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Q6 _08-34_


									Fall 2009

What are you thinking?




       Fall 2009


      What are you thinking?
       Robert J. Shiller

      What is behavioral?
      Nicholas C. Barberis, Ulrike M.
      Malmendier, Shane Frederick, and
      Andrew J. Redleaf

      Do you need a nudge?
       Richard H. Thaler

      Can behavioral economics
      improve law?
       Christine Jolls

      Are we good at making
      James Choi, M. Keith Chen,


                                                     What does a choice
                                                     look like?
                                                     Neuroeconomists peek
                                                     inside the brain

                                                     What was Polaroid
                                                     How faulty assumptions hampered
                                                     the company
                                                                                       Fall 2009

                                                                                       Sharon M. Oster
                                                                                       Dean and Frederic D. Wolfe Professor of
                                                                                       Management and Entrepreneurship

                                                                                       Elizabeth Stauderman
                                                                                       Associate Dean for Communications
                                                                                       and Strategy

                                                                                       Jonathan T.F. Weisberg

                                                                                       Ben Mattison
                                                                                       Managing Editor
      and Judith A. Chevalier                                                

                                                                                       Ted O’Callahan
74    Does money change your                                                           Online Editor
       Kathleen D. Vohs
                                                                                       John Zebrowski
90    Is risk rational?                                                                Staff Writer
      Andrew W. Lo
                                                                                       Concept and design by 2x4

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                                                                                       Back cover photograph by Richard Mosse
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Interviews for Q6 were conducted from
July through September 2009.
Visit for updates and ongoing discussion.
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Cover photograph by Richard Mosse
               Q6	2009	   Dialog	       	                                           5

What are you              Decades of economic research have
                          assumed people pursue their goals

thinking?                 in a rational manner, discounting
                          the effects of emotion, bias, error,
                          and other irrational forces. Robert
                          Shiller argues that economists need
                          to take a closer look at how people
                          make decisions.

                          Robert J. Shiller
                          Arthur M. Okun Professor of Economics, Yale University
                          Interview conducted and edited by Jonathan T.F Weisberg
                          Photograph by Richard Mosse
Q6	2009	   Robert	J.	Shiller	                                                                7
	          What	are	you	thinking?

Q: How important is it to understand what people are thinking and feeling when you
are trying to understand the economy as a whole?

           That’s been a controversial question in economics for a long time. Milton
           Friedman wrote a collection of essays in 1953 called Essays in Positive
           Economics, in which he argued that you shouldn’t try to infer what people
           are thinking because people really can’t tell you what they’re thinking. If you
           ask people why they did something, they will give you a conventional answer
           or mislead you. The idea was that the essence of economics is to look at the
           constraints that people have and assume that people are behaving rationally,
           subject to those constraints, and interpret economic data as reflecting that
           rational behavior. That is the defining characteristic of economics as a
           discipline — as opposed to psychology as a discipline — that, in understand-
           ing something as massive as the economy, it’s best to look at people’s actions,
           not their ostensible reasons. There is some appeal to that. I just wish it
           were more right.
               I can get enthusiastic talking about this theory because, in some respects,
           it is good. To give an example, suppose you are trying to understand the
           seasonality of food prices — why they go up in the winter and down in the
           summer. Well, it’s pretty obvious that it has something to do with the wea-
           ther as a constraint, but you better think it through, because we live in a
           global economy, and when it’s winter up here, it’s summer down south.
           Obviously they’ll ship food from one hemisphere to another. That puts a limit
           on seasonality. This is pure economics, and I’m sure it’s right, because the
           seasons occur year after year after year, and you have people whose job is to
           ship fruits and vegetables and food around. They’re going to find the best
           pattern of shipping, given all the costs. It wouldn’t make a lot of sense to
           ignore that. Thinking that people get emotional in the summer, or some-
           thing like that, would probably be wrong.
               The problem is that positive economics has been carried too far. Part of
           the reason is an institutional specialization problem in academia. Academics
           have to specialize in some method of research; you can’t know it all. This
           positive economics took over, and I think there’s an institutional reason why
           it got overemphasized.
               Fortunately, there’s a lot of enthusiasm among some people for behavioral
           economics now. It’s obvious that there are certain phenomena that don’t
           fit into Friedman’s prescription of positive economics, and those include
           speculative bubbles, for example. They’re kind of hard to pin down, but they
           really are there.
8	     	        	        	            	     	         	        	        	                          	   Q6	2009	    Robert	J.	Shiller	                                                                 9
                                                                                                       	           What	are	you	thinking?

Q: Some economists say that the positive approach gets you 99% of the way there                                    There was the beginning of a turnaround in confidence and the market going
and behavioral is about that last 1%.                                                                              up stimulated people to be more optimistic, and then there is a feedback loop.
                                                                                                                   The market is not really responding to any information. I’ve argued in books
            I’ve heard that before.                                                                                I’ve written that these are social epidemics. Ideas have a contagion, just like a
                                                                                                                   disease has a contagion, and a certain idea may spread only because, for some
                                                                                                                   cultural reason, the contagion rate is high.
Q: Where do you put the number?

           I think that the failure to predict this financial crisis had something to do               Q: How do you go about making an idea like that into something that’s testable?
           with failing to understand behavioral economics. So I don’t think that it’s
           99% there. I think it’s kind of the other way around. Positive economics                                It seems to me that we have to read the whole array of psychological research
           is great for explaining the seasonality of fruit and vegetable prices, but                              and sociological research and try to put it together into a view of the world.
           if you want to know why we go through financial crises, I think you need                                And conventional econometrics plays a role. Another direction is neuro-
           behavioral economics.                                                                                   science, which has started to change our ways of thinking.
                                                                                                                       The problem with science, any science, is that it’s hard to move linearly
                                                                                                                   forward. You have some breakthrough, and you explore that to the end. And
Q: The disciplinary problem you describe in economics seems to have a very direct                                  then you feel like you’re wasting your time and you have to go back and reflect
effect on economic activities outside of academia.                                                                 about something different. And it may be very different. It may be some-
                                                                                                                   thing that’s really off the track that you were on before. And then we gradually
            Right. This world now has over six billion people. We couldn’t have                                    grow into an understanding. I think that mathematical models play a role in
            sustained this number of people 100 or 200 years ago. In order to sustain                              this. But they’re not the only thing; they’re just part of the story. I’m thinking
            them, we need modern, big business activities going, and the framework for                             of great breakthroughs in science: Darwin’s theory of evolution — there’s
            that is the financial framework. We have to recognize that billions of lives                           very little mathematics in it, but it’s a very powerful theory. I think behavioral
            depend on this. Finance, and economics more broadly, is a technology that                              economics is a bit like that.
            has brought us to a very different world, and it’s a necessary technology now.                             Economics is describing a very complex phenomenon. You can’t reduce it
                                                                                                                   to a simple formula. We have to understand that what concerns us about the
                                                                                                                   economy is a bit psychological and sociological. That’s just reality.
Q: You mentioned speculative bubbles as an example where you might need a
behavioral explanation. Can you explain your thinking behind that?
                                                                                                       Q: I imagine that simple models or simple explanations are well received, though.
            I think that there was a huge error in overstressing efficient markets. The idea
            developed that the stock market was smarter than any individual, because it                            It’s also a challenge that academia rewards teaching. It’s good that professors
            pools the wisdom of all individuals. And so it becomes an oracle. In ancient                           want to be successful at teaching, of course. But sometimes that leads them to
            times, when a snake was found on the steps of the Roman Senate, or something                           oversimplify. You don’t want to say “on the other hand” too many times in your
            like that, it would be considered a hugely important omen and all the wise men                         lecture, because then it starts to feel unsatisfying. So there is a tendency to want
            would be asked to interpret it. Well, we’re doing the same thing with the stock                        to have some core theory or framework that students will memorize. And it
            market. There is this theory that when it moves up, that that’s revealing some                         has to be iconic. That may be the problem with behavioral economics: there is
            information. Even now, for example, the general interpretation of the recovery                         no simple paradigm. There’s no supply and demand curve or IS-LM model
            that we’ve had is that the markets saw some good news coming and that the                              that is considered the deep insight of the theory. In my new book, Animal Spirits,
            stock market, after March 2009, started to react to good information. Later                            written with George Akerlof, we talk about Keynes’s theory and why it was
            information confirmed that we were coming out of this crisis. But I don’t think                        such a revolution. And we think it was partly because it was early behavioral
            that that’s the right interpretation. This is what I think, though I can’t prove it:                   economics. It recognized some realities that weren’t modeled.
10	     	        	        	        	        	        	        	         	                         	   Q6	2009	    Robert	J.	Shiller	     	                                                             11
                                                                                                      	           What	are	you	thinking?

                                                                                                                  that some people are very worried about the future and then they tend to
Q: I wanted to get to some of the specific points in your book. Could you start with                              behave differently. I think there’s enough evidence that it’s important.
why you chose the term “animal spirits”?                                                                              We have been producing the Stock Market Confidence Indexes here at
                                                                                                                  SOM. But the problem with collecting data as a research agenda, by the way,
             Well, Akerlof and I thought that the most essential thing that we were saying                        is that you can do it for 20 years without anyone paying much attention,
             was that traditional macroeconomics leaves out something very fundamental. It                        unless you have enough data that it starts to correlate with historic events. It
             leaves out what’s driving people’s changing patterns of thinking. Economists                         isn’t a very rewarding career strategy to start collecting data and wait 20 years.
             like to think that people are rational and that means they never change their
             mind about anything. That doesn’t accord with the reality that I know.
                 So we thought of our book as reflecting a different approach to economics.
                                                                                                      Q: How much do those confidence surveys tell you?
            “Animal spirits” represents this, at least for people who know what it means.
             The term goes back to ancient Rome and the physician Galen, who talked
                                                                                                                  They give you a snapshot of what people are thinking. It’s fundamental to
             about spiritus animalis, meaning the animating spirit that drives people.
                                                                                                                  my understanding of what has been going on in the stock market and the
             And it’s used in one of the most important passages in Keynes’s works. In
                                                                                                                  housing market, but I don’t try to publish this in scholarly journals. They
             that passage, in the General Theory of Employment, Interest, and Money
                                                                                                                  just don’t respect it. They want to be scientists. That’s good, but in practice
             in 1936, he stresses the fundamental lack of knowledge about the future —
                                                                                                                  it often seems to mean to them that they will not try to figure out what mo-
             you just don’t know what’s coming. If people were completely rational, they
                                                                                                                  tivates people. I think that leaves out a whole world of things that are obvious,
             might be paralyzed by the uncertainty. But people have a natural urge to
                                                                                                                  and have to be studied to be understood.
             action. That’s what we mean by animal spirits. They’re going to do some-
                                                                                                                      For example, Akerlof and I talk about the changes in corruption and bad-
             thing. Maybe it’s dangerous, but you’re not going to stay home and just stay
                                                                                                                  faith behavior. The capitalist economy is forever vulnerable to declines in
             in bed all day. Or maybe you would, and that’s an economic depression. A
                                                                                                                  business ethics. We live in a society with rules, and enforcement of rules that
             depression is a period when the animal spirits are beaten down. I remember
                                                                                                                  attempts to bring people back when they deviate from what we call ethical
             reading an article from around 1933 by a psychiatrist and he said that what
                                                                                                                  behavior. But we rely on their good will. That’s part of animal spirits, that
             struck him about the Great Depression was that people were dejected. He
                                                                                                                  people have a sense of good will and tolerance toward others. It fluctuates
             said that they would go home at night — or maybe they’d be home all day
                                                                                                                  with time. That’s what matters. Look at this financial crisis that we got into
             because they couldn’t find a job — and just listen to the radio. He said a
                                                                                                                   — a big part of it was the emergence of the subprime lending business, which
             slave mentality had returned. That’s an extreme form, but more moderate
                                                                                                                  had somewhat lower standards of business ethics. People didn’t appreciate
             variations in our animal spirits are driving the economy.
                                                                                                                  that that was happening. The mortgage-broker industry was evolving and
                 We thought that that phenomenon really deserves the central place in
                                                                                                                  it wasn’t regulated, and so we started to see some processes set in motion
             macro theory. And it’s not even mentioned. How can you have a theory that
                                                                                                                  that would eventually lead to disappointment. And now we’re there. And
             doesn’t mention the driving force that makes everything move? It’s like
                                                                                                                  you won’t find this in a macroeconometric model.
             astronomy without gravity.

