Pod Insights Michael Covel's Trend Following Ep. 1355: Richard Thaler and Alex Imas with Michael Covel on Trend Following Radio About this episode My guests today are Richard Thaler and Alex Imas. Richard Thaler is a theorist in behavioral economics and a professor of Behavioral Science and Economics at the University of Chicago Booth School of Business. In 2017, he was awarded the Nobel Memorial Prize in Economic Sciences for his contributions to behavioral economics. Alex Imas is a professor of Behavioral Science, Economics and Applied AI and a Vasilou Faculty Scholar at the University of Chicago Booth School of Business. He studies behavioral economics with a focus on cognition and mental representation in dynamic decision-making. The topic is their book The Winner's Curse: Behavioral Economics Anomalies, Then and Now. In this episode of Trend Following Radio we discuss: Behavioral economics anomalies and their persistence Trend following, momentum, and mean reversion Nick Leeson and the Barings Bank collapse Development and evolution of their book Applications of behavioral economics in real-world decisions Jump in! --- I'm MICHAEL COVEL, the host of TREND FOLLOWING RADIO, and I'm proud to have delivered 10+ million podcast listens since 2012. Investments, economics, psychology, politics, decision-making, human behavior, entrepreneurship and trend following are all passionately explored and debated on my show. To start? I'd like to give you a great piece of advice you can use in your life and trading journey… cut your losses! You will find much more about that philosophy here: https://www.trendfollowing.com/trend/ You can watch a free video here: https://www.trendfollowing.com/video/ Can't get enough of this episode? You can choose from my thousand plus episodes here: https://www.trendfollowing.com/podcast My social media platforms: Twitter: @covel Facebook: @trendfollowing LinkedIn: @covel Instagram: @mikecovel Hope you enjoy my never-ending podcast conversation!
Transcript 0:00 Speaker 00 My guest today is Richard Thaler and Alex Imas. Their book, the updated edition, The Winner's Curse: Behavioral Economics, Anomalies, Then and Now. This is an updated edition from Richard's original book in 1992. And for those of you who have been living under a rock and don't recognize the name Richard Thaler, he happens to have a Nobel Prize. He happens to be the ninth Nobel Prize winner to appear on my podcast. And Richard is also the first star from The Big Short film to appear on my podcast. If you don't recall Richard and The Big Short, go watch it again. It's a great film.
0:44 Speaker 00 Without any further delay from me, let's jump right into my episode with Richard Thaler and Alex Imas. I hope you enjoy.
1:05 Speaker 00 In advance of speaking with you guys, I wanted to go check my own podcast to see who I have talked to. Not that I don't know all these names by memory, but some I forget. Some of you guys will probably be very close, personal friends with. Of course, I've had a chance to speak with Danny Kahneman, one of the best stories ever relayed on this podcast, why he became a psychologist, which I'm sure you guys know. It runs the gamut from Alison Gopnik to Vernon Smith, Angus Deaton, Robert Aman, Stephen Panker, Colin Cammerer. So, Richard, many of your peers, guys you know well, Cass Sunstein, a lot of interesting people. So I appreciate you coming on. I gotta tell you though, for me, the most fun thing, you're my first Big Short star to appear.
1:48 Speaker 01 You haven't had Selena?
1:50 Speaker 00 I know.
1:51 Speaker 01 And what about Margot, you know?
1:54 Speaker 00 See, now I got you started there when I was talking about the beauty of Vietnam. Now we've gone off in a direction.
1:59 Speaker 01 The record is not on yet, right?
2:02 Speaker 02 It actually is. It absolutely is.
2:06 Speaker 00 We have not said anything untoward or being very respectful.
2:08 Speaker 01 Yeah, no, that's true. If you get me started, I'll explain how Selena Gomez knew even less about blackjack than she did about collateralized debt obligations. That's probably a different story.
2:23 Speaker 00 Since we're going to go into some anomalies today, I want to lead with something because you both may or may not know something about my background. I am a guy who, political science degree from George Mason, an MBA from Florida State, but I got fascinated by a group of traders that went by the name of trend following traders in the mid 90s. It's become known as managed futures, time series analysis. Essentially, these are the guys that figured out how do we speculate and collect that hedging money from the Chicago futures exchanges? And capture trends. And for me, once I started to piece that together with a lot of data, and it's essentially the whole strategy is an anomaly, David Ricardo, let your profits run on, cut your losses. But when I saw and figured out, and I think I was the first
3:08 Speaker 00 person to write about this, where, who was on the other side of Nick Leeson's bearings bank blow up? And it was the owner of the Boston Red Sox right now. And to me, that was just a fascinating getting into it. Like you guys, you start in the academic world, you've got these fascinations and these desires, but me, I just stumbled into it. But this anomaly that I came into has led to, I don't know, eight books, a million plus books sold. So it's been a really fun, interesting ride. And so much of it has been right in the headspace of behavioral economics, really, because the strategy that I just mentioned would really not be a strategy unless those traders intuitively, instinctively understood behavioral economics.
