June 23, 2015
by Joe Tomlinson
Richard Thaler is out with a new book, Misbehaving, tracing his career in behavioral economics. It offers an appealing combination of entertaining writing and serious discussion of the many areas he has researched. The book is a natural complement to Daniel Kahneman’s classic, Thinking, Fast and Slow. I’ll briefly compare these two books and then address what Thaler’s work says about two issues particularly important to financial advisors.
Misbehaving is a quicker read than Kahneman’s book, but it still provides a wealth of material on a behavioral economics. It’s also a more personal book, chronicling Thaler’s career starting in the late 1960s when he began to take note of inconsistencies between the economists’ model of rational choice and how people actually behaved. The books are different in that Kahneman has studied human decision-making from a psychologist’s viewpoint, whereas Thaler’s is from an economist’s perspective, with much of the focus on how his views differ from those of classic economists.
[drizzle]A central theme of both books is the distinction between normative and descriptive theories. Normative describes the “right” way to make decisions in terms of a logically consistent approach to optimizing a goal. It’s the classical theory on which many economic models are based, including models that assume individuals make decisions with an aim of maximizing utility. Descriptive theories attempt to characterize how decisions get made in practice – with limited information, affected by a variety of biases and often relying on imperfect rules of thumb. It’s important to understand the descriptive aspects in order to better predict behavior and help people to achieve their long-term goals.
Kahneman makes a distinction between what he called “system 1” thinking, which is quick and automatic, and ”system 2,” which demands much more effort. Thaler makes a similar distinction between humans and Spock-like “econs.” Dealing effectively with financial issues such as choosing an asset allocation, determining a retirement withdrawal plan or deciding how to react to a market downturn calls for system 2 or econ thinking. However, people are limited in their intellectual and emotional capacity, so system 1 and the human approach to decision-making more often come into play.
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