Sendhil Mullainathan and Richard Thaler (M & T) address some interesting questions in their paper Behavioral Economics (September 2000). In doing so they justify the import and relevance of the concepts of bounded rationality, bounded willpower, bounded self-interest. Their application is finance and savings.
1. Don’t market incentives lead to rational choices? While it is true that incentives matter, in that they influence behavior, they are not decisive. The market may reward choice A over B so there is an incentive to choose A, but they do not force the choice of A.
2. Aren’t irrational choices arbitraged away? No arbitrage opportunities exist for all sets of choices. M & T use the example of the fictitious economist Sam who goes into the field of behavioral economics even though he could earn more money in finance. Remuneratively speaking he made an irrational choice. But there is no arbitrage opportunity for him or anyone else, not for this choice or his choice of how much to save for retirement, wife, car, and so forth.
3. Didn’t evolution select for rationality? Not at all. Evolutionary arguments can explain irrational behavior as well. It may, in fact, have been an advantage to be or appear overconfident. Appearing so would have provided an incentive for one’s foes to back down. Is the “irrational exuberance” of the modern age a vestige of evolutionary selection? It is at least plausible.
4. Don’t we learn from our irrational choices and correct them? Opportunity cost can prevent the switching from a sub-optimal choice to an optimal one. Even if one is not stuck in a non-optimal equilibrium, learning can take longer than the time scales of a changing environment allow. That is, by the time you’d have learned the optimal way to decide something the world has changed: there are new choices, you have a different income, different needs, and so forth. Finally, sometimes we only get to decide once. There are few, if any, chances to learn from our retirement saving decisions and the cost of experimentation is high.
Next, M & T focus on three unrealistic assumptions of standard economics: unbounded rationality, unbounded willpower, and unbounded selfishness.
5. What’s the problem with unbounded rationality? Well, it is just wrong. People don’t have unlimited brainpower. Assuming they do is bad economics, “the equivalent of presuming the existence of a free lunch.” There are loads of empirical studies that demonstrate various ways in which people are not rational; they solve problems with heuristics that lead to sub-optimal results.
6. Do people choose the optimum (rational) option even when they identify it? No, not always, due to lack of self-control. It is common for humans to overeat, over drink, over spend, under exercise, under save, under work, and so on. People procrastinate. In short, people have bounded willpower.
7. Finally, people are not as selfish as rational actors would be.
What are the implications for finance and savings?
8. First, M & T dispense with the efficient markets hypothesis (EMH) by describing some well-known ways in which it has clearly been violated.
9. If the EMH doesn’t hold, and moreover if markets sometimes over- and sometimes under-react, there doesn’t seem to be a unifying framework to explain market behavior. What next? M & T only make a few passing remarks about emerging research on this question. It isn’t clear they’ve made any real contribution in their paper so I’m not sure why they even raise the issue.
10. Turning to savings, M & T describe how bounded willpower explain lack of sufficient saving for retirement. The phenomenon of mental accounts explain the relative increase in savings that occurred when personal IRAs became available. When funds were mentally designated for retirement and placed in an IRA they were less likely to be used for other purposes.
Well, that was a rather weak conclusion to a paper with a very interesting start. No doubt behavioral economics can and has made important contributions to personal finance. They’re not to be found in this paper. I believe behavioral economics matters more than M & T let on. If you read their paper, do so for points 1-7 above. Those are well made.