3:53 Speaker 01 Or didn't. Somebody has to be doing something wrong. Is trend following the same as momentum?
4:00 Speaker 00 There's often, what, two forms of momentum. Trend following is the time series analysis, and then there would be the mean reversion type stuff.
4:07 Speaker 01 Okay, so the ancient result is that individual stocks have positive correlation over six months or so and negative over several years. So there's mean reversion in the long run and momentum in the short run.
4:26 Speaker 00 You know, you just said that somebody was doing something wrong, I guess to some degree, but also it's a matter of the hedgers, the hedgers are doing what they're supposed to be doing. So the speculators are collecting via a trend following strategy, collecting that hedging money.
4:41 Speaker 02 It's funny that you mentioned Nick Leeson. My job market paper was inspired by Nick Leeson.
4:46 Speaker 00 When did your paper come out?
4:47 Speaker 02 2016. I talk about Nick Leeson bringing down Barings Bank and all that stuff in the paper. The way that I explained it in the paper was that he was chasing his losses, basically. He didn't want to report any losses to his higher up. So he just kept going and going and trying to covering it until he ended up with a position that brought the entire bank down. And so my paper is like, how would somebody stop chasing their losses, essentially? And that was the realization effect, which we mentioned in the book. But yeah, it's very funny that you mentioned Nick.
5:16 Speaker 00 Did you know that John Henry, the owner of the Red Sox was on the other side of the trade?
5:20 Speaker 02 No.
5:20 Speaker 00 That was completely random that I learned of that. But then you could look at the performance data at the time, all that CFTC disclosure document data, and that you could just see with some of these trend following funds that were over a billion under management, you could see how it was almost like a one to one transfer, zero sum.
5:36 Speaker 01 Yeah.
5:36 Speaker 00 Here's where I want to start, though. And there's a little bit of background about me, so you know who you're talking to. I would like to know for you guys, because that's kind of my into the anomaly world. Richard, for you, let's start with you. Here you have guys like Danny Connaughton as your mentor, but what was the first anomaly that really got your juices flowing where you're like, man, this is my path. I'm not letting this baby go.
5:58 Speaker 01 Probably the first one is my old story about one of my professors and his wine. He was a wine collector and had been buying bottles of wine for five bucks and holding on to them and found that they would be worth a hundred dollars. There was a local wine store that said, "Look, I'll buy those from you for a hundred." And he said he wouldn't sell them. He would drink them occasionally, but he would never buy a bottle for more than 50 bucks. So at a hundred dollars, he's neither a buyer nor a seller, he's just a drinker. And that's not allowed in economics.
6:42 Speaker 01 Either the bottle is worth more than a hundred, in which case you should drink it and buy more, or it's worth less than a hundred, in which case you should sell. His behavior is impossible and he was the chairman of the economics department. That was an interesting observation for a grad student.
7:01 Speaker 00 Did you have a feeling, because going through your background, you were not necessarily going to go down this path because they might not have opened the door to you going down this path of research. Were there moments in time where you thought maybe the academic community might not be so open to, quote, "renegade" going down a path like this?
7:19 Speaker 01 Oh, I would have been against it. If I could have shorted my career as a hedge, I would certainly have done it. The first paper I wrote, which was published in 1980, had been rejected at six top journals. And the only way I got it published was to submit it to a new journal for their first issue. And they were desperate. And then the next half dozen papers were all fights. So it was very, very, very unlikely to work. There are not very many examples of similarly stupid career choices that happened to work out well.
8:03 Speaker 00 What kept you going? Why did you have a belief when so many people are like in the academic world? Follow the rules, stay on a certain track? What made you feel like, deep down, I can't let this go?
8:16 Speaker 01 I would say, A, I'm stubborn. B, I like a good fight. And C, I managed to hook up with my mentors, Danny Kahneman and Amos Tversky. And they gave me the one big aha insight, which is that you can find examples that are systematic bias. Economists knew, and would be happy to tell you, that almost everybody they know is an idiot. That was not news. But they thought that their idiocy was random noise.
