Behavioural economics pioneer Richard Thaler has been awarded the 2017 Nobel Prize for Economics.
Probably best known for his work on nudge theory, he has helped show how humans rarely behave as rationally as economists think they would.
Here on eZonomics we’ve been following Thaler for years; we’ve written about how his research can help you make better money decisions ever since we launched in 2009. So, to honour his Nobel win, we’ve put together a selection of his best insights.
Putting money in pots
One euro, pound or dollar bill is the same as any other euro, pound or dollar bill; they can be swapped to save or spend however we like – this is known as the fungibility of money.
Yet the way we treat money can differ depending on the way we received it or if it was originally earmarked for something else – that’s Thaler’s theory of mental accounting.
So, while we might feel free to splurge with an unexpected windfall – an inheritance from a distant aunt, say – we might not feel as inclined to blow an equivalent pay rise.
Similarly, people may save money in a jar for something special, like a holiday – while simultaneously carrying expensive credit card debt. Using these savings to pay off the debt would work out cheaper, but people are reluctant to touch the money in the jar.
Imagine a woman enters a casino with €200, gambles and is lucky enough to win another €200. She is likely to then wager the winnings in a much more aggressive manner – simply because she views it as “house” money from the casino.
Thaler and Johnson found that, in real life, investors are more likely to buy risky stocks after profiting from a previous trade. Because “house money” doesn’t really feel like our own, it can be easier to spend.
Home sweet home
How much is your house worth? And would a potential buyer agree?
Economists have found that we tend to overvalue what we own simply because we have it – a phenomenon known as the “endowment effect”.
Thaler demonstrated the effect in action in a classic 1980s experiment while working at Cornell University in the USA. He handed out free coffee mugs at random to students and asked those who had received mugs how much they would sell them for, and those who hadn’t how much they would pay for them. The typical recipient of the mug demanded $4.75 but the typical buyer offered $2.25. Mere possession of the mug – which arose only by accident – caused people to value it highly.
Thaler’s nudge theory is especially relevant to retirement planning. Research shows that when employees are enrolled automatically (a nudge) onto a retirement plan – with the option to withdraw – far more people sign up than would have done if they’d had to enrol themselves.
Thaler also co-designed the Save More Tomorrow (SMT) plan, where people are invited to commit now to increase their savings rate later, such as the following year. As Thaler explains, “self-control is easier to accept if delayed rather than immediate”. And, as planned increases are linked to pay rises, it is meant to diminish the effect of loss aversion – the tendency to feel losses more than larger gains. Staff do not see their pay fall because the increase in the savings rate is a portion of the pay rise.
At the first company that tried the plan, staff ended up almost quadrupling their savings rate from about 4% to 14% in under four years.
The scheme is now used by millions of people around the world, demonstrating the far-reaching effects of Thaler’s work in the field of behavioural economics.