                                                                                                      Q: The idea of fairness is something else you say has been left out. How has that
Q: You see confidence as a major part of animal spirits. We hear the word all the
time, but is it well understood or measured now?
                                                                                                                  I did a survey comparing economists with the general public. I asked the
            Keynes talked about it in the 1930s and lamented that nobody studied it.
                                                                                                                  same questions of professional economists and the general public, and I
            The first people that studied it, as far as I know, were at the University of
                                                                                                                  found a totally different world view in terms of fairness. Economists don’t
            Michigan more than 50 years ago, when they started the Consumer Sentiment
                                                                                                                  rank fairness as important for their thinking about the economy.
            Index. But academic economists have generally ignored it. There’s only been
                                                                                                                     One of the questions asked how “the effects of general inflation on wages
            a little bit of research on it, and I think that it has been encouraging. It’s been
                                                                                                                  or salary relates to your own experience and your own job.” And Choice 1
            shown that consumer confidence at an individual level drives human actions,
12	    	       	         	         	         	         	        	         	                         	   Q6	2009	   Robert	J.	Shiller	     	                                                            13
                                                                                                        	          What	are	you	thinking?

           was, “My employer will see no reason to raise my pay.” Choice 2 was, “Com-                              and hard work and accumulation. We’ve had many scientific advances in
           petition among employers will cause my pay to be bid up.” And Choice 3                                  history, but they all have a qualitatively different story. I think that the
           was, “A sense of fairness and proper behavior will cause my employer to                                 internet and the associated communications revolution was fundamental
           raise my pay too.” We found that 60% of the economists tended to pick 2,                                because it was intrusive in our lives in a new way. Compare it with other
           and only 11% of the general public picked that. They thought about their                                major technological advances, like nuclear power. Right now, the state of
           relationship with their employer. Either he was a good person who would                                 Connecticut gets most of its electricity from nuclear power. But that really
           raise their wage, or he was just an evil person. That’s a totally different worldview.                  doesn’t have much psychological impact. In fact, most people don’t even
               Keynes talked about how important fairness is. In particular, it is hard                            know that. The internet and communications revolution led to different
           to cut wages in an economic downturn, partly because somebody has to cut                                stories because it changed what we were doing for a good fraction of our time.
           them first. If I get a wage cut and other people don’t, then I’m very upset.                            More people got computers and spent time searching for something on the
           So there’s a coordination problem. If we could all agree at once to cut wages,                          web. You’d see these new businesses that were populated by young people
           it would be easier, but there doesn’t seem to be any such agreement. So you                             who became millionaires. It made the old story seem worn and outdated. I
           end up laying people off.                                                                               think it encouraged the development of interest in finance and business, and
               In times like the Great Depression, when prices were falling, this really                           encouraged the development of business media outlets, and it ultimately led
           inhibited the labor market, and that was part of the reason for the massive                             to the real estate boom as well.
           unemployment then. In the Depression, you can find references to the                                        It is not entirely logical. It’s all about a story. They make a movie about
           obvious fact that if employers cut wages, workers could still buy as much,                              Superman, and then millions want Superman memorabilia around for their
           because everything was getting cheaper. But that feeling was limited to an                              kids. There’s nothing logical about that. It follows the dictates from the story.
           enlightened few, and many others were mistrustful and cynical, and assumed
           that their employers were trying to take advantage of them.
               Truman Bewley, a professor here in economics, wrote a book titled Why
                                                                                                        Q: You’re saying that the logic of the story shapes people’s expectations. The
           Wages Don’t Fall during a Recession. He interviewed people who set wages and
                                                                                                        story of the internet entrepreneur becomes widespread and all of a sudden you
           salaries in a company, and it really confirmed Keynes’s story: issues of
                                                                                                        have different expectations about what you should be doing next week or next year.
           fairness and morale dominated. You don’t want to do something that
           disrupts the morale of your labor force.
                                                                                                                   And then we try to reinvent ourselves along those lines. I was just talking
                                                                                                                   about Superman. I happened to read that he appears to wear colorful tights.
                                                                                                                   But Superman was invented in the 1930s, and such tights were not available
Q: Could you explain how stories influence animal spirits?                                                         yet, because they hadn’t invented Spandex yet. It was invented in 1959 by
                                                                                                                   Joseph Shivers at DuPont. So what happened was our inventors invented the
           In Animal Spirits, we emphasize the work of Robert Abelson, who wrote                                   sort of clothes, Spandex, that athletes wear now. So the story becomes reality.
           with Roger Schank a series of papers about narrative-based thinking. The
           idea that they pushed forward was that the human brain has certain built-in
           organizational patterns, and one of them is to organize memories around
                                                                                                        Q: And athletes tend to look a little like Superman…
           stories. We build our lives into a story. And I think that each story evolves
           through time, and it ultimately changes our economic behavior — it has to.
                                                                                                                   Somehow, the story became reality. You see bicycles going by, and the riders
               In the boom period of the 1990s, for example, a different story about our
                                                                                                                   look like Superman out there.
           lives developed. It was the internet boom. Why did the boom end up affec-
           ting all of the economy, beyond its direct application in technology? I think
           it had a big psychological impact because it changed people’s assumptions
           about what kind of life they were leading, and it made people worry about
           being left out of the story of the time. The boom was associated with stories
           about entrepreneurial success, and it pushed aside stories of labor solidarity
14	    	       	        	        	        	        	        	       	                       	   Q6	2009	    Robert	J.	Shiller	     	                                                          15
                                                                                                	           What	are	you	thinking?

                                                                                                            be good. Sometimes there’s a conflict between different groups. And
Q: How does putting animal spirits in a primary place in your thinking about the                            sometimes businesspeople don’t like the rules imposed on them. We also have
economy affect your view of the role of government? If the economy functions                                self-regulatory organizations and self-appointed trade groups and the like that
rationally and well on its own, that seems to lead to one view of what government                           impose voluntary rules on their members. That is all part of rule making. It’s part
should do…                                                                                                  of what makes the economy work.

           I think we have to redefine our views. The efficient markets revolution had
           a profound impact on people’s thinking. It led people to think that the                          Q: One criticism I’ve heard is that policymakers are just as flawed and
           government is mostly incompetent and a nuisance. This is one of Milton                           act as irrationally as anyone else.
           Friedman’s legacies, as well — that most of the things a government does
           are veiled attempts to grab something. In his 1962 book Capitalism and                           We all make rules for ourselves. I’m going to exercise every day. Or I’m not
           Freedom, he talks about licensing. You can’t, for example, be a dentist or                       going to eat that whole box of chocolates. And we try to enforce that rule
           any number of things without being licensed. And that usually means pass-                        through some psychological mechanism. As soon as children are put together
           ing an exam to demonstrate competence. Friedman said that, in fact,                              on the playground and they’re playing some game, they’ll make rules. And
           licensing is just a veil for monopoly power. He gave as an example the licens-                   they’ll enforce rules. That’s part of human nature. The regulator doesn’t have
           ing of barbers, and argued there is no need to license barbers because all                       to be smarter than us. I think of it as being like the player in a sports event
           that would happen if we had unlicensed barbers is you’d have one bad haircut                     who may shout at the referee, but ultimately wants the referee there, because
           and you wouldn’t go back. Maybe he’s right about licensing of barbers. But I                     otherwise the game would be intolerable. People would be getting hurt.
           think that they carried it so far that they missed the essence of our economy.                       The criticism is often worse than what you just said. The people who
           The essence of our economy is that we have elaborate rules that make our                         are opposed to regulation tend to have a view that the regulators are not only
           competition work to the benefit of the general public. Otherwise, com-                           not smarter, but that they’re idiots, because they are people who couldn’t make
           petition would be vicious and destructive. And so it’s the rules that matter.                    it in the real world. And I think that is a pernicious view. The regulators I’ve
           The rules have to be complicated, because the regulations that the govern-                       met, who have reached important positions in the government, seem to be
           ment makes have to work around all the complexity of human nature. And                           perfectly thoughtful and intelligent people. I think that’s a place where we
           you have to keep adjusting past structures to create a congenial environment                     want to place some of our graduates, as regulators, and I’m just as proud of
           for entrepreneurship and business.                                                               them as the ones who make huge fortunes.

                                                                                                Learn more about Shiller’s research at
Q: In Animal Spirits you compare government to a parent, who has to be neither
too strict nor too lenient. The metaphor itself seems to put government in a role
of having a lot of influence.

           We maybe shouldn’t have used the parent/child metaphor, because that
           metaphor sounds, well, paternalistic. It’s really setting our own rules as a
           society. There is no parent. The basic truth is that human reproduction
           produces millions of highly competent people, and there is no one who is
           super-competent. Even Einstein — he was asked to be president of Israel
           in 1952 but he turned it down, I suppose because he knew his limits. He’s
           not able to run all of our society. He’s not that smart. That’s the problem.
               So I like to think about regulations of industry and finance as not
           imposed by the government, but chosen by us. The government responds to
           suggestions by people who are doing business as to what kind of rules would
Paris, France (photograph by Ian Berry)
              Q6	2009	   Dialog	                                                            19

What is                  A host of studies and academic theories that
                          apply psychological insights to economic

                          behavior have been grouped under the label
                         “behavioral.” Is this growing field changing
                          how the economy is studied — and how it

                         Nicholas C. Barberis
                         Stephen and Camille Schramm Professor of Finance, Yale School
                         of Management

                         Ulrike M. Malmendier
                         Associate Professor of Economics, University of California, Berkeley

                         Shane Frederick
                         Associate Professor of Marketing, Yale School of Management

                         Andrew J. Redleaf
                         Founder and CEO, Whitebox Advisors LLC
                         Interview conducted and edited by Jonathan T.F Weisberg
     Q6	2009	     Barberis,	Malmendier,	Frederick,	Redleaf	   	                                      21
     	            What	is	behavioral?

Q: What does “behavioral” mean in                     preferences. What that means is the following:
your field?                                           While we have been working with a certain
                                                      set of preferences and utility functions in
 Nicholas C. Barberis: When I hear the word           traditional economics — typically they involve
“behavioral,” what I think of is trying to un-        the maximization of our own well-being —
 derstand behavior that might be the result of        in reality, people have different preferences.
 less than fully rational thinking. So when we        A famous example is self-control problems.
 talk about behavioral finance, which is my own       People join the gym and plan to go regularly.
 area of interest, we’re trying to understand         That’s why they get a monthly membership,
 whether things that happen in financial mar-         which only pays off if you are actually going
 kets might be the result of less than                regularly. They end up not doing it. There is
 fully rational thinking.                             an inconsistency between their preferences
     Three areas of behavioral finance have re-       about future actions and their preferences
 ceived a lot of attention. One is what I might       when they actually are choosing the action.
 call applications to asset pricing — trying to       The same phenomenon can be observed in
 understand the pricing of stocks, the pricing        finance — people choose a certain means of
 of houses, bubbles in financial markets, and         financing, like a credit card, which is the right
 so on. A second area is investor behavior. For       instrument if you pay everything back at the
 example, we know that many people invest             end of the billing cycle, but then they end
 heavily in the stock of their own company, and       up not doing so. There is this discrepancy
 we think that perhaps that’s not wise from the       between how I want to act from a long-term
 perspective of diversification, and it might be      perspective, and how I do act, which is one
 the result of less than fully rational think-        example of nonstandard preferences. Others
 ing. The third area is corporate finance, where      are social preferences, such as altruism, shame,
 we’re trying to understand whether managers          guilt, conformity.
 of firms do things that might be the result of           Then, as the third deviation, there is what
 less than fully rational thinking. We know, for      people call “failure to optimize” or “failure
 example, that there is a lot of merger and           to maximize.” We don’t have a good term for
 acquisition activity that goes on in the cor-        that third deviation, but what that means is,
 porate sector, but the evidence suggests that        even if an economic agent had the standard
 there’s not a lot of value creation for the ac-      preferences we assume in traditional econom-
 quiring firm. So then why do we see so many          ics and even if he formed rational beliefs, the
 M&A transactions?                                    whole maximization process doesn’t always
                                                      work out perfectly. We sometimes just don’t
Ulrike M. Malmendier: One way to concep-              get it right, not because we are irrational or
tualize deviations from a standard economic           because we have funny preferences, but be-
model is to say that there are three types of         cause we have limited processing capacity or
deviations. The first one is in terms of belief.      limited attention. It’s Friday, and we are plan-
We don’t always form rational beliefs. We             ning our activities for the long weekend.
don’t form the right expectations, given the              Sometimes, even if you’re fully rational
information we have.                                  and have standard preferences, you may not
   The second deviation is nonstandard                act according to standard economic textbooks.

Shane Frederick: In my view, at least, a per-      Q: Do you take behavioral insights and
son or a study is behavioral to the extent that    find advantage in them in practice?
there is an explicit recognition of the distinc-
tion between a formal characterization of          Redleaf: Yes and no. Yes in the sense that if
some choice object and the mental represent-       you’re confronted with something that seems
ation of that object — the idea that people may    anomalous or seems to not make economic
think about the same thing in different ways.      sense, that should create dissonance and you
The same object can yield systematically dif-      should approach with some caution. If you
ferent evaluations by focusing attention on a      can find explanations that make the anomaly
subset of features or by describing the feat-      coherent or understandable, then you can be
ures differently. Everybody who is behavioral      more comfortable. You can have some sense
accepts that, and people who are not behav-        that what you see is a deviation from pure
ioral generally don’t. They want to define the     rationality, and a deviation from where an
object in terms of its formal properties. It has   asset should be priced. In my experience, I’ve
this probability and it has this amount of         done much better on things where I can figure
winning, for example.                              out what I thought people were thinking, and
    In marketing, I think there is really no re-   have a story or an explanation for why it was
sistance to the idea that people are behavioral.   wrong, rather than just having the argument
We know that all light beers are more or less      that it’s wrong without understanding the
indistinguishable. And yet many marketing          genesis of the anomaly.
efforts go toward changing people’s mental
representations of those objects. Marketing        Malmendier: This is parallel to why I find
 — at least a big part of marketing — is behav-    behavioral economics so important. What I
ioral at its core, and has been historically.      really love about behavioral economics is the
                                                   big emphasis on trying to get it right when
Andrew J. Redleaf: Financial markets may be        explaining why humans make decisions. We
the last area that isn’t cognizant that the eco-   are trying to be humble as economists, and
nomy is made up of interactions between hu-        to learn from evidence in psychology about
man beings rather than automatons. In busi-        why people think the way they think and
ness school, when you’re taking the class in       why they are choosing the actions they are
negotiation, they will not tell you to start       choosing, rather than saying, “Our standard
with the assumption that the person across         economic model may not get the psychology

                                                                                                    Ulrike M. Malmendier photographed by Steve Skoll
the table from you is an automaton with a          right, but it predicts what the correct action
predetermined set of instructions, which eith-     is.” No, we really would like to understand
er you can know or anticipate, in trying to        the truth. We would like to go inside the
figure out what’s important to him, how he         black box and be able to ask why a person is
values different trade-offs, and where the         making a certain choice. The benefit is, of
possibilities for a win-win outcome are. On        course, that we will have better predictions
the other hand, if you’re a banker or investor     for new situations.
talking to a CFO about the company’s capital
structure, the presumption is that here is an
automaton running an optimization program.
In a lot of ways, financial markets are either
paradigmatic or completely exceptional.