8:59 Speaker 01 If you're doing mostly the right thing, but then you have random errors, that does not present a problem for economic theory. The problem is if your errors are all or mostly in the same direction, then the predictions of economic theory are wrong because people are systematically behaving differently. That was like the meta lesson that I learned from reading Amos and Danny's papers and then spending a year with them in 1977, 78, which is when I decided to go all in on this exercise,
9:43 Speaker 01 mostly because I thought it would be really fun.
9:46 Speaker 00 I got a kick out of your point, though, and I forget the term you used, what Danny Kahneman said to you about getting a late start.
9:53 Speaker 01 This was seven years later, when I was about Alex's age, and I was spending my second year with Danny. We had three of them. I was 39, and he's musing, and he wasn't thinking about me. He said, "There's a point in your career when you can no longer be described as promising." I think it's about 40. And I'm 39 and I'm wondering, okay, what am I now? Has been or once promising guy? Danny was never mean, but yeah, that's a funny story. Alex, of course, just turned formerly promising.
10:40 Speaker 00 Alex, let me go to you, crossing generations on this conversation. For you, where was your first moment in terms of, wow, this idea of psychology and economics connecting anomalies? Where did you first have your spark?
10:55 Speaker 02 I came at economics, I don't know, it took me a long time to get there. So I was actually pre-med. I was not interested in economics. I was taking economics in order to boost my GPA because science classes were actually hard. So I was basically taking organic chemistry, all those classes all day. And then I'm like, I need something else. And economics was easy, but I never connected to it at all. I'm like, these models are absolutely crazy. This doesn't make any sense as far as like actual human behavior. And I just let it be. And then I was applying to medical school. Like I got into medical school. I was taking a road trip to Los Angeles, moving one of my friends over there from Chicago. And then I was listening to NPR and I remember somebody was interviewed a lot on NPR in 2008 for a certain book that they just released.
11:40 Speaker 02 The book was Nudge. I was listening to the interview and I was like, somebody's talking about psychology. And I was always really interested. I was going to be a psychiatrist, by the way, as a medical field. And I was like, huh, wait, you can think about psychology and economics? This is wild. And then by the end of the interview, I was like, I gotta figure out what this is. The second I got to Los Angeles, I Googled what behavioral economics was and ended up applying to econ grad school within a week. Ended up like turning down the medical schools and ended up going to UC San Diego. Where I was really lucky was the fact that, and I didn't know this at the time, was that Richard was spending a lot of the year at UC San Diego. So I ended up being essentially when adjacent offices and we started talking. I didn't have to buy into anomalies.
12:24 Speaker 02 It's not like I started with these economic models are very good and we need to follow them. I kind of came from psychology. And psychiatry. And I was thinking like, I never connected with the models. And then I realized I could actually take that and incorporate that into economics and make those models better. Then I was completely bought in. And like, the real example that kind of hooked me completely was exactly Nick Leeson, actually. Was when you saw an example of an anomaly, not with college students or with other sorts of convenient populations, but with people trading huge amounts of money. And at the very top of the field. I was thinking that if psychology and these sorts of anomalous behavior that I was
13:09 Speaker 02 reading about in these papers could show up at this height of expertise. This was super important. I wanted to get involved. And that was, as I mentioned before, that's my job market paper was exploring that phenomenon.
13:22 Speaker 01 One other comment about Nick Leeson, which is a theme that we talk about a lot. You can concentrate on Nick Leeson and say, here's a guy who was good for a while and then started losing money and then started chasing his losses and so forth. I think the story that most economists ignore is, how does a firm let that happen? How do they have one guy who can bring down an entire giant bank? Economists are now almost used to the idea
14:03 Speaker 01 that consumers and individual investors can be dumb. But they think firms are smart. And they forget about the fact that firms are run by people. So there was somebody or some group at that bank that let this guy do this. And of course, he's not unique. There were other rogue traders that took down giant banks. And the behavioral theory of the firm is unwritten. And is a big opportunity for.
14:43 Speaker 01 Promising young scholars.
14:46 Speaker 00 I'll add another caveat here to this bearing story. I was in London at a futures industry association event. I was in a small room. I think it was mid 1995, several months after the current owner of the Boston Red Sox had made all this money on the other side of leasing. Leo Malamed was speaking and sitting in front of me, there was only like five people in the room and I was just an intern essentially. These two guys in front of me were the CEOs of two brokerage firms, two futures brokerage firms, and they were elbowing each other about who was on the other side of the leasing trade. They dropped the bomb while I was sitting there listening. This is almost 30 years ago, but once I had that information, I was like, oh, that's interesting. But then you could look at the disclosure documents and see all the performance gains.
15:32 Speaker 00 I bring that story up for the randomness of you two meeting at the San Diego University. I think this is life, right? If you're just hustling and keep moving along, you never know what the hell's going to happen.
