Three financial lessons from Nobel prize winner Richard Thaler

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Three financial lessons from Nobel prize winner Richard Thaler

How do we decide what to buy and how much to save, and how do we experience these financial transactions? For his work in answering questions such as these, the US economist Richard Thaler won the Nobel Prize in economics on 9 October.

Thaler, who is a professor at Chicago Booth business school, is best known for co-writing the bestseller 'Nudge', which explored how people are guided by their emotions and biases when it comes to their finances.

In 2010, Thaler advised the UK government under prime minister David Cameron in setting up the 'nudge unit'. Insights from behavioural economics were used to create the auto-enrolment scheme for pension savings - an initiative that has been broadly hailed a success.

Thaler is one of the founding fathers of behavioural economics. "Thanks to his contributions and discoveries, this new field has gone from being a fringe and somewhat controversial part of economics to being a mainstream area of contemporary economic research," said Per Stromberg, the chairman of the Nobel Economics Sciences committee.

The committee lauded Thaler for making "economics more human". When asked how he planned to spend the prize money, Thaler answered: "Irrationally".

Here, we analyse three financial lessons we can learn from Thaler's work:

We divide our money into different 'mental blocks'

Even though money is fungible, which means it's interchangeable for different purposes, Thaler argues that we constantly engage in what he calls "mental accounting".

For example, we will spend more money on a credit or debit card when we shop than we do when we use cash, even though in both cases the money comes from our earnings.

Paying by card mentally decouples the purchase from the payment. This is also why people are more likely to remember the amount of their purchases if they paid by cash rather than by card.

Similarly, the acclaimed Nobel Prize-winning psychologists Daniel Kahneman and Amos Tversky, found that people are less willing to buy a second ticket to a play after having lost their ticket, than after having lost an equivalent sum of money.

Buying a replacement ticket does not appeal to many people because it is included in the "mental account" for going to the theatre, but the loss of a random cash sum is not.

Another study found that when subjects were asked what they would do with a particular windfall, such as $30 found in the pocket of a jacket, they tend to match the seriousness of the source of the windfall with the use to which they put it.

We have a "flat rate" bias

Thaler argues also that people don't like the experience of "having the meter running", which is why they have a "flat rate" bias.

He says that, for example, many urban car owners would be financially better off selling their car and using a combination of taxis and car rentals.

But paying $10 to take a taxi to the supermarket or cinema is perceived as raising the price of groceries and movies in a way that regular monthly car payments are not.

The value we attribute to our time depends on the context

A rational person would allocate time optimally, but Thaler argues that instead what matters is the context of our "financial frames".

Again, he builds on the work of Kahneman and Tversky, who asked participants in experiments the following question:

Imagine you are about to purchase a calculator for $15 (or $125). The salesman informs you that the calculator you wish to buy is on sale for $10 (or $120) at the other branch of the shop, located a 20-minute drive away. Would you make the trip to the other shop?

Most people say that they will travel to save the $5 when the item costs $15 but not when it costs £120.

Similarly, another study asked respondents how much they would be willing to pay to avoid waiting in a queue for 45 minutes to buy a ticket.

They found that people are willing to pay twice as much to avoid the wait for a $45 purchase as for a $15 purchase.

Thaler concludes that people make decisions on a piecemeal basis, and that they are heavily influenced by the context of their choice.

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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