff, Paul Slovic and others studying human judgment, further expanding his knowledge of relevant psychology

However, the economic establishment still viewed behavioral approaches as quirky at best and misguided at worst.

Section: 1, Chapter: 5

One of the key early findings in behavioral economics was the endowment effect - our tendency to value things we own more highly than identical things we don't own. However, Thaler and colleagues ran into several challenges in trying to demonstrate the effect:

• Experimental subjects had to be making real choices with real money at stake, not just hypothetical survey responses, or else economists would dismiss the results
• The experiments had to rule out alternative explanations like transaction costs or implied information value
• Results had to be replicated across different item types and with high levels of statistical significance

In the end, carefully designed experiments involving things like trading mugs and pens provided convincing evidence. But the process illustrates the high burden of proof required to shift established economic wisdom, even in the face of compelling anomalies.

Section: 1, Chapter: 6

As Thaler and colleagues tried to publish early behavioral economics research, they encountered a predictable set of objections from economists, which Thaler dubbed the "Gauntlet":

Overcoming these objections required careful experimental designs and an accumulation of empirical evidence across many studies. But the gauntlet also revealed the reluctance of many economists to incorporate psychological realism into their models, even in the face of contrary evidence.

Section: 1, Chapter: 6

The sunk cost fallacy is our tendency to continue an endeavor once we've invested time, effort or money into it, even when continuing is no longer rational. An example from Thaler's personal life illustrates how mental accounting can exacerbate the effect.

Actively spending money makes the sunk cost highly vivid and painful if the purchase isn't then utilized. We feel the need to "get our money's worth." But this means we often throw good money (or time or effort) after bad, continuing down an unprofitable path.

Section: 1, Chapter: 8

People often use mental budgets or "buckets" to constrain their spending - e.g., $200/month on dining out. But this heuristic can lead to irrational behavior.

In one study, subjects were told they were going to a play. Half were told they had recently spent $50 going to a basketball game (same bucket), while half were told they got a $50 parking ticket (different bucket). Subjects were then asked if they would still buy a ticket to the play.

Those who had gone to the game were less likely to buy play tickets, presumably because they felt they had already spent their entertainment budget for the month. But this makes no sense - the historical spending is a sunk cost and should be irrelevant to the play decision. Yet because it was categorized in the same mental bucket, it still affected their choice.

Section: 2, Chapter: 9

When gamblers are ahead in a gambling session, they often take bigger risks than they would otherwise. It's as if they consider the winnings to be "the house's money," not their own, so they're more willing to risk it.

Conversely, when gamblers are in the hole, they tend to chase their losses with bigger bets, hoping to break even again. They become risk-seeking rather than risk-averse in the domain of losses.

Thaler observed both of these tendencies in his own regular poker games with friends. When players were ahead for the session, they played looser and more aggressively. When they were behind, they would often take big risks in hopes of getting back to even. The math of poker suggests neither approach is ideal - your overall wealth should determine your risk tolerance, not your results in one session. But these deep psychological tendencies are hard to overcome.

Section: 2, Chapter: 10

While modern economic theory assumes that people have perfect self-control, early economists like Adam Smith and Irving Fisher recognized the importance of willpower and the fact that people often struggle to resist short-term temptations.

Smith wrote extensively about "passion" and the need to overcome it through reason. Fisher described impatient behavior by low-income people, such as workers getting drunk after payday rather than saving.

It wasn't until the 1930s-50s that economists like Paul Samuelson, seeking to make economics more mathematically rigorous, introduced the idea that people discount the future at a constant rate and have perfect self-control. This assumption became standard in economic models, even though it contradicted many earlier thinkers' insights about the very real problem of limited willpower.

Section: 3, Chapter: 11

Economists model intertemporal choice (i.e., decisions involving tradeoffs between the present and future) using the discounted utility model developed by Paul Samuelson. A key assumption is that people discount the future at a constant rate.

But behavioral research shows that real people tend to discount the future at a much higher rate in the short run than in the long run. Given a choice between $100 today and $120 a month from now, many people choose the immediate $100. But given a choice between $100 a year from now and $120 a year and a month from now, most people choose the $120. The difference in timing is the same (one month), but when that difference is in the future rather than the present, people are more patient.

This tendency is known as hyperbolic discounting. Like looking through a telescope, differences in the near future appear much larger than equivalent differences in the distant future. This inconsistency can lead to problems of self-control and procrastination.

Section: 3, Chapter: 11

The "mug experiments" were a series of studies designed to test the endowment effect - people's tendency to value items they own more highly than equivalent items they do not own.

In the experiments, some participants were given coffee mugs and became potential sellers, while others became potential buyers. According to standard economic theory, about 50% of the mugs should trade hands, since the mugs were allocated randomly.

However, in repeated experiments, only 10-30% of the mugs traded. Sellers' minimum acceptable price was typically about twice as high as buyers' maximum willingness to pay.

This effect persists even if participants are allowed to handle the mugs in advance or learn the market price. It appears to reflect a deep aversion to losing items we own, rather than just a lack of information. And it directly contradicts the Coase theorem, a classic economic principle which holds that in the absence of transaction costs, goods will always flow to their most valued use.

Section: 4, Chapter: 16

In 1985, the University of Chicago held a conference on behavioral economics, pitting leading behavioral researchers like Kahneman, Tversky and Thaler against prominent skeptics from the Chicago school of economics.

