Misbehaving:

The making of behavioral economics

Author: Richard H Thaler Book Summary

Behavioural economics and the role that it has played in evalua ng investor behaviour is now being widely lauded by
economists and market par cipants. In his book, “Misbehaving: The making of behavioral economics', Richard H Thaler traces
the development of behavioural economics and explains how investors can make more ra onal decisions by being aware of
their behavioural biases. He is considered a leader in the field of behavioural economics, which examines how people make
decisions and act on them. In today's me and age, when market movements can o en seem to be random in nature, the study
of behavioural economics can go a long way in helping investors be er understand markets and make op mal investment
decisions.

Key takeaways

Ÿ Tradi onal economic theory says that people make ra onal decisions, but behavioural economics shows that this is not true.
Ÿ Behavioural economists suggest that markets will reward those who make ra onal decisions and punish those who make
irra onal decisions.
Ÿ Percep on of value is far more important than price. What people are willing to pay depends on their percep on of what
they should have to pay.
Ÿ People have an aversion to losses. The fear of loss is usually greater than the joy of gain. As a result, they tend to make
irra onal decisions.
Ÿ Surveys are a great way for economists to understand the factors that influence an individual's choices.
Ÿ The efficient market hypothesis should be revisited since it is based on the assump on that investors make ra onal
decisions.

Economics is the most influen al social science because it has lots of theories that can explain how people's lives work and the
factors that influence their decisions. One of the basic assump ons of tradi onal economics is that individuals always make
ra onal decisions. However, behavioural economics proposes that this is an incorrect assump on. Due to several internal and
external factors, individuals cannot always make ra onal decisions. A be er understanding of this can help the management of
companies make be er policies. It can also help investors make be er investment decisions.

Behavioural economics can poten ally cause and in some cases has already caused, a paradigm shi in the study of
economics.

The famous philosopher Thomas Kuhn suggested that the way common people look at science is generally wrong. The general
assump on is that new facts are discovered. These new facts help in building new solu ons and give a be er picture of how the
world works. However, science works in much the opposite way. Scien sts generally develop theories and then organise facts to
support these theories. Tradi onal economics is similar in nature. However, behavioural economics is changing the way
economists think about economic theory. Instead of simply focusing on theore cal models that support exis ng theories,
behavioural economics encourages economists to study human behaviour in order to reinterpret and adjust those theories.
This has had a significant impact on the understanding of economic ac on. It has allowed economists to be er understand
human behaviour, its impact on decision making, and develop be er policies for people's benefit.

Tradi onal economic theory says that human beings make ra onal decisions. Behavioural economics shows that this
assump on is incorrect.

According to tradi onal economic theory, people always make ra onal decisions that are in their best interest. For example,
assume that a ra onal individual wanted to buy an instrument that she could not afford because she had to also pay for her rent,
groceries, and credit card bill. Now, let's say that she was gi ed the instrument by her friend. Tradi onal economics suggests
that this woman would probably sell the instrument and then use the money raised from its sale to pay for her credit card. The
assump on is that she would make the most logical economic decision. Behavioural economics, on the other hand, argues that
not everyone would sell such a gi to pay down on their liabili es. It is possible that she might be emo onally a ached to the gi
or possibly just wants to keep the gi . Further, it is also not necessary that she would make a ra onal decision in the first place,
i.e., not buy the instrument. There might be many people who would buy the instrument despite not actually being able to

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Misbehaving:
The making of behavioral economics

Author: Richard H Thaler Book Summary

afford it. Thus, the way humans respond to a par cular economic situa on is o en irra onal and can vary.

Tradi onal economic theory says that even if people are irra onal, the market will reward those who are ra onal.
Behavioural economics demonstrates why this is wrong.

To be fair, economists have always known that not all of the people can be ra onal all of the me. However, tradi onal
economists argue that the markets reward those people who take ra onal decisions. Over a period of me, when people make
the right decisions, they get to a posi on of power and become experts who control things and influence others to make ra onal
decisions. This ensures that the markets func on properly.
However, the biggest flaw in this argument is that experts are not always ra onal. For example, the stock market crash on Black
Monday in 1989 occurred for no reason and without any news to jus fy it. Experts simply stopped valuing stocks as highly as
they had previously done. Tradi onal economics assumes that experts are ra onal individuals and that they always know what
they are doing. Behavioural economics argues that experts can o en be irra onal. Some mes it is best to a ribute success to
luck or to being at the right place at the right me rather than to assume that the outcome is a result of the ra onal choices
made.

Economists should speak to people, gather responses, and then analyse these responses to be er understand how people
make economic choices.