15:42 Speaker 01 It's not completely random, right? There are occasions where you meet somebody and click, and then if you just let that go away, nothing happens. I ended up spending a year with Kahneman and Tversky because I had written them a letter. Kids, you used to write down stuff and send it in the mail. It would take a week to get to Israel. I wrote them a fan letter. Basically, I stalked them and went to California to follow them. And then when Alex and I found ourselves stuck in the same miserable sunny location of La Jolla.
16:24 Speaker 00 La Jolla is rough.
16:26 Speaker 01 Yeah, it's rough. It's rough. So we had to cope by talking to each other and suffer.
16:32 Speaker 02 Who's making $17,000 a year, by the way.
16:35 Speaker 00 I can't let you escape, Richard. What was in this letter?
16:38 Speaker 01 I sent them a draft of a very early paper, the one that eventually got published in 1980. I think this was about 1975. And I said, I think we're thinking along similar lines. I got a friendly noise back. I haven't done that very often. Another similar letter I sent was to Michael Lewis when I read Moneyball. And I said, you may not know it, but Moneyball and behavioral economics are the same thing. Maybe we should chat. And he was on the Moneyball book tour. I said, if you're ever in Chicago, let me know. He says, I'll be there next week.
17:22 Speaker 01 And we had dinner and he and I have been talking ever since. I now spend half my time in Berkeley, which is where he lives. So we continue to talk, but when you find somebody that you're on the same wavelength with, you should talk to them more. It's like a no brainer.
17:43 Speaker 00 I chased a famed hedge fund manager through letters at the time for 18 months. And he did not reply to me at all. And I finally sent a fax to his office and it said, the top 10 reasons you must meet with Michael Covel right now. They said, okay, you've got 30 minutes on this date. So there you go. Same headspace of hustle, right?
18:04 Speaker 01 Stalk your heroes.
18:07 Speaker 00 Oh, you both might get stalked today. Let's jump into though, because you do have a new work out here. It's actually a redoing of a work and you might want to explain. Both of you can give a perspective on it. The winner's curse, I think about 30 years old. Yeah.
18:21 Speaker 01 Yeah.
18:21 Speaker 00 Yeah, but you guys have repackaged it. And I know something about this. I've had one book where I've done five editions. So it's always fun to go back in there and redo things and add things and make it cooler, cooler. What was the original thinking here with the winner's curse, Richard?
18:37 Speaker 01 So the old one or the new one? The old ones, I'll give you the brief complete history. In about 1985, there was a new journal started by the American Economics Association. And I convinced they were going to have columns essentially, 10-page journal articles, but regular. And I pitched them the idea of having a series on anomalies. And they went for that. And I did that for about four years. And when I had enough that looked like a book, I stapled them together. And that was published as The Winner's Curse in 1992.
19:21 Speaker 01 Then about five years ago, the publisher said, hey, would you want to freshen this up? Or something perhaps stupidly, given how much work it's been. I got an idea to do something more ambitious and recruited Alex. And the idea was to go back to that old stuff. And I wrote a bunch of more of these columns after the book came out. And to go and say, look, here's the old thing. Does it hold up? Because the old ones, a lot of them were on lab experiments.
19:59 Speaker 01 And the ones that were with actual archival data, maybe it doesn't hold out a sample. And there's this replication crisis in some parts of psychology. That was the book we conceived. The key part of the title is Behavioral Economics Anomalies Then and Now. Each chapter has a then part that is more or less word for word, stuff I wrote 40 years ago.
20:34 Speaker 01 And then a now that Alex captained those now parts where we say, okay, what happened? And did this all go away? And if not, what did people do with it? And that's the book. I actually don't know of any book remotely like that. I like to think of an example, suppose that we can resurrect Darwin. And we hand him the origin of the species. And we give him a few years to kind of read up on the literature. And we say, how did you do?
21:17 Speaker 01 We're not suggesting the Winter's Curse is the origin of the species, but it's a book everybody knows. That's the thing we tried to do. We wanted to have fun with it. The chapters we chose to include were ones that we thought a lay audience could understand and relate to. There's a chapter on foreign exchange arbitrage that we didn't think anybody could read, so we skipped that one.
21:45 Speaker 00 Hey, beyond new examples, Alex, philosophically, to go back to all these anomalies set forward by Richard earlier in the early 90s, was anything wrong?