Q: Nick, what do you think are the
exciting areas in your field right now?
                                                    Frederick: There’s a really interesting study
                                                    about organ donations by Eric Johnson pub-             “ What’s important
                                                                                                             to me is to really try
                                                    lished in Science, where they showed that
Barberis: There are a couple of things that         whether or not people elect to have their
have been in the news quite a lot, and I think      organs donated if they should die in an auto

                                                                                                             to capture the truth
those are indeed some of the exciting things.       accident goes pretty much from 0% to 100% ,
The first is associated with this well-known        depending on whether you are defaulted in
book, Nudge, by Richard Thaler and Cass             as an organ donor or defaulted as a non-
Sunstein. The rough idea there is that, look,       donor. This default setting has as big an eff-

                                                                                                             of what’s driving
people make incorrect decisions sometimes,          ect as you could imagine for one of the more
so can we help them? Can we perhaps nudge           important decisions you could imagine.
them towards making the right decision, but             I don’t think there’s anything in market-

                                                                                                             human thinking and
without actually taking any options away            ing that’s as exciting or as important as that.
from them? Thaler and Sunstein call their           What I do find exciting is the work on the
philosophy “libertarian paternalism.” One           role of metacognitive judgments — for in-

                                                                                                             actions, whether it’s
example is that a lot of people don’t save as       stance, that people form a sense of whether
much as they’d like to for retirement, so one       they are an expert or not based on cues as
specific policy change that was made recently       subtle as the font in which something is print-
was to switch 401(k) plans from opt-in plans,       ed. If the font is unclear or if it’s an atypical or
where the default is that you are not enrolled
and you have to fill out a bunch of forms to
become enrolled, to opt-out, where the default
is that you are enrolled and you have to fill
                                                    unfamiliar font, you get the sense that this is
                                                    hard to process and feel insecure. And from
                                                    that, your choice strategy actually differs.
                                                    You couldn’t imagine, ex ante, that these
                                                                                                             rational or irrational.”
out a bunch of forms to get out of the plan.        subtle changes could have these significant
Now, in a world where everyone is fully ra-         effects. These things are real discoveries,
tional, it shouldn’t make a difference what         so I find that pretty exciting.
the default is. You can just choose whatever
you want. But we know that in the real world,       Q: Thaler says that he thinks marketers
where people have inertia and they procras-         and advertisers have been nudging forever.
tinate, the default really matters. And so we       Does that make sense to you?
might predict that the people who are auto-
matically enrolled will end up saving more          Frederick: I think that’s certainly true. Along
than people who are automatically not en-           with two of my colleagues at Yale, we just
rolled. Studies have demonstrated exactly           published a paper which featured an experi-
that. That simple policy change could have a        ence I had once had in a store. I was buying
real impact on how much people are able to          a stereo, and wasn’t sure which one to buy —
save for retirement.                                the cheaper one for $600 or the more expen-
    And the second thing I’d mention that           sive one for $900. And then the salesperson
has also been in the news a lot, obviously, is      said, “Think of it this way — if you buy the
the financial crisis, the housing bubble. I         $600 stereo, you can have $300 worth of CDs.”
don’t know if I can call the work on this excit-    Suddenly, the choice, which had been very
ing, because it’s still at an early stage, but we   tough, was quite clear. I would buy the cheap-
have an amazing event in history to work on.        er one.
How did this housing bubble form?                       For a neoclassical economist, this makes
                                                  Q6	2009	       Barberis,	Malmendier,	Frederick,	Redleaf	   	                                       27
                                                  	              What	is	behavioral?

                                              no sense whatsoever, because the decision to           have an opt-in savings plan versus an opt-out
                                              buy should go through the concept of op-               savings plan, because I’m nervous about who
                                              portunity costs. Is the opportunity cost to have       decides which is actually optimal. I’m for
                                              the nicer stereo worth it or not? But here’s           heightening awareness of any insights that
                                              somebody who studied decision making for               come out of this line of inquiry, as opposed
                                              a decade, and I just didn’t think of the choice        to explicit use by government.
                                              in that way. Have people been nudging for de-
                                              cades? Yeah, this guy did.                             Q: Why do you think behavioral approaches
                                                                                                     have become more prominent recently?
                                              Malmendier: Given that we’ve shown that
                                              being serious about behavioral insights can            Barberis: By the time we reached the 1990s
                                              make a big difference to important economic            it just became clear that lots of things in fi-
                                              decisions, both firms and policymakers are             nance were hard to explain in a model where
                                              becoming more open to our data demands                 everyone in the economy was rational. I think
                                              and our suggestions. For example, in 25                when the tech-stock bubble came along, peop-
                                              minutes I’m going to be running a behavioral           le were more convinced that we had to find
                                              lunch. One of the projects we’ll discuss is a          an alternative to the rational paradigm, and
                                              weatherization program, which is supposed              that the behavioral finance paradigm seemed
                                              to help more low-income households with                like a very plausible alternative. Now that
                                              insulation and other energy-saving remodel-            we’ve been through the housing bubble, I
                                              ing. Having in mind that people who want               think people are all the more convinced that
                                              to apply for the funding might procrastinate,          this is a very promising direction to explore.
                                              the Department of Energy is open to allow-             The field has also gotten an extra push in the
                                              ing some randomization in how the procedure            past year because of the new administration
                                              is implemented, which will help researchers            in power in Washington. A lot of the econom-
                                              gather good data on the relevance of this              ic advisors to President Obama have actually
                                              behavioral bias and ultimately to improve the          worked on behavioral economics and behav-
                                              process.                                               ioral finance during their academic careers.
                                                                                                         I do want to say one other thing, which is
                                              Redleaf: I have to say, listening to all of this,      about the power of a conceptual advance. If
                                              I find it interesting, but I also feel some trepi-     you talk to people on the street and say, “If
                                              dation. I want the world to be materially and          people are irrationally exuberant, they’re go-
                                              economically better off, and I think the right         ing to push the stock market up, and if they
Andrew Redleaf Photographed by Joe Treleven

                                              use of all of this information is to better al-        are irrationally pessimistic, they’re going to
                                              locate resources. And it seems to have great           push the stock market down,” that sounds
                                              potential there. But I also worry that the insights    very plausible. But when you think about it,
                                              are apt to be taken in policy directions that          it’s not so clear. If irrationally pessimistic
                                              I don’t like and that have the risk of making          people push the stock market down, then there
                                              people worse off. I mean, most of the time,            is a very strong incentive for smart people, for
                                              market imperfection is used as an excuse for           hedge fund managers, for example, to come
                                              government expansion, which is anathema to             in and buy the stock at those bargain prices
                                              people on my side. So I’m made nervous by              and thereby push the stock market back up
                                              people saying you get different results if you         to its correct level. This is sometimes called

the arbitrage argument, and it suggests that      researchers would look at why farmers don’t
irrational people cannot affect the prices        use fertilizers that would increase their in-
of financial assets for a very long period of     come. They thought there must be standard
time. That argument was very convincing to        economic mechanisms at work, such as asym-
academics for decades, and it’s the reason that   metric information about the usefulness of
the rational paradigm was so dominant in          fertilizers, so let’s do an experiment which
universities. What happened in the early          reduces asymmetric information and see
1990s was we realized that this argument          whether that will have an effect. They found
didn’t make sense. Irrational people can affect   very little effect. Once they opened up to the
prices for a significant amount of time, be-      idea of a time-inconsistency problem — if I
cause it’s actually not so easy for hedge fund    give the farmers the money for fertilizers now,
managers to correct mispricing. Hedge fund        they may waste it on going out for drinks or
managers face a lot of risks in correcting mis-   other spending that doesn’t help in the long
pricing and so they may allow mispricings to      term, but if you offer them a commitment de-
survive for quite a long period of time. It was   vice, maybe that makes a difference and they
really that conceptual advance that opened        do actually go for the fertilizer — they found
the gates to more behavioral finance research.    huge effects. And so people in development
                                                  have started to be serious about modeling be-
Malmendier: What I’ve observed over my            havioral traits and incorporating them into
research life — the last five or ten years — is   the design of their field experiments.
a change in the presumption that if you go
outside of the standard models and assump-        Redleaf: It’s an interesting question to what
tions with which we work, you’re giving up        extent the academic belief in efficient markets
all rigor and discipline. This was, of course,    filtered down to the masses, as it were, to inves-
always a very weird argument, if you think        tors — and to what extent that has facilitated
about it, for scientists. We want to understand   bubble behavior and the bubbles that we’ve
what truly drives economic decision making        had in the subprime area. At the cultural level,
and how we can better predict how people          people know to be wary of used car salesmen
will act in the future, not how to squeeze it     and to take what they say with the appropri-
into an existing but possibly wrong model,        ate shakers of salt. On the other hand, even for
just to prove our “rigor.”                        relatively financially unsophisticated people, I
    I would say that ultimately the truth won.    think they have a sense that financial markets
We economists realized that we could only         are different somehow. It’s not just that the
get so far with the assumption of rationality.    practitioners are professionals with profes-
And we realized that we don’t let hell break      sional codes different than used car salesmen.
loose if we allow for some novel assumption.      I think there’s some sense that financial mar-
If we dare to allow for unconventional but re-    kets get things right. If I can get this loan,
alistic assumptions about human behavior,         I must have a reasonable prospect of being
we find that they have a really big impact on     able to pay it back, even if it doesn’t seem to
investment decision making, consumer deci-        add up to me. Because it’s touching finance,
sion making, or firm decision making and          it must be okay. They gave me the loan, after
help us to explain some long-standing puzzles.    all. So apart from explicit fraud on either the
    For instance, in development economics,       lender’s or the borrower’s part, there was a
30	      	         	        	        	        	        	        	        	                       	          Q6	2009	      Barberis,	Malmendier,	Frederick,	Redleaf	   	                                       31
                                                                                                            	             What	is	behavioral?

susceptibility on both sides, given a cultural      is forcing people to give a public rationale for    ence sufficient to justify the extra expendi-         and then analyze it from a behavioral perspective.
understanding of the efficiency of the finan-       their actions.                                      ture? It becomes a much more complicated                 As I said in the beginning, what’s impor-
cial markets. I don’t think behavioral finance                                                          decision and people have a certain distaste           tant to me is to really try to capture the truth
has changed that yet.                               Redleaf: In financial markets, writ large,          for that.                                             of what’s driving human thinking and actions,
                                                    though, I don’t think that behavioral econom-          I love Brian Wansink’s work on anchoring.          whether it’s rational or irrational, standard
Q: Are there ways that behavioral research          ics has had any effect to date. I would guess       He has taken this basic insight that you can          preferences or nonstandard.
is filtering out to have an impact on the           that that would be at least 10 years off.           specify any number and people will anchor
spheres of business and policy?                                                                         on that, and he put up signs saying “limit of 12
                                                   Frederick: I agree that not a lot of ideas have      per customer” for cans of soup. People weren’t
Barberis: One set of people that has been          made it into business. One thing that I’ve           buying 12, they weren’t buying close to 12.
 interested in behavioral finance is the invest-   recognized recently in our field is that there’s     But the faux limit put this notion in people’s
 ment management community. And there are          a lot of attention to one-off behaviors, like        heads that 12 is the reasonable number of cans
 a number of large investment firms out there      whether you can get people to choose option A        of soup that they should buy. And he showed
 that, I would say, fall under the umbrella of     rather than option B by setting up the choice        that you sold significantly more soup in that
 behavioral finance in the sense that they see     set in just such a way in the stylized micro-        case. Some things like that are catching on.
 themselves as systematically exploiting mis-      world of the experiment. The assumption is
 takes made by less sophisticated investors.       that if you can do so, that translates directly to   Malmendier: When I hear that question, I
     An interesting question I have been get-      business. But what I think is often ignored is       immediately reverse it. I get my ideas from
 ting in recent years from investment manag-       that there are downstream effects. Suppose, for      business. For example, I have worked on how
 ers is, okay, we know the ways in which people example, you trick me into buying something             firms design the pricing of goods that chal-
 are less than fully rational. Can you now help    too expensive, say, a dinner, by the way you         lenge consumers’ self-control. Namely, if firms
 us design an investment process that will get     set up the menu. I end up spending $120 on           know that their good is tempting and people
 rid of those errors in our own thinking? I’ll     dinner and wine. Afterward, I might feel bad         will tend to over-consume, firms charge a
 just give you one example that I heard from       about that. And so I have this negative affective    low flat fee and then charge above-market
 a hedge fund manager in New York. He said,        tag associated with the restaurant experience,       costs each time you consume — for instance,
“When my analysts pick a stock, they often set     and I don’t go back there again. While you           each time you use your credit card to borrow
 a target price, as well. So I’m buying a stock at have succeeded in a narrow sense, the bigger         money. If there’s a good that you will un-
 $50 and I expect to sell it when it reaches $65.” message is lost: Was this good for business?         deruse, because it’s something like going to
 What he was finding was, often, when the          It’s not entirely clear.                             the gym, which you hope you will do a lot but
 stock reached $65, his analysts wanted to put         I do think there are some ideas that people      you’re not going to end up doing it, then firms
 on a second-round bet that the stock would        outside the academy are considering more             charge you a whole lot up front and less per
 rise even higher. And he often found that that now. The idea that complexity is bad is catch-          usage. That study was inspired by talking to
 second-round bet didn’t work out. He put it       ing on. We did a field study where we had            health clubs, originally, and later the credit
 down to some kind of overconfidence — hav-        prices for juice that were either all high or a      card industry. I wrote another paper compar-
 ing seen their initial hunch confirmed, these     mixture of high and low. Strict economics            ing how large investors and small investors
 analysts became too confident. To try to solve would say it’s a pretty clear knife-edge predic-        react to analysts’ recommendations. People
 this problem, he instituted a policy where ev-    tion what’s going to happen: You should sell         often under-appreciate incentive misalign-
 ery time an analyst in his firm wanted to raise   more in the second case. At least for awhile,        ment, so, small investors don’t understand
 the target price, they had to send an email       we sold less. Psychologically you can sort of        that analysts tend to exaggerate recommenda-
 to everyone in the firm explaining why. This      see why. The decision becomes very complex           tions — a hold recommendation really means
 removed the problem. Indeed, he was just us-      with multiple prices. It’s not just a question       sell, buy means hold, et cetera. That idea was
 ing a well-known technique in the psychology of which is my favorite fruit juice, it’s which           already out there. Very often, as an academic,
 literature for de-biasing overconfidence, which is my favorite and is the intensity of my prefer-      I learn from what’s done in the business world
São Paulo, Brazil (photograph by Stuart Franklin)
Q6	2009	   Dialog	                                                         35

           Do you need
           a nudge?
           Richard Thaler outlines how principles
           from behavioral economics can help
           policymakers — and managers — achieve
           better outcomes.

           Richard H.Thaler
           Ralph and Dorothy Keller Distinguished Service Professor of
           Behavioral Science and Economics, University of Chicago Booth
           School of Business
           Interview conducted and edited by Ted O’Callahan
           Photograph by Matthew Gilson
36	       	        	        	        	         	        	        	         	                  	   Q6	2009	    Richard	H.	Thaler	      	                                                        37
                                                                                                  	           Do	you	need	a	nudge?