Tradi onal economic theory assumes that people are always ra onal in their decision making and can easily predict their next
set of ac ons. For example, a er a snowstorm, demand for snow shovels rises sharply. Therefore, store owners should raise the
price of snow shovels to the point where all the available ones are sold and no one else wants them at that price. However, the
ground reality can o en be completely different. A study conducted by Thaler, Daniel Kahneman and Jack L. Knetsch found that
Canadians considered a price hike on snow shovels a er a snowstorm unfair. The authors concluded that sellers risk consumer
anger if they raise prices during mes of high demand. Behavioural economists believe that people react differently to a given
situa on. Thus, it is important to be er understand reac ons in the real world. However, it is equally important to recognise
that surveys can o en be fairly tricky and that survey results may not always paint an accurate picture. Thus, economists should
conduct mul ple surveys, tweaking variables to objec vely assess the responses of people in a given situa on.

Most people value the money or goods that they have more than the poten al money that the sale of those goods can bring.
Thus, the fear of losing money/goods that you have will most likely be greater than the joy of earning money.

Tradi onal economic theory suggests that people always make ra onal decisions. Hence, they will never pass on the
opportunity to make the most money from their product. The assump on is that if people have a product for which they are
offered a great price then they would be more than willing to sell that product. Behavioural economics, on the other hand,
argues that people will not take the best offer because they're a ached to their products. This means that the product has more
than monetary value which increases the worth of the product in the mind of the person holding it. Thus, they may or may not
sell the product. Even if they do sell the product, it will have to be at a price which reflects its true worth to the person.
Behavioural economists further argue that the pain of losing something that you own is twice as much as the joy from gaining
something new. It exemplifies the old saying, 'you can't miss something that you don't have'. This is called loss aversion and is
very relevant in our investment and trading decisions.

Loss aversion and poor management can cause businesses to be too risk averse.

Loss aversion generally encourages people to avoid losses rather than convince them to make gains. Thus, when businesses
suffer from loss aversion, they tend to be more risk averse and consequently, do not always take advantage of profitable
opportuni es that might come their way. For example, if a company has the opportunity to make $5 million with a 50% chance
of losing $3 million, it should take it because the upside is greater than the downside. Companies can combat risk aversion by
encouraging their employees to take risks and evaluate them based on a certain me frame instead of individual projects.

02
 Misbehaving:
Get Rich
The making Carefully
of behavioral economics
Author: James J. Cramer
Author:Richard H Thaler Book Summary
It is irra onal to expect people to exercise perfect self-control when making economic decisions.

Tradi onal economic models assume that people inherently make the choices that they want to make. However, behavioural
economists argue that this is not always the case. Take the example of cookies. You might want to avoid ea ng them because
you believe that they are contribu ng to your weight gain. However, despite not wan ng to eat the cookies you might end up
ea ng one or two or even ten. Clearly, individuals don't always make the choices that they want to make. Essen ally, there are
two parts to every individual. One is the planner who makes the decision to not eat the cookies. The other is the manager who
impacts your ac ons and tells you to eat the cookies anyway. Some mes the planner wins and some mes the manager.
However, the planner cannot always win.

What people are willing to pay for a product or service depends on their percep on of what they should have to pay. The
perceived fairness of a price can be more important than the price itself.

O en, the price of a product is not as important as the value that it is perceived to have. Which is why you might not buy a
product for let's say $20, but might buy it if you received a discount of $5. The percep on that something is a great deal makes it
more appealing. This is why stores offer coupons, discounts, and several types of deals to a ract customers. People like ge ng
discounts, so this strategy can help businesses run be er.

Reconsidering the Efficient Market Hypothesis

The efficient market hypothesis states that the price of a stock reflects its true value which is nothing but the present value of
future dividends. However, in 1981, Robert Shiller's research showed that while this was generally true, actual prices were
highly variable. Thus, the efficient market hypothesis is a useful guide on how markets should work, but it's not very good at
predic ng real market behaviour.

Inarguably, biases and emo ons can play a very strong role in your ability to make op mal investment decisions. While you
should certainly try and overcome these biases, you can also consider inves ng through investment vehicles that can help you
achieve this goal. One op on to consider would be to invest through mutual funds. These are investment vehicles that invest
across investment asset classes like equity, debt, gold, etc. Further, they are professionally managed and the investment
decisions are usually guided by specific investment mandates and rules. This helps to minimise the behavioural bias in
investment decisions. Addi onally, you should also consider inves ng in mutual funds through systema c investment plans
(SIPs). SIP is an investment vehicle that will allow you to invest a certain sum of money into an investment avenue of your choice,
on a periodic basis. The systema c and regular inves ng eliminates bias and inculcates investment discipline.

An investor educa on ini a ve

All Mutual Fund Investors have to go through a one me KYC process. Investor should deal only with Registered Mutual Fund
(RMF). For more info on KYC, RMF and procedure to lodge/redress any complaints – please visit on
h ps://www.edelweissmf.com/kyc-norms

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