Misbehaving Chapter 1: Econs vs. Humans

"The core premise of economic theory is that people choose by optimizing. In reality, people are not super-rational calculating machines." — Richard Thaler

The Investment Context

In Misbehaving, Nobel laureate Richard Thaler outlines the history and core concepts of behavioral economics. He begins by attacking the fundamental assumption of classical economics: that the world is populated by "Econs."

An Econ is a fictional, hyper-rational being who perfectly calculates probabilities, feels no emotion, has infinite willpower, and optimizes every financial decision. Thaler points out that the real world is populated by "Humans." Humans are emotional, have limited self-control, and make predictable, irrational mistakes.

The Wall Street Translation

For the investor, understanding the difference between Econs and Humans is the key to both protecting your own portfolio and profiting from the mistakes of others.

1. The Efficient Market Fallacy: The Efficient Market Hypothesis (EMH) assumes the market is driven by Econs. If that were true, bubbles and crashes would not exist. Because the market is driven by Humans, prices constantly deviate from underlying value due to fear, greed, and herd behavior.
2. The Anomaly Checklist: Thaler began his career simply writing down a list of "anomalies"—irrational things Humans do that Econs would never do. For example, driving across town to save $10 on a $20 radio, but refusing to drive across town to save $10 on a $1,000 television. (An Econ knows that $10 is $10).
3. Accepting Your Humanity: The first step to becoming a better investor is dropping the ego and admitting you are a Human. You are susceptible to panic, you will anchor to past prices, and you will hate taking losses.

Actionable Trading Rules

1. Design Your Environment: Because you are Human, do not rely on sheer willpower to avoid bad trades. Build an environment (a trading plan with hard stop-losses and automated contributions) that protects you from your own emotions.
2. Trade the Emotion, Not Just the Math: When a company releases a slightly disappointing earnings report and the stock crashes 30%, ask yourself: "Is this the rational calculation of Econs repricing cash flows, or is this the panic of Humans?"
3. Write Down Your Thesis: Before you buy a stock, write down exactly why you are buying it. Humans have a terrible habit of changing their narrative to justify holding a losing stock. If the original written thesis breaks, sell the stock.