 Q: Could you explain some of the key          Q: Could you give some examples of                       Q: How is it that nudges haven’t been you want to repeal the inheritance tax,
 ideas in Nudge: nudges, choice archi-         where nudges have influence?                             the norm all along?                            it’s very smart to call it a death tax.
 tecture, and libertarian paternalism?         Probably the areas that have received the                They are the norm. We’ve been nudged for-
“Libertarian paternalism” suggests that        most attention so far are savings and                    ever. Eve and the serpent nudged Adam.         Q: How do defaults get set poorly in
 these two seemingly contradictory terms       investment. The simplest example of a                    Religions have been nudging us for thou-       the first place?
 can actually define a non-contradictory       successful nudge is the default option. A                sands of years. Marketers nudge us.            The status quo is typically the default.
 and attractive policy alternative. By         default option is simply what happens if                 Ads are nudges. We can be nudged for           And the choice architect typically doesn’t
“libertarian” we simply mean respect-          you do nothing. Normally, nothing hap-                   good or for evil. There is a company we        think very carefully about this. Let me
 ing people’s right to choose, whenever        pens, but sometimes even when you do                     talk about in the book that pipes the          give you an example. In most companies
 possible. And by “paternalism” we mean        nothing, something happens. So while                     sweet-smelling aroma of their extremely        now, there is a period of open enroll-
 caring about the outcomes for people,         I’m sitting here talking to you, if I do                 fattening cinnamon buns out into the           ment, typically in November, where you
 as judged by themselves. So we would          nothing on my computer long enough,                      hall, which acts a bit like the sirens in The  get to rethink your benefit package. And
 like to create environments where people      pretty soon the screen saver will come                   Odyssey in terms of drawing people in.         at least at the University of Chicago,
 are more likely to choose things that         on. How long it is until that happens was                    We don’t claim to have invented nudges. you’re required to do this online. Of
 they, themselves, think are good for them.    itself a default option that came with my                What we are suggesting is that in lots         course, some people are going to forget.
     Now, the person who is in charge of       computer that I never changed. What we                   of domains, people aren’t thinking about       And the choice architect has to decide
 that choice environment is somebody           know is that default options are extreme-                them as much as they should be. Mar-           what to do with the people who forget.
 we call a “choice architect.” There are       ly powerful. Many people just go with                    keters do think about them, but econo-         Now, typically there are two options to
 choice architects in virtually every en-      the flow and take whatever the default is.               mists are often in charge of many aspects      consider. I call them “same as last year”
 vironment. When a professor teaches a         That means that the choice architect has                 of public policy and they could think          and “back to zero.” For your healthcare
 course, he is the choice architect. When      immense power by choosing the default,                   about them more.                               plan, back to zero is pretty harsh. So
 somebody puts this magazine together,         sometimes knowingly and sometimes                            In the book we distinguish between         most places go with “same as last year.”
 they will decide in what order the articles   unknowingly.                                             two types of creatures: humans and Econs. But for flexible spending accounts, where
 appear and what illustrations and photos          A good example is in the area of pen-                Humans are the people we interact with         you lose that money if you don’t spend
 accompany them that may or may not            sion policy. In many 401(k) plans, the                   every day, and Econs are these strange         it, many places say, well, I don’t want to
 attract people’s attention. That’s a good     default option is not to join. If you are                creatures only found in economics text-        presume that people want to put money
 example, because people are free to throw     going to join, you have to fill out some pa-             books that are unemotional, really smart,      away since they would lose it if they
 the magazine away. They are free to read      perwork. Some companies have tried the                   and never have self-control problems. If       don’t spend it, so we’ll make that one
 whatever they want, but the magazine          opposite default, which is that you are                  you want to design policies that will         “back to zero.”
 designer will have some influence on          enrolled unless you fill out some paper-                 work, you want to design them for hu-              Now, at Chicago I had scheduled a
 which articles they read, and in which        work. We know that speeds enrollment                     mans unless you live in a world of Econs, meeting to talk to some of the top admin-
 order. And what we know is that all           greatly and doesn’t really cost anything.                which, if you do, you have my sympathy.        istrators at the university about chang-
 kinds of small things, like whether there     Shlomo Benartzi and I have added to                          A simple example of a nudge in the         ing the default on the supplemental
 is an illustration that accompanies an        that a policy called Save More Tomorrow,                 politics domain is the brilliant strategy of   savings account where you could put in
 article, will influence whether people        where people are invited to join a plan in               the Republicans to rename the inheri-          money on top of the usual pension. The
 read that article. And those small things     which they agree to increase their savings               tance tax the “death tax.” Polls show that     default was “back to zero,” and I was sug-
 are what we call “nudges.” So a nudge         contribution every time they get a raise.                a majority of Americans are opposed to         gesting changing it to “same as last year.”
 is any small feature of the environment       That’s another good example of libertar-                 the death tax and in favor of an inheri-       It turned out that that meeting occurred
 that attracts people’s attention and alters   ian paternalistic policy. No one is forced               tance tax. Econs would know that the           on, just by coincidence, the last day that
 their behavior but does so in a way that      to join it. People sign up of their own free             death tax and the inheritance tax are          people had to log on and re-enroll, and
 doesn’t compel.                               will, but in the first company where we did              the same thing. But humans might be in         none of the people at the meeting had
                                               this we more than tripled savings rates.                 favor of one and against the other. So if      yet done that. And that made my case
                                                                                                                                                       extremely easy.
                       Q6	2009	    Richard	H.	Thaler	      	                                                           39
                       	           Do	you	need	a	nudge?

“Government has              Q: In some cases, when there is an ef-
                             fort to switch the default, there’s resis-
                                                                           as minor. There is a nice example, I
                                                                           think, in some research that we mention

 to make decisions.
                             tance. What can cause that?                   in Nudge. If you tell people on their elec-
                             Most of the time, you change the default      tricity bill how much energy they are us-
                             and nobody notices. There can be some         ing compared to their neighbors — and
                             special circumstances in which people get     there’s a company called Positive Energy

 They have to nudge.         their backs up. Maybe a good example
                             of that is organ donation. In the U.S., the
                             default is that unless you do something,
                                                                           that has been doing this — you can
                                                                           reduce energy utilization by something
                                                                           between 2% and 6%. Now that sounds

 So why not do it
                             your organs will not be made available if     like not a very big deal. But if you think
                             you die in an automobile accident or some     about it, these messages cost nothing.
                             such. Some of the European countries have     You have to send out electricity bills any-

 effectively and
                             the opposite default — what they call pre-    way. If by changing the information you
                             sumed consent, so you are presumed to         put on the bill, you reduce energy use
                             give your consent unless you choose other-    by 2% to 6%, why in the world wouldn’t

                             wise. There have been attempts to switch to   we do it? If we can come up with 100 of
                             that presumed consent in some countries,      those ideas, we can have a significant im-
                             most recently in the UK, and that was         pact on the climate.
                             met with resistance, in particular from the
                             Muslim community. Illinois has adopted        Q: People seem to have a hard time
                             my favorite solution to this problem, and     making decisions that don’t give feed-
                             it’s a neat little compromise which is        back for a long time. How do nudges
                             called mandated choice. When you go to re-    address these long-term issues?
                             new your driver’s license and get a new       The solution to all such problems is to re-
                             picture, which you have to do periodically,   ward short-term behavior. So going back
                             they simply ask, do you want to be a do-      to the previous example, it turns out that
                             nor or not? You must answer that question.    if they put a little smiley face on the bill if
                             They won’t hand you your license until        you’re using less power than your neigh-
                             you say yes or no. And about half the         bors, that helps. In some places, they
                             people say yes. And that, as near as I can    let owners of hybrids use the carpool
                             tell, has met with exactly zero resistance.   lanes on the highway. Maybe you’ll get
                                                                           somebody who doesn’t really care about
                             Q: And does that increase the number          the environment but cares about getting
                             of donors?                                    somewhere on time to switch from a gas-
                             Yes, because it is easy and people are re-    guzzler to a Prius. That’s going to help. I
                             minded that right now is a good time to       don’t care what motivations they have if
                             do this.                                      we can get the right outcome.

                             Q: Nudges can appear very small and           Q: Who decides what the best out-
                             straightforward, yet, played out on a         come is?
                             big scale, they become significant.           Well, there’s the question. Clearly it’s
                             I think that’s right. Because the manipula-   not Richard Thaler and Cass Sunstein.
                             tions can be small, people think of them      One criticism I frequently hear is that we
40	      	         	        	         	          	        	        	        	                   	   Q6	2009	    Richard	H.	Thaler	      	                                         41
                                                                                                    	           Do	you	need	a	nudge?

think we know what’s best for people             I think that can be a problem, and one                   own choices, and that’s the essence of lib-
and this is elitist thinking. I think in         possible solution is what we call struc-                 ertarian paternalism.
many situations, it is pretty easy for the       tured choice. Let’s go back to 401(k)
choice architect to have a good idea what        plans. When they first came in, they                     Q: Is there research behind this? Do
choices people would really prefer. I think if   only had about half a dozen options.                     we perform better if we have a sense
we go back to default options in the open        And choices were pretty easy. But then                   of freedom and choice?
enrollment period, do we think that              a subset of employees would lobby for                    I’m not sure we can give a satisfactory
people who forget to enroll are going to         the fund that invests in Slavic tech funds,              answer to that, but I think most of us
want no healthcare? Probably not. So it’s        and so on and so forth, and now plans                    would prefer to live in such a society. I
not that we think we know what’s best            have 100 options. And the research                       also think it’s pragmatic in the sense
for them. It’s that we have a pretty good        shows that with more options, people                     that maybe I want lots of wine options
idea of what they would want the default         are slower to join.                                      because I know something about wine,
to be if they were the choice architect.             So what’s the solution to that? One                  but I want somebody else to help me pick
Sure, there may be some tough cases,             would be to reduce the number of                         a computer. We don’t want a one-size-
but I think most of us would rather be           choices, which we don’t like. We prefer                  fits-all solution to any kind of problem.
healthier. We’d rather have our kids             to start out with a good default fund
be well educated. We would rather not            and say to somebody that’s joining the                   Q: What can managers take from
starve in retirement. We would rather not        plan, okay, there’s lots of choices here,                this work?
wake up some morning and have our mort-          but if you don’t want to make a decision,                Managers are choice architects. They
gage doubled because of some term that           here’s a default investment strategy that                need to structure environments to im-
was buried in the fine print. So I think         some experts think might work for you.                   prove behavior. It shouldn’t be surpris-
we can make a lot of progress without            It might be what they call a target date                 ing that many of the traders who took
much controversy. And there will be a few        fund, so the fund will change your asset                 down companies were doing what they
cases where it’s harder, and that’s what         allocation as you age. Would you like                    were doing, because they were getting
the politicians are elected to deal with.        that, or would you like to make a more                   paid lots of money while they were
                                                 active decision? If you say you’d like to                doing well, and then could walk away
Q: How do politicians sort out those             make a more active decision, then maybe                  when it blew up. There is a famous old
hard cases amid conflicting interests?           the second stage would be a choice be-                   paper in organizational behavior: “On
It’s difficult. I want to emphasize that we      tween aggressive or conservative target-                 the Folly of Rewarding A, While Hop-
don’t envision a larger role for govern-         date funds. Would you like to pick one of                ing for B.” If a manager understands be-
ment. Government has to make deci-               those? No? Okay, here are all 100 funds.                 havioral economics, she will not be able
sions. They have to nudge. So why not            Go for it. Have fun. I think that that’s the             to change her employees into Econs, but
do it effectively and transparently? And         way to handle this. We wouldn’t want                     she will be able to mitigate some of the
if we don’t like the way the government          the government to say there should                       biases through clever choice architecture.
is doing it, then throw the bums out and         only be three funds.
elect somebody who will do a better job.             I think the nudge philosophy is prag-
                                                                                                    Read more from Richard Thaler on the development of behavioral economics at
                                                 matic, and it says that in some sense we
Q: Could you talk a bit about choice?            can get the best of all worlds. We can
Some research suggests too much                  make it easy for neophytes to get some-
choice can be problematic, but the               thing reasonable. At the same time we
libertarian aspect of nudging is all             can make it possible for sophisticated
about making choice available as                 investors — or those who wrongly think
often as possible.                               they’re sophisticated — to make their
Tokyo, Japan (photograph by Chris Steele-Perkins)
Q6	2009	   Vignette	                                  45

           What does
           a choice look

           A number of economists, psychologists,
           and neuroscientists are using imaging
           studies to peek at the brain in action —
           trying to better understand why we
           make some of the choices we do.
           By Ted O’Callahan

The sealed and soundproofed room could be a recording studio. It            Our neural
                                                                            architecture comes
is windowless except for a plate-glass panel looking into a control
booth. But rather than recording albums in this basement lab on the
Princeton University campus, a team of scientists is recording brains

                                                                            out of millions
making decisions. Cords and cables snake in and out of a multi-mil-
lion-dollar, liquid-helium-cooled MRI machine. A graduate student
volunteer is fed into the mouth of the machine with the aim of gain-

                                                                            of years of evolution;
ing insight into a troubling modern problem: how, despite our best
intentions, we end up watching too much TV.
    For two hours, the subject remains strapped to the bed of the
MRI. He is shown previews of Saturday Night Live sketches; he can
choose to watch the sketches, but for each one he selects in the
                                                                            what now appear
                                                                            to be irrational
first hour, he will have a period of silence one and a half times as
long during the second hour. Headphones pipe in the soundtrack
and muffle the firing of the machine, which sounds like a jack ham-

                                                                            behaviors might
mer striking concrete at a carefully calibrated 17 times a second. In
the control booth, monitors show a 3-D image of the subject’s brain.
    This is a functional MRI (fMRI) study: in addition to showing the

                                                                            have made perfect
anatomy of the brain, the scanners collect data on activity in the
brain as the subject makes decisions. When neurons fire, they need
oxygenated blood. The blood rushing to those neurons shows up