21:56 Speaker 02 There's two ways to answer that question. One, you could be wrong because it is something that happens in college students at a random upstate New York university. And then you go out into the real world and it's not really that relevant. So you're wrong about this being relevant for economics. That's one way of being wrong. The second way of being wrong is what Richard mentioned, the replication crisis, where you run the exact same experiment with college students and it doesn't replicate. And what we did in the book was look at both, essentially. The updates really stress, and we talk about this in the preface, that behavioral economics has moved out of the lab in the last 40 years and into the real world.
22:38 Speaker 02 So all of these things that were written about by Richard and his co-authors in the anomalies columns using these college samples, the new stuff that's been going on in the field, which is why it's such a big deal now in the field of economics, is that professional traders exhibit these anomalies, professional golfers exhibit these anomalies.
22:57 Speaker 02 Large swaths of the American households managing their real money exhibit these anomalies. So every single chapter, we follow up with an update saying, here is field data on all of this stuff. One example, talking about financial traders, for example, there were these anomalies shown on like how people tend to certain stocks versus others. There's a paper we talk about, which was written by me and some co-authors, looking at institutional investors managing billion dollar portfolios. We got their individual level daily trade data and basically said, hey, what is the population that should absolutely not exhibit any anomalies? They do, and they're losing millions of dollars, right?
23:37 Speaker 02 So that's like the new wave of behavioral economics is showing that all of this stuff holds up completely out of sample. The other part that we do in the paper is that we basically replicate the original experiments. We take the exact instructions, we post them on an online appendix, or this book comes with a lot of online material, by the way. So, you know, if you're interested in running any of these experiments, go online on the link and there's all these crowdsourcing platforms where you can collect data. Run it yourself. There's instructions on how to do that. And that's exactly what we did. We ran the exact same experiments again and saw what we find. The takeaway from that is that there's no replication crisis in behavioral economics that we found.
24:18 Speaker 02 Essentially, every single anomaly that Richard and his co-authors were talking about with the original experiments, they hold up now. Not too much of a surprise, to be honest, because Richard was running a lot of these things in the classroom. I've been running a lot of these experiments in the classroom, like the classic winner's curse with the jar that we talk about in the beginning of the book. There's thousands of these demonstrations. So everything holds up in both ways. So we really didn't see anything that was wrong in either direction. Like things are holding up out of sample in the real world and things are holding up within sample as far as replicating the original experiments.
24:55 Speaker 00 A question for both of you, are there still areas of the investment world, academia, corporate world where there's pushback on these ideas? Are there people that still hold on to their sacred cows and just say no? Or has there genuinely been an open mind to these many concepts that you both have put down over the many decades?
25:15 Speaker 01 I would say in the financial world, the practitioners have pretty much always been open to this, with the possible exception of my buddy Gene Fama's firm, Dimensional Fund Advisors, which at least claims to be an efficient market believing fund. Aside from Vanguard, the financial services industry has to believe in market inefficiency, or they got nothing to do. They were eager to believe that there were opportunities. So
25:54 Speaker 01 they were motivated. As opposed to traditional economists, there was a guy years ago, like 40 years ago, who would say to me, "Look, I understand what you're saying, but the only thing I know how to do is solve optimization problems. If you're right, what am I supposed to do?" And I told him that wasn't my problem. Now, I would say that's in finance. Everywhere else, I don't think most CEOs have drank our Kool-Aid. They still seem overconfident. When they start paying you that much money, you start to think you really know something.
26:36 Speaker 01 I think it varies. And there's still a lot of inertia in how organizations work, including universities, the institutions we know best. We have not changed the world. There are pockets of places that were receptive to our message.
26:56 Speaker 00 As you say that, though, does that mean if we had to look ahead 80 years from now, or 100 years from now, do you think there's always going to be some inertia in some of these large operations where they're just not going to want to accept some of these revelations?
27:09 Speaker 01 I have difficulty forecasting next week. On the other hand, a forecast of what's going to be true in 80 years, I'm pretty safe making a prediction.
27:20 Speaker 00 Don't pick on me that hard.
27:23 Speaker 01 Institutions move slowly.
27:25 Speaker 00 Alex, you want to add a perspective?
27:27 Speaker 02 I agree with Richard. The way that I got into behavioral finance was largely into finance was that they were the most receptive. And I have a theory about this, which is that they're also the most empirical field. They're empirical, so they just care about what works. And behavioral economics works, so they're receptive to it. A lot of other fields in economics are becoming more empirical as the data becomes better and better. So in the last 10 years, we've had a complete revolution in terms of what data has been available for the other fields of economics. Finance data has been available for a long time. There's very good data. It's easy to say, hey, is this your model? Here's the graph. Does your model look like the graph? No? Okay, write a new model. The updating process is a lot
28:12 Speaker 02 quicker when you have good data. So my prediction is that there are pockets of resistance mostly in the other subfields, but as the data becomes better, the subfield is either going to dry away and fall off the tree, or it's going to adjust, just like finance did.
