Every year at this time, the Nobel Prize winners are announced. These prestigious honors, which are worth about $1 million to the winners, are awarded in Physics, Chemistry, Medicine, Literature, Economic Sciences, and Peace. Alfred Nobel established a foundation upon his death to recognize outstanding achievements in these disciplines, sort of an Oscar for brainiacs.
Dr. Richard Thaler of the University of Chicago is this year’s recipient of the Nobel Prize in Economics. Usually, this particular Nobel Prize goes to someone who developed a complex economic theory. Recent winners tackled the rarefied subjects of contract theory, empirical analysis of asset prices, cause and effect in the macro economy, and markets with search friction. Dr. Thaler’s subject earned his Nobel Prize for his contributions to behavioral economics. His body of work is a little less Econ 101 and a little more Psych 10, which was the basic survey course at my alma mater. This is not to denigrate Dr. Thaler’s research, but rather distinguish it from past honorees.
Dr. Thaler’s hypothesis is known as limited rationality, which theorizes how people make financial decisions by focusing on the impact of the individual decision rather than its overall effect. In other words, people make bad financial decisions using only a limited amount of information which usually means thinking short-term instead of long-term. For example, an investor will sell a strong stock to feel they made money instead of a weak stock which they hold to hopefully make their money back. “Buy low and sell high” looks good on a billboard and sounds nice in theory but rarely is utilized in practice.
This theory is nothing new to anyone who works or has worked in a credit union, bank, securities brokerage, or financial planning company and is something we’ve known and I’ve mentioned in this column for many years. For whatever reason – family history, preconceived notions about investing, or trying to “time the market” – economic decisions are made on a human level and are not made strictly rationally. Human behavior is the reason why we buy a shirt at Nordstrom instead of the exact same but cheaper shirt at J.C. Penney, why people buy a Lexus instead of the lower-priced Toyota (it’s all the same under the hood), and why amateur investors think they will be millionaires by day trading.
But this doesn’t mean people can’t change their behavior. With apologies to Dr. Thaler, people’s mindsets can change from wants to needs. If a consumer focuses on their needs instead of wants, they will look for the best price for a product or not even buy that product and save the difference. For instance, Walmart, for better or for worse, has changed the way consumers shop for everyday goods. Online shopping has also changed consumer behavior but has turned out to be a convenience rather than cost saving.
The Nobel Prize for Economics is a relatively new award, starting nearly 70 years after the other disciplines started to be awarded. As a result, some doubt Nobel winners in Economics are the equal to the other winners. However, Dr. Thaler brought humanity to the forefront of an otherwise pretty dry and statistics-heavy subject. The good doctor himself brought some humor into his award when he replied to the question of how he will use his award winnings, “I will say that I will try to spend it as irrationally as possible.” He also expressed disappointment for not being considered for a real Oscar for playing himself in the 2015 film “The Big Short.” Yes, economists are humans, too.