                                                                            sense in other
on the fMRI. Correlating the flow of blood with the moment the sub-
ject presses a button to play a sketch may help tease out how the
prefrontal cortex, a reasoning part of the brain, negotiates with the

nucleus accumbens, a region which is responsive to immediate
gratification. Fundamentally, this experiment is aimed at increasing
our understanding of choice, which, in the eyes of some, makes it an
economics experiment, or more precisely, a neuroeconomics experiment.
    A small group of economists are trying to peek inside the black
box of the brain. For years economists have tried to understand de-
cision making by using theory, constructing complex mathematical
models, and mining data sets from real economic interactions. So
how could mapping blood moving through the brain add to this
work? “There are some economists who say brain data is just out-
side the domain of economics,” says David Laibson, a professor of
economics at Harvard University and one of the researchers working
48	    	       	       	       	       	       	       	       	          	   Q6	2009	   What	does	a	choice	look	like?	                                      49

on the Saturday Night Live study. “Economists have a very spare                             In most circumstances, when there is a purely rational choice to
framework for understanding human behavior. The framework is op-                         be made, the appropriate region of the brain takes the lead making
timization. And that is a wonderful tool for understanding most eco-                     that choice. And when you touch a scalding object, a different, in-
nomic behavior, but there is a lot of economic behavior that deviates                    stinctive part of the brain takes over: there is no listing of pros and
from full optimization.” Laibson doesn’t want to abandon economics                       cons before you pull your hand away. But in some situations, what
as it has been done but neither does he want to exclude potentially                      region of the brain should be taking charge is not as clear. Neuro-
useful information.                                                                      economists are very curious about how our brain negotiates those
    “What has been and will be successful in economics are elegant,                      situations that aren’t black or white. But understanding the brain,
powerful mathematical models that explain the world and success-                         whether at the level of interactions among specialized regions or the
fully predict what will happen next,” Laibson says. “What has                            level of a single neurotransmitter, is in no way simple. Human brains
changed is the presumption that the good models will be perfectly                        have 100 billion neurons, and each makes contact with about a
rational and free of psychological mechanisms.” He adds, “More                           thousand others, creating more potential pathways for connections
and more economists are saying even though choice is the preemi-                         than there are stars in our galaxy.
nent object of analysis we’re interested in, to the extent they help us                     Though neuroeconomics is perhaps a decade old, it is generat-
better understand choices, the underlying mechanisms that effect                         ing a tremendous amount of new information in forms that econo-
economic behavior belong in the economic models.” And the activ-                         mists don’t typically deal with. Some neuroeconomics looks at the
ity in the brain in the seconds leading up to a decision may be the                      molecular level, where the biochemistry of trust, which spills into the
ultimate underlying mechanism.                                                           world as the social cooperation at the foundation of every financial
    Jonathan Cohen, a professor of psychology at Princeton Univer-                       transaction, appears to be controlled by oxytocin and the dopamine
sity and co-director of the Princeton Neuroscience Institute, is work-                   system seems to be a fastidious bean counter tracking rewards. Ani-
ing with Laibson. Cohen says psychology and neuroscience have                            mal studies record the sound of a single neuron firing. Then there
traditionally been heavily experimental, but he shares an econo-                         are eye-tracking studies, and an alphabet soup of fMRI, TMS, PET,
mist’s presumption of optimization, with a caveat. Our neural archi-                     EEG, and MEG data.
tecture comes out of millions of years of evolution; what now appear                        Camelia Kuhnen, a professor of finance at the Kellogg School of
to be irrational behaviors might have made perfect sense in other                        Management, has correlated risk profiles from neuroeconomic stud-
environments. For example, people have a difficult time saving                           ies with genetic markers and found that two genes may predict a
enough for retirement. They seem to irrationally value the present                       great deal about our risk tolerance or aversion. She quickly cautions
over the future. “When we were lizards there were no bank accounts,                      that “genetic factors only account for about 30% of the variation
there were no refrigerators, and there were no property rights, so                       across people in how much financial risk they take. The other 70%
there was no future. There was just what you had right now. We de-                       comes from non-genetic factors like culture, education, and experi-
veloped steep discount rates — use it or lose it,” Cohen says. “Over                     ence in the marketplace.” Parsing the roles of nature and nurture in
the course of evolution we ended up developing, as humans, a part                        financial behavior could help both individuals and policymakers.
of our brain, the prefrontal cortex, that knows how to think about the                      Neuroeconomics may help resolve the information inefficiencies
future. I would contend that it is the very part of the brain that gave                  and fairness issues that have made economically optimal decisions
us things like bank accounts and refrigerators and property rights. It                   about public goods impossible. Whether the public good is national
created a world in which there was a future.”                                            defense, clean air, or a town swimming pool, because everyone can
                      Q6	2009	   What	does	a	choice	look	like?	                                        51

Human brains                     share the benefits equally, each person has an incentive to under-

have more potential
                                 state its value to him or her, in order to minimize his or her contribu-
                                 tion toward funding it. This leaves leaders without accurate informa-
                                 tion. Antonio Rangel, an economist at Caltech, led an experiment in

pathways for                     which a group of volunteers assigned values to a mock public good
                                 while being scanned in an fMRI machine. Knowing that all of the

connections than
                                 participants’ valuations would be corroborated with fMRI scans,
                                 each person gave very accurate information, eliminating the “free
                                 rider problem.”

there are stars in
                                    Though the technology is expensive and the applications largely
                                 experimental right now, Rangel looks into the future, imagining how

our galaxy.
                                 this approach could be used to address a variety of problems. He
                                 speculates that a technology that provided ongoing neural feedback
                                 might let people making decisions with high uncertainty in high
                                 pressure environments, such as a financial trader or a commander
                                 on a battlefield, correct bad decisions before they are implemented.
                                    The promise of neuroscience makes him willing to do exploratory
                                 work that may straddle disciplines awkwardly for a time. “I believe
                                 strongly that neuroscience is reaching a critical point with a set of
                                 tools and a set of theories that are allowing us to test for the first
                                 time the basis of human nature in a number of domains, especially
                                 how we make decisions. And I think over the next couple of de-
                                 cades that is going to fundamentally change how the world under-
                                 stands what a human being is,” Rangel says. “At the same time, it is
                                 not obvious at all how this is going to change the way economics is
                                 done on a day to day basis.”
                                    The mix of excitement and uncertainty is common among those
                                 working in the field of neuroeconomics. Laibson says, “In the long
                                 run, it is going to be a very, very useful body of work. In the short
                                 run, it is impossible to tell whether anything we have done to date
                                 will have merit as insights unfold over the next 20 years.”
Paris, France (photograph by Patrick Zachmann)
                 Q6	2009	   Dialog	                                                     55

Can behavioral              Economics has long been used to evaluate
                            the law. But what happens when economics

                            gets things wrong? Law professor
                            Christine Jolls describes the role behavioral
                            economics can play.

improve law?

                            Christine Jolls
                            Gordon Bradford Tweedy Professor of Law and Organization,
                            Yale Law School
                            Interview conducted via email by Ted O’Callahan
56	    	       	        	        	        	        	        	        	           	       Q6	2009	       Christine	Jolls	 	                                                57
                                                                                         	              Can	behavioral	economics	improve	law?

Q: How has economics influenced law and what impact is behavioral                                   human behavior. Naturally, this approach carries strong poten-
economics having?                                                                                   tial to improve the predictive power of law and economics, and
                                                                                                    the success of behavioral law and economics in recent years
           Most people would agree that to decide if a particular law is
                                                                                                    has borne out this hope.
           good or bad, one important factor is the effects of the law. Eco-
                                                                                                          A simple example comes from employment law. Some
           nomics has long provided a powerful tool for analyzing a law’s
                                                                                                    critics of laws requiring specific workplace safety measures
           effects. Imagine a major new piece of legislation that provides a
                                                                                                    say that such laws are objectionably “paternalistic” and that
           range of protections to employees. Economics can help both to
                                                                                                    it should be enough to warn workers of the risks of an unsafe
           predict and to test empirically how these protections may affect
                                                                                                    workplace. Behavioral economics suggests that warnings will
           employees’ treatment on the job, their wages, and their chances
                                                                                                    lead some workers to underestimate their own personal risks
           of being hired and fired. Knowing those things helps to deter-
                                                                                                    and, thus, accept jobs that they actually would not want to take
           mine whether the new legislation is having its desired effects.
                                                                                                    if they didn’t erroneously assume — like the business school
           Law and economics is the field that uses economic analysis to
                                                                                                    students — that they would all prove to be “above average.”
           study the effects and desirability of legal rules.
                                                                                                          While this example is straightforward, my research has
                But sometimes economic theory mispredicts the effects
                                                                                                    explored many diverse aspects of the relationship between
           of law. This happens because traditional economics relies on
                                                                                                    employment law and behavioral economics.
           highly unrealistic assumptions about human behavior. If a risk
           facing individuals is 1%, economic theory assumes that people
           will use the 1% figure in making their decisions. In fact, a large
                                                                                     Q: How does less-than-rational behavior in the legal process affect
           body of evidence suggests that most people will tend to think
                                                                                     lawyers, defendants, judges, legislators, etc.?
           that their personal risk is far less than 1%. A wonderful illustra-
           tion of “unrealistic optimism” from the business school environ-                         A large body of research in behavioral law and economics
           ment is a study that asks MBA students to predict their perfor-                          explores this question. An important example is the effect of
           mance in a class before the term begins. Students select the                             hindsight bias in the legal system. People tend to give far too
           decile in which they believe their performance will fall. Neces-                         much weight to outcomes of uncertain events when analyzing
           sarily only 20% of the class can be in the top two deciles, but in                       those events after the fact — a phenomenon common enough
           fact most students believe they will be in these top two deciles.                        in sports to have a name: “Monday morning quarterbacking.”
           Less than 5% of the class expects to perform below the median,                           Hundreds of empirical studies demonstrate the extent of the
           where necessarily 50% of the students must fall. And it’s not just                       hindsight bias, and it’s of particular importance to the court sys-
           the students: 94% of professors at one university rated them-                            tem because judges and juries are almost entirely in the busi-
           selves as above average.                                                                 ness of assessing situations after the fact. Various measures
                If most people living under a particular legal rule — say,                          can be, and in many instances have been, adopted to reduce
           a rule requiring a warning statement describing the risks of a                           “Monday morning quarterbacking” within the legal system. For
           product — will tend to assume, as a result of their unrealistic                          instance, sometimes it is possible to keep information about
           optimism, that the risks are much lower for them personally,                             how a situation ended up unfolding out of the hands of jurors,
           then the legal rule will not have the effects that traditional eco-                      thus forcing them to confront the same uncertain decision that
           nomic theory would predict.                                                              the defendant in the lawsuit faced.
                Behavioral law and economics seeks to modify traditional
           law and economics by incorporating the growing body of em-
           pirical evidence on the biases and confusions that often afflict
                           Q6	2009	       Christine	Jolls	 	                                             59
                           	              Can	behavioral	economics	improve	law?

“ Behavioral law and
                       Q: How has behavioral economics affected your thinking about antidis-
                       crimination laws? How do the law and legal theory work through issues
                       of implicit bias?

 economics seeks                      This is, to me, one of the most exciting areas of behavioral law
                                      and economics today. Just as people may misestimate the

 to incorporate the
                                      probability of a harm because of unrealistic optimism or hind-
                                      sight bias, they may misestimate the risk of poor performance
                                      by an employee who comes from a traditionally disadvantaged

 growing body of
                                      racial group. The employer is not “prejudiced” against the
                                      employee in the traditional sense; instead, the employer simply
                                      undersells the employee’s abilities as a factual matter. The em-

 empirical evidence
                                      ployer has no awareness of treating members of the traditionally
                                      disadvantaged racial group any differently and in fact might be
                                      horrified to learn of such behavior. In response to this sort of

 on the biases and
                                      “implicit racial bias,” my research suggests the ways in which
                                      antidiscrimination law might, and to some degree already does,
                                      seek to reduce the level of implicit bias.

 confusions that
 often afflict human
              Q6	2009	   Dialog	                                          61

Are we good              Do the choices we make as consumers
                         serve our economic interests? Do they

at making
                         even reflect our real preferences? Three
                         Yale scholars discuss research — their
                         own and others’ — that sheds light on

choices?                 these questions.

                         Interview conducted and edited by Ben Mattison
                         Photograph by Richard Mosse
                                                                      Judith A. Chevalier
                                                                      William S. Beinecke Professor of Finance and Economics,
                                                                      Yale School of Management

James Choi
Assistant Professor of Finance,
Yale School of Management         M. Keith Chen
                                  Associate Professor of Economics,
                                  Yale School of Management
64	      	        	        	         	        	        	        	         	                      	          Q6	2009	      James	Choi,	M.	Keith	Chen,	Judith	A.	Chevalier	                                 65
                                                                                                            	             Are	we	good	at	making	choices?