28:29 Speaker 01 Yeah, they knew we were wrong. The academics, yeah. What's also true is certainly in economics, and I think in most of academia, to coin a phrase, there's trend following. And there's lots of taste issues. And so there are still many economists who evaluate a paper on the way you would evaluate a musician. Are they showing amazing skill? Rather than, did we learn something from this paper? Some of the early Kahneman and Tversky papers, people
29:09 Speaker 01 said, look, you ask some questions. How hard is that? What's the big deal? There was no illusion of science there.
29:20 Speaker 01 Whereas if you build some big fancy, what economists call structural model, that looks really hard. It makes the results difficult to interpret. But there are many people who think if you're not doing that, you're not serious. Those kinds of taste questions will always be there.
29:42 Speaker 00 In my world, loss aversion, a huge issue with the traders. Alex, let me go with you first, then come up with you, Richard. Of all the anomalies that are set forward, set forth in the winner's curse, what still makes you most excited today? You know, you meet somebody on the elevator, they want to know what you do. And you want to give them an example. You want to get them into your headspace. What is your most successful technique, story, whatnot, that gets them into your world? Because it can get a little bit complicated for the average guy in the street who's not been indoctrinated.
30:15 Speaker 02 The cleanest and most jarring example of an anomaly is the winner's curse itself. You go into a bar with a jar of coins and you say, okay, bid for this jar of coins. And then you get whatever money is in it. We'll exchange it for dollar bills. So you don't have to leave the bar with a bunch of coins. And systematically, the fact that the winner ends up losing money because actually their bid is higher than the amount of money that's in the coin in the jar. And the fact that this is not just a jar thing. This was demonstrated initially with oil executives who are bidding on wells. And they found that systematically, whenever you won a well, there was less oil there than you thought there was. So like the winner basically loses systematically.
30:57 Speaker 02 I think that's really easy to demonstrate, explain why that's an anomaly, and get the average person excited. The thing that I'm most interested in as far as going forward is slightly different. It's the violations of dominance, which is super simple to to explain. So let's say you have a health insurance choice between two different plans. One has a deductible of $1,000 a month. That means you have to pay up to 1,000 of whatever expenses you have over the year. Sorry, the annual deductible is $1,000. And then you basically stop paying. So the most that you could spend is $1,000. But there's another plan that has a $100 a month premium, right? Which one do you choose?
31:41 Speaker 02 And you don't have to pay out of pocket. You just have to pay the premium. If you do the math, it's super simple. The second option is dominated. You're guaranteed to pay $1,200 over the year. With the first one, you're guaranteed to only pay 1,000. It doesn't matter what happens. My favorite papers that's come out in the last 10 years is the fact that, hey, people actually face this choice all the time. And people go with the second option. They pay $100 a month rather than the high deductible plan, which is like insane, right? It just violates every single sort of principle that we think about in economics. And it turns out what is going on is that the things that economists think is really simple. Oh, here's a health insurance choice. Of course, people are going to be able to make it. Turns out, real people like really struggle with it.
32:25 Speaker 02 It's a complex choice. There's a lot of moving parts. And people reduce that complexity for themselves in a very strange way that leads them to violate dominance. So I think the thing that I'm really excited about these days is thinking about complexity systematically. The sort of complexity everybody kind of encounters in their everyday lives. How do they reduce it? And how do we as advisors to governments potentially, or just people who are writing papers that out there in the world? How can we think about this systematically and help people make better decisions?
32:58 Speaker 01 If I have to explain what I do to somebody at a cocktail party, I'll probably start with mental accounting, which is the term we use to describe how people think about money. I started this conversation with my ancient story about my economics professor. I'll start with another ancient story. A friend of mine, when I was living in Rochester, New York, were given two tickets to a professional basketball game in Buffalo, which is normally about an hour drive. We got these tickets for free. And then there was a big snowstorm. My friend Jeffrey calls me up and says, no way.
33:40 Speaker 01 We're going through this blizzard. It doesn't make any sense. So far, so smart. But then he says, but if we had paid for those tickets, we'd be going. Now economists refer to this as the sunk cost fallacy, S U N K. And the idea is the money we might have paid for those tickets is gone. It should be irrelevant. The decision should be, is it worth driving dangerously through a snowstorm to watch a basketball game or not? Because either way, it's going to be free to go. And people get this wrong all the time. Early in my career, Alex wanted to be a psychiatrist.