Kahneman and Tversky presented their famous "Asian disease problem," showing how framing influences risk preferences. They also shared findings on fairness and loss aversion, the endowment effect and mental accounting.

Economists largely dismissed the behavioral evidence as a collection of "quirks" that would be eliminated by market forces. They argued that psychological factors were irrelevant as long as the aggregate predictions of rational models were correct.

The heated debate crystallized the core points of contention between the behavioral and neoclassical camps. While minds were not changed overnight, the conference put behavioral economics on the map as an important emerging field.

Section: 5, Chapter: 17

Narrow framing is the tendency to evaluate risks in isolation rather than as part of an overall portfolio. This can lead to suboptimal decisions.

• Investors hold low-return bonds in taxable accounts while holding stocks in tax-free retirement accounts (the opposite of what tax efficiency dictates)
• Employees buy company stock in their 401(k), duplicating (rather than diversifying) risks from their human capital
• Casino gamblers bet more recklessly with winnings ("house money") than with money from their own pockets

Experiments on risky choice find that people make different decisions when choices are presented one at a time (narrow framing) vs. collectively. People will reject a single risky bet but accept a package of similar bets, even though the aggregate risks and returns may be equivalent.

Narrow framing can lead people to be risk averse in some contexts and risk seeking in others, deviating from global risk neutrality. It's a pervasive bias that influences many real-world choices, from casino floors to corporate boardrooms.

Section: 5, Chapter: 20

John Maynard Keynes likened the stock market to a newspaper beauty contest in which readers try to pick the most popular faces among other readers, leading to an infinite regress of anticipating what others believe average opinion will be.

Similarly, investors don't just evaluate stocks based on fundamentals. They also try to anticipate other investors' valuations, which leads to self-reinforcing bubbles and crashes. The result is a market driven by "animal spirits" and herd behavior rather than rational analysis.

As Keynes wrote: "The actual, private object of the most skilled investment today is...to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow...this battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional; - it can be played by professionals amongst themselves."

The implication is that stock prices can diverge significantly from fundamental values, and that making money in markets requires anticipating these swings in sentiment. This view contradicts the efficient market hypothesis but accords with behavioral finance and the reality of market booms and busts.

Section: 5, Chapter: 21

If markets are efficient, stock prices should respond quickly and accurately to new information. But empirical studies find pervasive evidence of both underreaction and overreaction.

Examples of underreaction:

• Post-earnings announcement drift: stocks with surprisingly good (bad) earnings outperform (underperform) for months after the announcement
• Momentum: stocks with strong (weak) returns over the past 3-12 months tend to continue outperforming (underperforming) in the next 3-12 months

Examples of overreaction:

• Long-term reversals: stocks with strong (weak) returns over the past 3-5 years tend to underperform (outperform) over the next 3-5 years
• Value/growth: "value" stocks with low price/earnings ratios outperform "growth" stocks with high P/E ratios, contrary to efficient markets logic

Section: 5, Chapter: 22

The efficient market hypothesis (EMH) holds that stock prices instantly and accurately reflect all available information. This implies it's impossible to consistently "beat the market" by buying undervalued stocks or selling overvalued ones.

However, value investing strategies, which involve buying stocks with low price-to-earnings or price-to-book ratios, have historically outperformed growth strategies. Fama and French (1992) confirmed the outperformance of value stocks, contradicting the EMH.

Behavioral economists argue this reflects mispricing due to investor overreaction. When a stock disappoints, investors overreact and push its price below fundamental value, creating a value opportunity. When it exceeds expectations, overreaction makes it overpriced.

But EMH defenders argue value stocks are simply riskier, so their higher returns just compensate for this. The question remains unresolved, illustrating the challenges in distinguishing mispricing from risk premiums.

Section: 5, Chapter: 23

According to the efficient market hypothesis, stock prices should reflect the discounted value of a firm's future cash flows. This implies prices should only change when new information about cash flows arrives.

But Robert Shiller (1981) found that stock prices are much more volatile than the dividend streams they supposedly reflect. A firm's stock price can double or halve even when its underlying dividends and earnings are stable.

This "excess volatility" puzzle challenges market efficiency. If prices only reflect fundamentals, why do they swing so wildly in the absence of concrete news?

Shiller argued this reflects "fads, fashions, and bubbles" among investors. Prices are driven by sentiment and speculation as much as real information. This explains why prices move more than fundamentals.

Section: 5, Chapter: 24

Thaler and colleagues sought to bring insights from behavioral economics to the analysis of legal rules and regulations.

This behavioral law and economics approach contrasts with traditional law and economics, which relies heavily on rational choice theory. For instance, behavioral research shows the Coase theorem may fail due to endowment effects and fairness concerns, even with low transaction costs.

Likewise, behavioral findings on limited self-control, overconfidence, and impatience suggest regulations like mandatory retirement savings or consumer protection may sometimes be justified, challenging libertarian anti-paternalism dogma.

Behavioral law and economics aims to make legal analysis more realistic and empirically-grounded. But it remains controversial, especially the paternalism debate. Nonetheless, it has grown rapidly and influenced numerous legal domains, from contracts to criminal justice to corporate governance.

Section: 6, Chapter: 27