James Choi: Over the last ten years I’ve been doing a lot of work on how people make choices            at Tuesday, you hugely discount Wednesday’s gain relative to Tuesday’s pain, and you decide
in retirement savings plans, and whether they appear to be optimizing in the way that we think          not to exercise on Tuesday. You see these choice reversals: when you’re choosing between two
that rational economic agents would. One of the main decisions we make in our financial lives           future periods, you’re relatively willing to delay gratification, but when you’re choosing between
is how much to save. And one of the best ways to save for retirement is a 401(k) plan because it’s      pleasure now versus pleasure in the future, you’re very impatient. This can generate a kind of
tax-advantaged and typically there’s a matching contribution from the employer.                         procrastination, where you delay sacrifice today, thinking that you’ll be more patient tomorrow
    Because this is a high-stakes decision that has major implications for your material well-being     and will get to it then. But in fact when tomorrow rolls around, again, you become impatient and
in retirement, economists have traditionally thought that people would put a lot of thought into        want to push the sacrifice off one more day.
this decision and make it in a sensible way. One feature of sensible decision making is that the           Of course, there are other things that also give the default power. For example, we know that
outcome doesn’t depend on characteristics of the situation that don’t affect its fundamental            there’s something called the endorsement effect, where people believe that a default that the
economics. One such characteristic is what happens when somebody doesn’t act. In traditional            employer has set carries implicit advice about what the right choice is.
economic theory, not acting is, in and of itself, a decision that reveals something about your
preferences. So if I’m passive and as a result don’t get enrolled in my 401(k) plan, then traditional             Judy Chevalier: Especially if they have what you might think of as high cognitive
economic theory would say that I’ve revealed that I don’t want to be in the plan. If you change                   costs for dealing with this particular problem.
the plan so that I’m automatically enrolled unless I opt out, traditional economic theory would
say that the outcome should be exactly the same: I would act so that I still end up not enrolled        Choi: Exactly. There’s some evidence now that people have much better ideas about what a good
in the plan.                                                                                            savings rate is than what a good asset allocation is. You actually see in the data that savings rate
    In fact, what we’ve observed is that when the default is being enrolled in the plan, many more      defaults are less sticky than asset allocation defaults. When you ask people, “What do you think
people — the overwhelming majority — end up enrolling in the plan than if the default is not            the right savings rate for you is?” they give answers that sound pretty sensible if you compare
enrolling. Most automatically enrolled people come into the plan at the default, which might            them to what professional financial advisors would recommend, usually something like 12, 13,
be something like a 6% contribution rate invested in a lifecycle fund. Four years after the initial     14% of income. So I don’t think the primary problem for people is not knowing how much to
automatic enrollment in the plan, about half the people are still at these defaults, which they         save; it’s just that they can’t get themselves to save that much.
would not have chosen if they had to actively opt into the plan.                                            But asset allocation, I think, is completely baffling to most people. This is something that
    A major reason why people get pushed around like this is that they procrastinate. Quite             people have to pick up on their own. Most people have no formal education in asset allocation.
frankly, the cost of delaying action in your retirement plan just one more day is not that large,       And so they’re looking for anything in the environment that’s going to give them clues, and the
and there are all sorts of things that are pressing today that you’d rather be tending to — the         default is one such clue.
kid is screaming, dinner’s not ready, the game is on TV — and thinking about your retirement                Now the problem is that, historically, these defaults were not chosen because the employer
savings plan is something that can wait until tomorrow. Of course, when tomorrow rolls around,          necessarily thought that they were the best choice for people. They were chosen because employers
other issues are pressing and you again choose to delay. Before you know it, a couple of years          did not want to get sued. There was a concern that if employers chose to include stocks in the
have gone by and you haven’t changed from the status quo in your retirement plan. That’s why            default 401(k) asset allocation and then the stock market fell, employers would face litigation
the default is so powerful.                                                                             risk. And so the defaults became very conservative — very low savings rates, typically invested
                                                                                                        in a money-market fund or stable-value fund, which most experts think is not a good idea. But
                  Keith Chen: Do you think that it’s exclusively hyperbolic discounting that’s          the Pension Protection Act of 2006 created a safe harbor where employers could create asset
                  driving this phenomenon?                                                              allocation defaults and contribution rate defaults that are more aggressive and not worry about
                                                                                                        getting sued by their employees.
Choi: I think hyperbolic discounting plays a big role. Let me describe what hyperbolic discount-
ing is. Generally, when economists have modeled inter-temporal choice — that is, choices between                  Chevalier: There’s an interesting question about which kinds of decisions people
two different times — we’ve treated your discount rate as not systematically depending on how                     are good at making, and which they’re not. I have a paper that I wrote with Austan
imminent the earlier time period is. But if you’re a hyperbolic discounter, then the present gets                 Goolsbee, looking at the college textbook market. You might think, these are college
over-weighted relative to the future.                                                                             students, they’re not thinking rationally about these decisions. And I’ve certainly seen
    Say the choice is whether to bear a little pain by exercising on Tuesday for the sake of better               lots of things written about college textbooks that make you think that not everybody
health on Wednesday. On Monday, you feel that this tradeoff between Tuesday and Wednesday                         thinks about the college textbooks market the right way. But what we find in the paper
is a good deal, because Wednesday’s gain doesn’t get discounted so much relative to Tuesday’s                     is that students actually get it right.
pain. So you’re happy to plan on Monday to exercise on Tuesday. But once you actually arrive                              One thing we know about college textbooks is that they tend to be revised every

          few years. When a book is not revised, the student can buy it at the beginning of the        “ Thinking about
          semester and sell it back at the end of the semester, usually for half of the purchase
          price. So, a $100 book will have cost the student $50 in total for the semester if it’s
          sold back at the end. But when a book is revised, the book can’t be sold back. A $100          your retirement
          book costs $100 to use for the semester. In our paper, we look at books in economics,
          psychology, and biology, and we look at student purchasing behavior. And we show
          that the students’ elasticity of demand looks about the same when you compare
                                                                                                         savings plan is
          changes in book prices and changes in the probability that the students are going to be
          able to sell back the used book. So if the book is a new edition, the probability that a
          student is going to be able to sell back the book is really high, and the students appear
                                                                                                         something that can
          in the data to be willing to pay plenty for it, because they are almost certainly going to
          be able to sell it back for half price to the college bookstore. But when the book gets
          close to the end of its expected life, when there is a high risk that they’re not going to
                                                                                                         wait until tomorrow.
          be able to sell it back, then the same $100 looks very expensive, and students are less
          likely to buy it.
                  In general, we find that the students do a pretty good job planning for the
                                                                                                         Of course, when
          future in that market. So what is the set of things about which people do a pretty good
          job? They manage to avoid buying books that they’re not going to be able to sell back;
          why do they do that well, if they don’t invest well in their 401(k) plan?
                                                                                                         tomorrow rolls
                  Training is probably part of the answer. It’s not training by us as their
          professors, but there’s a sort of received wisdom that is more or less right. In the
          example about asset allocation that James gave, it’s not that crazy to think that your
                                                                                                         around, other issues
          employer would set the default in a way that is more or less appropriate for the average
          employee. It turns out that for various institutional reasons that’s a bad assumption.
          But I think that textbooks is an area where there’s this intense cultural training where
                                                                                                         are pressing and
          students pass on this wisdom to each other.
                                                                                                         you again choose
                                                                                                         to delay.”
                 Chen: Maybe another difference between your setting and James’s setting
                 is that in James’s setting, what we’ve seen, if anything, is that the short run
                 feedback may actually push people to make the wrong decision, like when
                 they pay too much attention to short-run fluctuations in the stock market
                 and they push their allocation further toward bonds. And the ultimate feed-
                 back that would push them toward the right decision is far into the future —
                 it’s hypothetical and requires some kind of mental simulation that they can’t
                 really do. Whereas the short-run feedback in your setting actually pushes
                 people toward the right decision.

          Chevalier: Yes, if they blindly purchase their books in their first semester in college
          and they get hammered on the one that they can’t sell back, they won’t make that
          mistake again.
68	      	          	        	         	        	         	        	         	                       	           Q6	2009	      James	Choi,	M.	Keith	Chen,	Judith	A.	Chevalier	                                    69
                                                                                                                 	             Are	we	good	at	making	choices?

Choi: I think the feedback is very important. There is a big difference in the quality of the feed-          five pounds, then I’ll return the money to you. People are generally very reluctant to write those
back. With savings, it is not at all clear whether you’ve made the right asset allocation, ex ante.          kinds of contracts, even though they would like to lose those five pounds.
It’s very easy, ex post, to play Monday morning quarterback and say, oh, I shouldn’t have been in                Of course, self-commitment devices exist in the world. For example, personal trainers are
the stock market in 2008. That’s not a very useful form of feedback when you’re trying to make               arguably a self-commitment device. They provide some know-how, but do I need a personal
asset allocations for the next 30 years of your life.                                                        trainer to tell me to work on the treadmill for 20 minutes at a reasonable pace? Probably not.
                                                                                                             Primarily I think the value is in the commitment to show up three times a week, and if I don’t
                   Chen: There is some new and very exciting work in the animal literature in                show up, then I’m out $100.
                   this area. For example, it’s not a paper of mine, but there’s a new bird paper out
                   where pigeons are pecking levers. These levers are going to pay off in food, and                    Chevalier: There is some literature about the role of educational interventions. I can
                   they are going to pay off in different amounts of food in different amounts of                      really explain to people why they need to save more, but it turns out that it’s not all
                   time. So if the pigeon pecks the left lever, it gets one cup of bird seed in one min-               that effective, I believe. What’s the state of the art on educational interventions?
                   ute. If it pecks the right lever, it gets three cups of bird seed in, say, two minutes.
                   But the levers are mutually exclusive, so once you peck a lever, both levers disappear.   Choi: There is still disagreement, but my view is that education is remarkably ineffective, unless
                       Now what’s interesting is that about two-thirds of the pigeons peck the left          it’s tied to an action that people can take in response to the education immediately. You walk
                   lever when they’re presented with the levers. So the pigeons appear to have an            out of the financial seminar room, go home, and turn on the TV and eat some dinner — at that
                   unusually high discount rate, which is consistent with the behavior that James            point you’ve basically lost it. You need to have some way in the financial seminar itself to push
                   is talking about…                                                                         a button and increase your savings rate while it’s still at the front of your mind. Generally when
                                                                                                             you interview people coming out of these financial seminars, they say that they are going to raise
             Chevalier: The other third of pigeons are the ones that take over the world.                    their savings rate; they’re going to change their asset allocation. You check the administrative
                                                                                                             data afterwards, and they’ve pretty much done nothing.
                   Chen: Right, the other third of the pigeons actually go to the Ivy League
                   schools. And all of the other pigeons are working for them.                                         Chevalier: To get back to the pigeons, are there examples of self-commitment devices
                      But what’s interesting in this new study is: Suppose you take a pigeon — and                     that work?
                   you already trained it in the other settings so it would know that this is what
                   the levers do — suppose you present the pigeons another two levers. And what              Choi: One thing that we have seen in the marketplace is food packages that serve out very small
                   these levers do is prevent that original left lever and the original right lever          portions — cans of soda that are extremely small and hundred-calorie snack packs. Of course,
                   from appearing to you in the future. So you have Left One and Right One. If               the question is whether or not that actually reduces consumption. The way it’s marketed is that
                   you peck Left One, Left Two never shows up. And if you peck Right One, Right              with these smaller package sizes, you commit yourself not to consume too much. And there is
                   Two never shows up. So now the pigeon can decide to make sure that he doesn’t             work by Brian Wansink of Cornell University suggesting that portion size has a large impact in
                   see one of these levers in the future.                                                    how much we end up consuming.
                      And what it turns out is that very quickly, almost every pigeon learns to peck
                   Left One, in some sense to prevent themselves from having the temptation in                                Chen: There’s actually a huge amount of self-control literature in the animal
                   the future of getting the immediate but poor payoff. Now, whether or not the                               literature. Just anecdotally, I see monkeys, when they know that they should
                   pigeons are actively thinking of this as a self-control device or something like                           pull Lever B, but are tempted by Lever A — they’ll sit on their hands or they
                   that is unclear. I think it’s suggestive, but there could be just some very simple                         will turn away or go to the other side of the cage, as far away from Lever A as
                   reinforcement story underlying this.                                                                       they can, and stare into the corner. There’s a lot of self-generated self-control
                                                                                                                              devices that you see.
Choi: There’s an interesting tension between this work and what we see in the market. The
pigeons seem to have a strong demand for self-commitment. And yet when you look at the                       Choi: You would think that technology could lead to more sophisticated and more pervasive
marketplace among humans, we see surprisingly little demand for self-commitment. Suppose                     self-commitment devices. You could program your refrigerator not to open between the hours
you’re trying to lose five pounds, and I offer you a self-commitment contract: you post a $1,000             of 7:30 p.m. and 6:00 a.m. And that could conceivably do a lot to reduce food consumption. But
bond to me, and if you don’t lose your five pounds, then I’ll keep your $1,000. If you lose the              this is not in demand, as far as I can tell.
                      Q6	2009	     James	Choi,	M.	Keith	Chen,	Judith	A.	Chevalier	                                 71
                      	            Are	we	good	at	making	choices?

“People tend to            Chevalier: I wouldn’t want that. I also think that the lack of a commitment device in

 choose things that
                           the marketplace could well be informative about people’s motives. I mean, people don’t
                           want to starve in retirement. We know that to be true. So we feel comfortable imposing
                           on them some of these defaults which are really quite paternalistic. But there may be a

 are going to make
                           lot of people who, if you asked them, would say, yeah, I’d rather be five pounds lighter
                           than I am, but not actually at the expense of not eating. I’d like it if I didn’t want my
                           midnight snack.

 them happier,                    Chen: I have some new research on cognitive dissonance that basically says that
                                  the choices that people make say a lot about what they really want.
                                     There has been a really long psychology literature that claims that the mere

 even though they
                                  act of choosing changes the way we feel about things, because we like to think
                                  of ourselves as people who make good decisions. These experiments ask a
                                  bunch of people to make choices between simple consumer goods. So, which of

 may not be able
                                  these two things would you like to take home with you today? Which of these
                                  posters would you like to take home with you today and hang in your dorm
                                  room? And there has been a really, really long line in the psychology research
                                  that claims that, not only in adults but also in monkeys and in four-year-old

 to express why.”
                                  children and in people who have neural damage and don’t even remember what
                                  choices they make, that the mere act of choosing between CD A and CD B —
                                  say, a Debbie Gibson CD and a Madonna CD — causes people to like the good
                                  that they chose more after making the choice than before.
                                     My research is about how that appears to be slightly true, but not nearly as
                                  much as the psychologists were claiming. In fact, the reason that this literature
                                  has actually been misleading for such a long time is because it hasn’t taken into
                                  account how, on some level, people tend to be very, very careful in the choices
                                  they make, and choose things that are going to make them happier or choose
                                  things that make them better off, even though they may not be able to express
                                  why this will make them happier or make them better off. We may actually be
                                  better about expressing our preferences by making choices about things than
                                  when we try to describe why we think like we do.

                      Learn more about the research of Choi, Chen, and Chevalier at
Sofia, Bulgaria (photograph by Donovan Wylie)
              Q6	2009	   Dialog	                                                            75

Does money               You encounter it every day. You might count it or
                         spend it or wish you had more of it. But can just

change your
                         thinking about money affect your behavior?


                         Kathleen D. Vohs
                         Associate Professor of Marketing, McKnight Land-Grant Professor,
                         and McKnight Presidential Fellow, Carlson School of Management
                         at the University of Minnesota
                         Interview conducted and edited by Ben Mattison
76	     	       	         	        	         	        	         	        	            	   Q6	2009	   Kathleen	D.	Vohs	                                                             77
                                                                                          	          Does	money	change	your	thinking?