34:24 Speaker 01 I became what some of my psychology friends refer to as world's first clinical economist. I remember talking to some mom who was fighting with her first grader daughter, who decided she didn't want to wear skirts to school. And the mother was saying, yeah, but I bought you all these skirts. I was brought in as a mediator. I explained to mom that the fact that she had spent money on those skirts was irrelevant. It was more important to have a good relationship with her daughter. And she should let her daughter wear pants to school if she wanted to.
35:07 Speaker 01 And she said, really? And the fact that I was an economist telling her this, this was okay to not use the skirts just because she had paid for them, was like a weight lifted. And she got along way better with her daughter as a result. I did not switch to being a clinician. But I think there are like life lessons. The example Alex was giving about the health insurance. Here's a one line bit of good advice to all consumers, which is when in doubt, take the biggest deductible. Or even better, self insure.
35:50 Speaker 01 Rent a car, never ever take the collision damage waiver. They're charging you a ridiculous amount of money to insure against a $2,000 loss. And it's probably covered by your credit card. And never take extended warranties, never ever. Unless you know that you have a habit of dropping your phone into the toilet, just don't do it. There are lots of dumb things people do that they could learn not to do. And until they all learn not to do those things, we'll have plenty of stuff to write about.
36:27 Speaker 00 A follow up, Richard, just hit me, listening to you, first time we've met. Your talking style, your persuasion ability, where did it come from?
36:36 Speaker 01 Are you asking an evolution question?
36:39 Speaker 00 Come on now. No, seriously. Look, Alex knows why I'm asking it. There's something about listening to you and the way that you present information, carry on a conversation. Very persuasive, very persuasive, not in a hammer-like way, but persuasive in a way like bringing you in, right? So where did you learn this?
36:58 Speaker 01 I don't know. I think that's my natural speaking term. But I did learn from my buddies, Amos and Danny. Amos died at age 59, which was a tragic loss to his friends, family, and to society. He knew he was dying. He had some kind of cancer and had five or six months to say his goodbyes and so forth. And at his funeral, his son read a note Amos had given him. That said something like, "We learn through stories, not through equations."
37:41 Speaker 01 In my classes, people would say, "Look, all Thaler does is go in and tell stories." And lots of them are about sports. What's he doing? I get emails from students who had a class from me at Cornell 40 years ago. Saying they still remember such and such a story that they still think about. Now, I guarantee you, no one remembers the derivation of Bayes' rule.
38:14 Speaker 01 Much less how to do it. If you tell stories that have a message and they're memorable, then you get some stickiness.
38:25 Speaker 00 I was inspired to put a chapter in my first book about baseball and trend following and John Henry, based on the Moneyball book. So you reached out to Michael Lewis. Did he know about you at that time?
38:37 Speaker 01 No, the book was just out a week or two. And like I say, he had a trip planned to Chicago. So he came over to the house. He and I sat in a room around the corner from here for a couple of hours and then went out to dinner. And that conversation eventually led him to write his book, The Undoing Project, which is a book about Kahneman and Tversky. Since I know everything about how to write a good book and Michael is a complete amateur, I kept telling him what a stupid idea this was. How are you going
39:16 Speaker 01 to write a book about two guys who spend all their time thinking and talking in Hebrew and English? Anyway, he fortunately ignored that bit of advice. But we ended up spending a lot of time. I took him to some conferences so he could do some ethnographic research and see what academics do at a conference and how it all works. We realized though, pretty early, that we were thinking along similar lines. Cass Sunstein and I wrote a review of Moneyball. Michael read that review and took it to heart.
39:57 Speaker 00 It's what struck me was the way they looked at baseball statistics. And then from my perspective, I'm writing these trend following books and I'm saying, there's a little bit of a parallel here because the trend following traders said, to hell with the fundamentals. We don't care. We are just going to look at price data only and we're going to make trading decisions based off price data only. That was like, wow, okay, it's an entirely different way of looking at the world.
40:20 Speaker 01 The sports analytics, I think, is just the opposite, which is to say, prices are wrong, and there are some things that are overvalued. And it's basically a Warren Buffett kind of strategy. What's cheap and what's expensive? Billy Bean was stuck working for an organization that didn't have very much money. And the only way he could succeed was to find players that other teams didn't want. Eventually, sell them, once he showed that they were good. That was his business model. And by the way, 30 years later, or whatever it's been,
41:02 Speaker 01 he did the same thing with the Toulouse soccer team that was in the second division and basically applied the same principles, got them promoted to the first division, has made a lot of money for his investors. There are lots of ways to make money. Still, the best one is finding undervalued assets.
41:25 Speaker 00 It's hard to argue against Warren Buffett, really, right? He does win. Winner winner, chicken dinner. I mean, you know.
