Economic Theory, Human Behavior, The Markets And Your Portfolio
I’ve recently read an interesting and frequently hilarious book by Richard Thaler: “MISBEHAVING: The Making of Behavioral Economics.” In this 2016 book he describes his efforts, and that of others, to challenge the entrenched belief that traditional economic theory is a reliable and accurate tool to explain human economic and market behavior. From his work with psychologists and other economists, he developed the now accepted field of behavioral economics. This article shares a few key concepts from his book and the related mental exercises are fun and reveal a bit about ourselves and the markets.
Thaler, an economist and the Charles R. Walgreen Distinguished Professor of Behavioral Economics at the University of Chicago Booth School of Business, was awarded the Nobel Memorial Prize in Economic Sciences for his contributions to behavioral economics in 2017. Incidentally, he is also a partner in Fuller and Thaler, a California-based investment management company.
Thaler uses the name “Econs” for the hypothetical beings assumed to behave as economic theory predicts. Not surprisingly, he calls the rest of us who “misbehave,” relative to economic theory expectations, “Humans.”
Thaler: “The core premise of economic theory is that people choose by optimizing. Of all the goods and services a family could buy, the family chooses the best one it can afford. Furthermore, the beliefs upon which Econs make choices are assumed to be unbiased.” (Remember this last point when we get to the confirmation bias discussion below.)
A bit later he writes, “This premise of constrained optimization, that is, choosing the best from a limited budget, is combined with the other major workhorse of economic theory, that of equilibrium. In competitive markets prices are free to move up and down, those prices fluctuate in such a way that supply equals demand. To simplify somewhat, we can say that Optimization + Equilibrium = Economics.”
