Economists spend a great deal of time developing concepts such as “market efficiency” and “rational behaviour”. Unfortunately, the models developed from such concepts only seem to work for economists. They don’t usually work for humans.

Richard Thaler’s book, “The Winner’s Curse”, provides evidence that supports this dichotomy between economic thought and the real world.  The sub-head is “Paradoxes and Anomalies of Economic Life”. Full details on the book below.

I have briefly summarised four of the 13 papers in Richard’s book, using the same chapter headings. All are supported by extensive experimental evidence. And common-sense.

Co-operation

A fundamental tenet of economic analysis is that individuals act rationally and selfishly: that is, to their economic benefit ahead of benefit to others. This is clearly not so, perhaps unless you are an economist.

For example, many people generously donate to various causes for the satisfaction it gives, not for economic benefit.  And people are altruistic. People take pleasure in giving others pleasure. Think of all the opportunities for gift giving throughout the year. We are all willing participants because it is pleasurable (mostly) to both sides.

The Winner’s Curse

In brief, where there are many bidders, the winner will overpay for the asset. Overpayment would not occur if the bidders were rational – but they are not (see above). Losing bidders are often surprised at the winning price, precisely because it is irrational.

This is regularly reported in Sydney, in the midst of a remarkable housing bubble. Read more about that here.

The Endowment Effect, Loss Aversion, and Status Quo Bias

These are all variations on the same theme. Economic theory states that an individual will make choices in order of economic merit. This is “preference order theory”.

However, in reality, instead of an individual making the most sensible economic choice, their choice will depend upon their current situation.

For example, say you have bought a ticket for a sporting event for $200. High demand drives tickets up to $400. Most holders of $200 tickets would say that $400 was too high, and they wouldn’t pay that much. But at the same time they would, paradoxically, not wish to sell for a $200 gain, but rather see the game.

Savings, Fungibility, and Mental Accounts

There is an economic theory called “life cycle theory”. Its inventor won a Nobel Prize for his efforts.

The theory states that an individual will decide how much to consume in a given year by taking the present value of their wealth and calculating the resultant annuity. The individual would then consume that annuity during the year.

This theory makes the assumption that all of an individual’s wealth is fungible. But this is not so. People treat current income differently from savings, and certainly differently from a major asset such as a house.

For example, people will regularly spend most of their current income, but would rather reduce expenditure that sell their house. Current income is viewed differently to savings and to tangible assets. Wealth is not fungible.

Conclusion

An investor is better served by being a student of the human condition, rather than of economic theory. Richard Thaler demonstrates this with overwhelming evidence.

I highly recommend reading his book. Buy it here.

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The Winner’s Curse
By Richard H Thaler
Princeton University Press, 1994, pp223,
ISBN-13: 978-0-691-01934-5
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29 April 2015 Macro