41:30 Speaker 02 But there's two ways to think about the stock market, right? There's one, which is this like fundamental value, dividend flow way. But then there's the Keynes way of the beauty contest, which is essentially what determines the price of the stock, what other people think the value of the stock is. So that way of thinking about the stock market is completely divorced from fundamental value. And I think that's what trend following, and now we see this with meme stocks all the time, like a bunch of people realize that, hey, if we post on Reddit saying, hey, diamond hands, or something like that, all of a sudden, everybody else is going to say, diamond hands means we need to coordinate on the stock. And the way that we make money is knowing that everybody else knows that everybody else
42:13 Speaker 02 that knows that everybody else is going to do the same thing, and the price is going to pop. What does that have to do with fundamental value? Nothing. It's a coordination device in the way that Keynes was talking about, and Schelling had been talking about, that we just need to know what everybody else is thinking. We don't need to... Do any fundamental analysis. We don't need to do any research about the company. It could be AMC, it could be Kohl's, it could be the neighborhood pizza shop. As long as everybody else knows that everybody else knows that everybody else is doing the same thing. We're going to make money. Whenever I get asked questions about finance or I'm like in those sorts of audiences. The second question is about meme stocks.
42:52 Speaker 00 Or Bitcoin.
42:53 Speaker 01 Or Bitcoin.
42:53 Speaker 02 Bitcoin is exactly the same thing. Bitcoin does fundamentally has no intrinsic value, right? The only value it holds, and all of crypto is the same way, is based on what everybody else thinks that everybody else is going to do. Right? That's the entire value of Bitcoin. I talk about Bitcoin in the same breath as I talk about GameStop. It's the same concept.
43:15 Speaker 00 I still think back to early 2000 and Michael Saylor of MicroStrategy appeared on 60 Minutes. And essentially told the world in early 2000 before the dot com crash. That he was essentially going to run American healthcare and now 25 years later, he runs Bitcoin. It's an amazing world, isn't it?
43:33 Speaker 01 Yeah, I will say principal in a money management firm that manages mostly small cap US equities. We basically would never buy nor sell GameStop. Because we don't think we have any ability to predict. What other people are going to think about it next week or even next hour. There are some circumstances when you can predict what average opinion is going to change. If you're a value investor, yes, you're attracted to stocks that seem cheap.
44:10 Speaker 01 But they also have to be stocks that you think other people will agree with you relatively soon. It doesn't have to be in five minutes, but more like a year. So far, that approach has worked well for the past 30 years.
44:29 Speaker 00 Guys, I've kept you for about an hour, which is what I promised. We could probably find all kinds of points to talk about, but we all have lives. You guys got to roll. The book, The Winner's Curse, Behavioral Economics, Anomalies Then And Now. Richard, Alex, I appreciate it. Where can we send people? Where would you like to direct people? Obviously, they can find the book at all your bookstores and online places and that kind of stuff. Is there a website you want to direct people to or multiple websites? Or if they can't find you, maybe they have a problem in this world of connectivity.
44:59 Speaker 01 Everybody knows where to find a book that's coming out. Alex, what's the pointer for our online website?
45:07 Speaker 02 It's the title of the book, The Winner's Curse. Put it online, you have all of the information about the book. And then you have all of the supplementary material in there. How to replicate these things. If you're a teacher, you want to teach this stuff to a class. We're going to have lecture slides for every single chapter. You got to sign behavioral economics. You don't want to teach behavioral economics. Buy the book, it'll be easy.
45:31 Speaker 00 I'll leave you guys with this too. If you ever make it to Saigon, but I got to tell you, from a behavioral economics standpoint, this is a place of street side cafes, street side, street food, motorbikes everywhere. There is a certain behavioral thing going on here. That's probably a little bit different than the rest of the world. It'd be a great place for a lab to set up and find new examples, new anomalies in Saigon.
45:54 Speaker 01 Sounds good. Food's not bad either.
45:57 Speaker 00 Food's great. Guys, I appreciate it.
45:59 Speaker 01 A pleasure. Thanks for having us.
46:01 Speaker 02 Have a good night.
46:08 Speaker 03 I see a time when those awake will understand how to make money in up, down, and surprise markets. Whether new trader or experienced, college student or financial advisor, protecting against a crash or just trying to make a lot of money. Trend following offers everyone an answer in uncertain times. To get started immediately, send me an email, [email protected] . I will send you the right trend following steps to take, along with my free video.
46:44 Speaker 03 But if you want to buy and hold, trust the government and trust Wall Street, this is absolutely not for you.
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