You’ve done a series of studies looking at how money affects people                                                     Then they were given either a challenging task or an actu-
psychologically. Why do you think this is an important question?                                                  ally impossible task to perform, and we let them know that they
                                                                                                                  could ask for help. For example, the experimenter would say,
            Money is ubiquitous. The possibilities for psychological effects
                                                                                                                 “I’m right outside if you need anything — if you want any tips
            are innumerable because of the number of times we are ex-
                                                                                                                  or advice or want to know how best to go about the puzzle.” In
            posed to the concept of money. So its frequency in the natural
                                                                                                                  another experiment, we sat a peer in the same room as the
            environment in and of itself makes it important to know about.
                                                                                                                  subject and we said, “She just completed the experiment that
                                                                                                                  you’re doing. I’ll be back in a little while, but if you have any
In one of your studies you tested how money affected people’s willing-                                            questions, you could ask her.”
ness to help others and their desire to get help. How did you test that,                                                In both of those settings, we found that when people were
and what were your results?                                                                                       reminded of money, they were less interested in receiving help
                                                                                                                  from others, suggesting not that money makes people selfish,
            First we exposed the subjects to concepts of money in very subtle
                                                                                                                  but that it makes people self-sufficient, that they are interested
            ways. For example, we would have some Monopoly money on the
                                                                                                                  in performing tasks and goals on their own.
            table on which they were working, or we would have them do
            a word task that involved unscrambling words that made up
            logical phrases, and sometimes those phrases related to money.
                                                                                                     There was another series of experiments that were done in China, on
            Then we gave subjects the opportunity to help someone else. For
                                                                                                     how money affects the perception of pain, both physical pain and the
            example, in one experiment, after the subjects were either remind-
                                                                                                     pain of social rejection.
            ed of money or not, the experimenter would take them across the
            room, when they’re intercepted by another person. That person is                                      In that study, the subjects came into the lab and were ran-
            part of the experiment, but it looks like she is just generally working                               domly assigned to do either one of two what we told them were
            for the laboratory. She is holding in her arms a whole lot of different                              “finger dexterity tasks.” One of the finger dexterity tasks had
            things — papers and pencils, and in particular she has a manila                                       them count out 80 slips of paper and the other one had them
            envelope full of those little tiny golf pencils. She drops the pencils                                count 80 bills of currency — each bill was equivalent to $14 in
            right in front of the subject.                                                                        the United States. Ten minutes later, we brought them into a
                 So the question is how many pencils the subject helps her                                        different room and had them put their hands in either very hot
            pick up. And it turns out that it varies as a function of whether                                     water or only warm water. Subjects who had earlier counted out
            or not they earlier were reminded of money. Subjects who                                              money felt the pain of that hot water as being far less painful —
            were reminded of money were less helpful than subjects not                                            in fact, it looked equivalent, statistically, to their ratings when
            reminded of money.                                                                                    they put their hands in the warm water.

You also found that people ask for help less for themselves.
                                                                                                     You also tested how people would react to social rejection. How did you
            Yes, we designed some experiments to see whether we could                                do that?
            determine whether people were simply being selfish when they
                                                                                                                 We used an online virtual game, where subjects log in and
            were reminded of money, or whether they were what we would
                                                                                                                 meet two other players and the three of them pass a virtual ball
            call self-sufficient — wanting to do things on their own but also
                                                                                                                 back and forth. So you can set up the game such that the other
            wanting other people to do their goals and tasks on their own.
                                                                                                                 two players are playing naturally and inclusively with the subject
            So we engineered a few situations where subjects were either
                                                                                                                 — we call that the normal play condition — or you can rig it so
            reminded about money or not. For example, some of them read
                                                                                                                 that the subject is passed the ball a few times in the beginning
            an essay about what life was like having a lot of money.
                                                                                                                 but then is subsequently ignored by the other two players. The
                                                                                                                 subject spends the rest of the game watching the two players
78	     	       	        	        	        	        	         	        	          	   Q6	2009	   Kathleen	D.	Vohs	                                                              79
                                                                                      	          Does	money	change	your	thinking?

            pass the ball back and forth with no one passing the ball to him                     One thing that struck me about your work is that when you’re testing
            or her. This is a commonly used experimental game, and it’s                          people, they don’t actually own the money. They just have to touch it or
            well known to have these social exclusion effects: people feel                       think about it to feel these effects. Given that there are lots of ways to
            bad and lonely and they feel like no one likes them.                                 get a hold of money without owning it fully — taking out a home-equity
                 So we had the subjects go online and play the game in                           loan, for example — might people think that they are more self-sufficient
            one of those two conditions — either normally or in the social                       than they are, and would that cause them to do things that maybe aren’t
            rejection condition — and then subsequently we said, “How did                        the wisest choices?
            you feel during that game?” And we saw that after subjects had
                                                                                                              That’s where I would go with it as well. I think that that’s exactly
            been counting out money, they weren’t that bothered by being
                                                                                                              right, because you don’t actually need to own that money or be
            socially rejected. The reminders of money seemed to amelio-
                                                                                                              endowed with that money, and yet it has these effects on you. It
            rate social pain as well as physical pain.
                                                                                                              speaks to the power that these effects could have on people in
                                                                                                              their daily decisions. That may be where that linkage to irratio-
                                                                                                              nal decision-making comes in.
Do you connect that with the idea of self-sufficiency?

            I do. A self-sufficient person is going to have the mindset that
            I have to live life on my own and I have to be able to achieve
            whatever goals I want on my own. Being able to withstand pain
            is a big part of that, since you only have yourself to rely on. We
            didn’t say it like that in the paper, but that was what I think the
            connection is.

Much of economics is based around the idea that people respond to
situations in terms of their economic self-interest. If when you introduce
money into the equation, they start to respond in ways that have to do
with these additional factors, does that mean they’re behaving irrationally?

            That’s an interesting question. It’s paradoxical: reminders of
            money might make people less interested in behaving rationally.
            I wouldn’t say that we’ve tested that directly. You could, I sup-
            pose, make the case that people perceiving painful experiences
            as less painful is irrational. But it can be seen as very rational
            when you’re thinking about goal achievement, because goal
            achievement means that you have to overcome some discom-
            fort or inconveniences or displeasure. And so in order to achieve
            your goal, you have to be able to stand pain, broadly defined.
Dublin, Ireland (photograph by Stuart Franklin)
Q6	2009	   Vignette	                             83

           What was
           Polaroid thinking?

           Polaroid went from ubiquity to
           obsolescence as digital photo-
           graphy replaced the print.
           But as early as the 1960s, Polaroid
           had been doing research into
           digital imaging. Did mistaken
           assumptions keep the company
           from making the transition
           to the digital world?
           By Andrea Nagy Smith
           Photograph by Tony Rinaldo
84	    	       	       	       	      	       	       	       	          	   Q6	2009	   What	was	Polaroid	thinking?	                                              85

Polaroid was one of America’s early high-tech success stories.                              First, Polaroid leaders believed that customers would always want
Founded in 1937 by scientist Edwin Land, the company built its                          a hard-copy print. In his 1985 letter to stockholders, CEO I. MacAl-
initial business during the interwar period, prospered as a defense                     lister Booth reasoned,
contractor during World War II, and then found new success as an
                                                                                                 As electronic imaging becomes more prevalent, there
innovator in the post-war boom years.
                                                                                                 remains a basic human need for a permanent visual record.
    In 1948, in response to a question from his young daughter, Land
                                                                                                 Whether that record fulfills an emotional requisite in the
invented a camera that produced finished photographs in minutes.
                                                                                                 visual diaries of amateur photography or provides practical
The invention was an immediate success, and over the next two de-
                                                                                                 data in an industrial or scientific setting, the universal insa-
cades, the instant camera became widely used both in the consum-
                                                                                                 tiable appetite for visual communication and portable infor-
er market and in the business market for such purposes as driver’s
                                                                                                 mation will be constant, reflecting a continuing need for
licenses, crime reports, and real estate advertising.
                                                                                                 instantly available, high-quality print media.
    By the 1960s and early ’70s, Polaroid held a monopoly in the
instant photography market, and its sales accounted for about 20%                       Through the 1990s, Polaroid executives continued to believe in the
of the overall market for film and 15% of the U.S. market for cameras.                  importance of the paper print. Gary DiCamillo, CEO from 1995 to
At its peak the company employed 21,000 people.                                         2001, said in a 2008 interview at Yale, “People were betting on hard
    The basis for the instant camera was a chemical process that                        copy and media that was going to be pick-up-able, visible, seeable,
mimicked the darkroom. However, Polaroid was not unaware of the                         touchable, as a photograph would be.”
progress of electronic imaging; on the contrary, the company was                           When customers abandoned the print, Polaroid was taken by sur-
involved in developments in the field early on. During the mid-1960s,                   prise. “It’s amazing, but kids today don’t want hard copy anymore,”
Polaroid took out some of the first patents on electronic shutters.                     said DiCamillo. “This was the major mistake we all made: Mac
Then in 1981, an official electronic imaging group was set up to de-                    Booth, Gary DiCamillo, people after me…. That was a major hypoth-
velop a “printer in the field,” an instant camera that would produce a                  esis that I believed in my marrow that was wrong.”
film-based print from a digital image.                                                     Even though it performed thorough market research, Polaroid
    By 1989, 42% of Polaroid’s research and development funding was                     was unable to foresee that the photo album would be replaced by
being spent on digital imaging. By the late 1990s Polaroid was a top                    the digital slide show.
seller of digital cameras.                                                                 A related mistaken belief was that the Polaroid Corporation would
    However, the company was unable to capitalize on this success.                      always be able to make money through developments in chemis-
As digital cameras flooded the market, Polaroid began losing some                       try, especially photographic chemistry. In spite of its early research
of its big customers in the real estate, insurance, and photo identi-                   in digital photography, the company culture had a bias against
fication businesses. Film sales plummeted, and in October 2001,                         electronics that went back to the days of Edwin Land. According to
Polaroid filed for bankruptcy.                                                          former vice president Sheldon Bucker, Land was skeptical about in-
    Why was Polaroid unable to make the transition to digital photog-                   vesting in electronics:
raphy? The key may have been some fundamental assumptions that
                                                                                                 From his point of view, instant photography was going to
did not allow top management to adjust to new market realities.
                                                                                                 be his legacy. It was going to last forever. And the idea that
                                                                                                 there was some kind of fancy new technology from the
86	    	       	       	       	       	       	       	      	          	   Q6	2009	   What	was	Polaroid	thinking?	                                          87

       physics side, in contrast to instant photography, which was                      which are produced instantly, can be carried in one lightweight de-
       heavily founded in chemistry, that was going to displace the                     vice. Now that the camera has been joined to the cell phone and
       creation of his genius was not a pleasant thought.                               other handheld devices, it is truly “a continuous partner of most hu-
                                                                                        man beings.” Ironically, the fulfilling of Land’s vision led to the end
Another former Polaroid executive, Hugh MacKenzie, recalled that
                                                                                        of his company.
Polaroid researchers resisted the whole idea of making money on
hardware: “The culture of the leadership was chemistry and media
                                                                               The author of this piece, Andrea Nagy Smith, is a member of the Case Study Research
first. It had little respect for hardware…. They had a considerable
                                                                               and Development team at Yale SOM and also wrote a case about Polaroid that has been
amount of fear from the chemical and film people about what would              used in a class at the school.
their job be if we got into electronics.”
     The sheer profitability of film sales created another obstacle to
thinking about new business models. When sales began to decline,
Polaroid was on the horns of a dilemma. As former CEO DiCamillo

       We knew we needed to change the fan belt, but we couldn’t
       stop the engine. And the reason we couldn’t stop the engine
       was that instant film was the core of the financial model
       of this company. It drove all the economics – not instant
       cameras and not hardware or any other product; it was in-
       stant film…. So we knew that we had to watch the film and
       its rate of decline or erosion, and we had to replace it with
       something that was equally profitable or approximately as
       profitable. And instant film had gross margins well in excess
       of 65%. So if you’re dealing with a media change, how do
       you replace that with something that’s almost or probably
       as profitable as instant film?

When Edwin Land first invented his camera and film, he imagined
that instant photography would change people’s lives. He said that
the camera should “go beyond amusement and record-making to
become a continuous partner of most human beings...a new eye,
and a second memory.”
   Land did not realize how right he was. When he wrote those
words, the camera was a bulky appliance, and the print was stored
in a heavy album. Today the camera and hundreds of images,
Tokyo, Japan (photograph by Stuart Franklin)
                    Q6	2009	     Dialog	                                                      91

Is risk rational?   Misunderstanding of risk was a major factor
                    in the subprime crisis and ensuing recession.
                    Andrew Lo argues that one has to look at both
                    logical and emotional parts of the brain to grasp
                    how people respond to financial risk.

                    Andrew W. Lo
                    Harris & Harris Group Professor of Finance, MIT Sloan School of Manage-
                    ment; Founder and Chief Scientific Officer, AlphaSimplex Group, LLC
                    Interview conducted and edited by Jonathan T.F. Weisberg
92	      	        	         	        	         	        	        	         	                       	        Q6	2009	      Andrew	W.	Lo	                                                                   93
                                                                                                            	             Is	risk	rational?

Q: What is risk? It seems like a multi-              that same circuitry kicks in — increased heart        imposing that deadline. And yet when we are         Q: In one article, you compare a disaster
faceted term, ranging from how I decide              rate, blood pressure, and so forth. While that        overwhelmed by extreme emotional stimulus —         that befell a mountain climbing expedition
to drive down the highway to how hedge               response may be very helpful in protecting us         for example, losing half of your 401(k) plan        on Mt. Hood to what has happened in the
funds are related to banks.                          from physical threats, it’s actually counterproduc-   over the course of three months last year — that    financial system. Could you explain that?
In order to fully understand what’s been going       tive in protecting us from financial threats,         can be extraordinarily traumatizing. The            That was a situation where some very experi-
on in the financial crisis, we need to go back       which are much more subtle and require the use        fight-or-flight response may very well have         enced climbers made what many considered
to basics and define what we mean by risk.           of different parts of the brain, parts that shut      kicked in for a large number of people around       a rookie mistake. And the reason was because
For individuals, risk is anything that they per-     down in the face of extreme emotional stimulus.       the world. And that will lead to potentially        their perception of risk was actually quite a
ceive as threatening their well-being. Threats                                                             unproductive responses.                             bit lower than the reality. We all have mental
come in many different forms, so that risk is,       Q: Is emotion a clouding factor when                                                                      models of the world — all of us, except perhaps
in fact, a multidimensional attribute. We have       you’re thinking about investing?                      Q: It seems like self-interest, which is the        a few fortunate Zen masters. In many cases,
to remember that fact as we start consider-          Yes, extreme emotion is. Recent research in           basis of the rational model, is also at the         those mental models are misleading. Some
ing economic contexts, because individuals           the neurosciences has greatly enhanced our            heart of your emotional response, right?            of us think of ourselves as better athletes
very often will confuse risks to their financial     understanding of the role of emotion. For ex-         Exactly. But when emotion gets out of balance       than we are, or as more attractive than we
wealth with risks to their physical health.          ample, Antonio Damasio at USC has reached             with the logical faculties of our brains, that’s    may be. It’s important to bring these models
That’s perfectly natural, because the decision-      the rather startling conclusion that emotion          when behavior becomes irrational.                   into agreement with reality when discrepan-
making mechanisms that we have developed             is absolutely essential for what we consider to                                                           cies can actually hurt us. Ultimately we do
over thousands of years of evolution don’t           be rational behavior. In his wonderful book           Q: And the rational model of economics              that through the forces of natural selection.
always distinguish between those two. If we          Descartes’ Error, he describes patients who have      doesn’t necessarily take that into account.         We learn by trial and error. In the case of the
begin with that definition, we can start to see      undergone surgeries to remove tumors                  The rational framework of neoclassical eco-         mountain climbers, unfortunately, the error
how it is that behavior ends up going off the        in regions of the brain responsible for emotion,      nomics and the efficient markets hypothesis         was extraordinarily costly in terms of taking
rails in so many different contexts.                 and afterwards these individuals act very ir-         are not completely wrong; they’re simply in-        their lives.
                                                     rationally, focusing on minute and irrelevant         complete. They focus on the behavior of mar-
Q: What kinds of emotional responses do              tasks for hours on end without any concern            kets and economic agents during “normal”            Q: And you see a similar dynamic in the
people have to risk, and when do they be-            for missed deadlines, waiting clients, and            times, during times when there is that proper       build-up to the financial crisis.
come inappropriate in a financial context?           other responsibilities.                               balance between emotion and logical delibera-       Absolutely. The example of the mountain
The first point to make is that humans have              You need a certain degree of emotion to           tion. What the behavioral economists have fo-       climbers is so instructive. Many people are
very elaborate neural systems to address             just get up in the morning and get things             cused on is just the opposite — circumstances       now asking, “How could it be that some of
threats. We didn’t get this far by being passive     done. You’re going to write this article for          where that balance is out of whack and people       the most sophisticated financial institutions
with respect to our environment. But there is        the magazine because there’s a deadline and           act quite irrationally.                             in the world ended up making what now, in
a very important distinction between threats         because you want to achieve something, and                In fact, neither of these schools of thought    retrospect, seem like rookie mistakes, such
in the modern world versus threats on the            if you don’t, you will be suitably embarrassed,       is correct; they are both different halves of the   as taking on too much leverage?” But the fact
plains of the African savanna at the time we         frustrated, and stressed out. All of those reac-      complete picture, which I call the “Adaptive        is, when you’re building a business and the
branched off from chimpanzees and other              tions are emotional responses that help you to        Markets Hypothesis.” In that framework, in-         perceived risks have declined because of years
great apes. In particular, the emotional circuitry   get things accomplished in your life. Imagine         dividuals are simply biological agents that end     of success and prosperity, well, you become
that all of us have as part of our so-called         if all of those emotions suddenly disappeared.        up reacting, adapting, mutating, competing,         complacent about some of those risks in the
mammalian brains kicks in to protect us from             But with too much emotion, we very quick-         and evolving. Instead of focusing on either of      same way that these very experienced moun-
perceived threats. We’ve all heard of the “fight-    ly become overwhelmed and the ancient circuit-        the two extremes of rationality and irrational-     tain climbers figured this was not a very chal-
or-flight” response. That’s probably the most        ry that protects our physical existence kicks         ity, we should acknowledge both aspects of          lenging mountain. It was that false sense of
significant kind of emotional circuitry to be        in. The fight-or-flight response is probably          our behavior and try to understand how and          security and perceived lack of risk that led to
activated when we are threatened. Unfortu-           not an appropriate reaction to your deadline;         why we switch from one mode to the other.           their demise.
nately, when we are faced with threats from          you don’t want to run away from that respon-                                                                  This is not just a metaphor. This is exactly
the modern world, such as financial threats,         sibility, nor do you want to kill your editor for                                                         what happened with those financial market
94	      	         	         	         	        	       	        	        	                       	     Q6	2009	      Andrew	W.	Lo	                                                                   95
                                                                                                        	             Is	risk	rational?

participants who took on too much risk, who          mented a number of new sources of risk that       not about losing money. People have been los-       I think the government has a very big role to
over-leveraged, who became too aggressive            didn’t exist 15 or 20 years ago, largely be-      ing money ever since there has been money.          play, but not in the way that most people have
about building their businesses. They didn’t         cause of the tremendous influx of assets into     The real problem is when the wrong parties          been arguing. I don’t believe that government
think it was all that risky. They actually thought   various exotic trading strategies. One way to     lose money, and by that I mean parties that         can possibly engage in the fine tuning of sys-
that they had been able to deal with those           deal with these complexities is to design more    are not properly prepared for those losses.         temic risk. It’s just not something that we have
risks reasonably well. Unfortunately they            sophisticated tools, in the same way that we      For example, when a hedge fund investor             been able to do in the past, and I don’t see why
were wrong.                                          developed the wheel, the lever, and all of the    loses 50% of her investments, that’s unfortunate,   we’ll be able to do it any better going forward.
                                                     tools that are responsible for the wonderful      but it’s hardly a national tragedy. On the other    For example, the Federal Reserve System was
Q: Can I push the comparison one step                prosperity that we enjoy in modern society.       hand, when a money market fund, a bank, or          set up for addressing bank runs and other
further? The climbers were tied to each                                                                an insurance company loses 50% of its assets,       liquidity crises. Over the last 15 or 20 years,
other, and then they were right above an-            Q: Do you think you’re close to having im-        that’s a major problem, because those institu-      the Federal Reserve has been very active, and
other group, right? All the ties between             proved tools?                                     tions (and their clients) are not prepared for      yet it’s been clear that they were not able to
people and institutions seem important.              Absolutely. In fact, we’ve had them over the      those losses. And it must be the case that          forecast, much less prevent, the current crisis.
Yes, we are all “tied” to each other. In fact,       last five years. In papers that I wrote in 2004   those institutions were either mis-measuring            The financial system today is far too com-
there is an interesting although somewhat            and 2005, my co-authors and I warned about        their risk exposures or, somehow, the risks         plex for any single organization to be able to
morbid phrase that the mountain climbers             the impending crisis, because we actually saw     they were taking were inconsistent with the         address it. One of the biggest challenges is to
use: When you tie yourself to another climber        it in the data using some of these new tools.     risks their clients and counterparties were         develop additional expertise and understand-
and that other climber doesn’t engage in “be-        The New York Times wrote an article in Sep-       expecting. So the first point about dealing         ing for how the financial system imposes sys-
laying,” that is, securing himself to the side of    tember of 2005 where they pointed out that        with crisis is to make sure we have an accurate     temic risks that didn’t exist a decade ago. I’ve
the mountain using pitons, screws, and other         the hedge fund industry was heading for a ma-     measure of the actual risks that investments        called for the establishment of an equivalent
devices, then you’ve entered into a “suicide         jor dislocation, according to our research. And   are providing to their investors, in order to       of a National Transportation Safety Board
pact” with the other climber — your fate is liter-   it was ignored, because, as the former CEO        properly prepare for those risks. You cannot        for financial markets, sort of a Capital Mar-
ally tied to the other climber’s fate. And, in       of Citigroup, Chuck Prince, said, if the music    manage what you do not measure.                     kets Safety Board, whose sole function is to
effect, all of us were tied to the U.S. residen-     is playing, you’ve got to dance. So people            Once we understand exactly what types           investigate financial “accidents” and produce
tial housing market. We just didn’t know it.         continued dancing. Until the music stopped.       and magnitudes of risks we’re facing, it’s actu-    reports detailing the underlying causes. The
                                                                                                       ally not that difficult to prepare for them.        NTSB does not regulate the airline indus-
Q: Is it much easier to overlook the risk in         Q: You run a hedge fund. How do you han-          One cannot legislate away hurricanes, but one       try; all the NTSB does is examine accident
that sort of tie than one that is a threat to        dle risk from the practical end, as opposed       can provide early warning and preparation.          sites, collect the black boxes, sift through
our physical well-being?                             to the theoretical end?                           It turns out that if you provide localities with    the wreckage, and produce publicly available
The financial world that we live in is so much       I think that the tools that we developed are,     just a few hours notice about the impending         reports that describe what happened, how
more complex than even 10 or 15 years ago.           in fact, quite practical. So we practice what     arrival of a hurricane, you can reduce the losses   it happened, why it happened, and how we
Fifteen years ago, the word “subprime” meant         we preach. And so far it has held up well, pre-   from that hurricane by a tremendous amount.         might keep it from happening again. If we
sub-standard beef. The modern world is               cisely because we manage those risks aggres-      Insurance companies have figured this out.          did this for every single financial crisis or
fraught with dangers that our biology is not         sively and dynamically. That’s one of the most    Similarly, if we can properly warn the various      blow-up that occurs, then, over time, we’re
adapted to address naturally. So we have to          exciting aspects of academic finance — some       parties that they are about to get exposed to       going to see common patterns and themes
work at it. We have to engage in research and        of the most esoteric analytics have immediate     major financial dislocations, they can prepare      that will enable us to better prepare for these
development and create technologies to pro-          practical applications.                           for them, and we can reduce the degree of col-      kinds of dislocations. Once we understand
tect ourselves from these kinds of dangers —                                                           lateral damage significantly — pun intended.        better what the underlying mechanisms are
in the same way that mountain climbers use           Q: What are some of your ideas for im-                                                                for these kinds of crises, we can then impose
different technologies like pitons, crampons,        proving how the whole industry responds           Q: The government has ended up being                the appropriate safeguards. We certainly don’t
and synthetic ropes to protect themselves.           to risk?                                          the insurer in the case of the financial hur-       need more regulation; we just need smarter
    In some of the research I’ve done over these     The first point that I’ve made in some of my      ricane. How big a role do you see for the           regulation.
last few years on hedge fund risks, I’ve docu-       writings is that the financial crisis is really   government?
            Fall 2009
         Fall 2009 Fall 2009

         Dialogs Dialogs

     What areare you thinking?
      What you are you thinking?
           What thinking?
     4 4
        Coming in Q7: look like? like?
                   Shiller      look look
         Robert J. Robert J. Shiller
            Robert J. Shiller        like?
                                                44 44
                                                     Vignettes Vignettes

                                                           What a choice
                                                      What does does
                                                     What does a choicea choice

                                                         Neuroeconomists peek peek
                                                     Neuroeconomists peek
        Can we afford sustainability?
             is behavioral?
     What isWhat is behavioral?
    18      18
        Nicholas Barberis, Ulrike M. M.
     Nicholas Nicholas C. Barberis, Ulrike M.
              C. C. Barberis, Ulrike
                                                     inside theinside the brain
                                                         inside the brain                              2009 Fall
                                                                                                  Fall Fall 2009 2009
              Malmendier, Shane Frederick, 82 What was Polaroid
                                                     What was Polaroid
        Malmendier, Shane Frederick, and and82 What was Polaroid
     Malmendier, Shane Frederick, and            82
                                                                                                            M. Oster
                                                                                                  Sharon M.Sharon M. Oster
        Andrew J. Redleaf
     Andrew J. Redleaf Redleaf
             Andrew J.                               thinking?
4 34
         Qn Online:
            need a a nudge?
     DoDo you needneed a nudge?
        you Do younudge?
                                                     How faulty assumptions hampered
                                                               How assumptions hampered
                                                         How faulty faulty assumptions hampered
                                                         company company
                                                     the the company
                                                                                                     Dean Dean and Frederic D. Professor of
                                                                                                           Frederic D. D. Wolfe Wolfe of
                                                                                                  Dean andand FredericWolfe Professor Professor of
                                                                                                  Management andand Entrepreneurship
                                                                                                           Management and Entrepreneurship
                                                                                                     Management Entrepreneurship

         Ongoing discussion of past questions at
            Richard H. Thaler
         Richard H. ThalerH. Thaler                                                                   Elizabeth Stauderman
                                                                                                  Elizabeth Stauderman
                                                                                                             Elizabeth Stauderman
                                                                                                  Associate AssociateCommunications
                                                                                                      Associate Dean for Communications
                                                                                                             Dean for Dean for Communications
                                                                                                       Strategy Strategy
                                                                                                  andand Strategy
       Can behavioral economics
           Can behavioral economics
     Can behavioral economics
4 54        54
       improve law?
     improve law? law?
            Christine Jolls
         Christine Christine Jolls                                                                    Jonathan Weisberg Weisberg
                                                                                                             Jonathan T.F.
                                                                                                  Jonathan T.F. T.F. Weisberg
                                                                                                      Editor Editor

           What’s the new capital up to?
       Are Are we making
            good at at making
     Are wewe goodgood at making
    60 60                                                                                          
     choices?                                                                                         Mattison Mattison
                                                                                                  BenBen Mattison

           Jon Carson ’84, CEO of BiddingFor-
        James Choi, M. Keith Chen, Chen,
              James Choi, M. Keith
     James Choi, M. Keith Chen,                                                                      Managing Editor
                                                                                                  Managing Managing Editor
         Judith A. Judith A.
              and A. Chevalier
     andand JudithChevalier Chevalier                                                      

           Good, and Scott Griffith, CEO of Zipcar,
                                                                                                             Ted O’Callahan
                                                                                                  TedTed O’Callahan
        Does money change your
              Does money your
     Does money change change your
    74      74
                                                                                                      OnlineOnline Editor
                                                                                                  Online Editor

           discuss for-profit social enterprise.
            Kathleen D. Vohs
         Kathleen D. Vohs D. Vohs
                                                                                                     John Zebrowski
                                                                                                  John ZebrowskiZebrowski
0 90          Is risk rational?
        Is risk rational?
     Is risk rational?
            90                                                                                               Staff
                                                                                                     Staff Writer Writer
                                                                                                  Staff Writer

           Where’s the value in globalization?
        Andrew W.
     Andrew W. Lo Lo W. Lo
                                                                                                     Concept design by 2x4 2x4
                                                                                                           Concept and by
                                                                                                  Concept andand designdesign by 2x4

           Princeton philosopher Peter Singer                                                         Office Office of Communications
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           individuals for addressing global poverty.                                                  Qn, a publication ofYale Yale School of Management,
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                                                                                                  Qn, a publicationa publication of the of Management, is is
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                                                                                                       cover photograph by Richard Mosse
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