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Behavioral Economics, Richard H. Thaler and Sendhil Mullainathan
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An early study by Werner De Bondt and Richard Thaler (1985) was explicitly motivated by the psychological finding that individuals tend to overreact to new information. For example, experimental evidence suggested that people tended to underweight base rate data (or prior information) in incorporating new data. De Bondt and Thaler hypothesized that if investors behave this way, then stocks that perform quite well over a period of years will eventually have prices that are too high because people overreacting to the good news will drive up their prices. Similarly, poor performers will eventually have prices that are too low. This yields a prediction about future returns: past “winners” ought to underperform, while past “losers” ought to outperform the market. Using data for stocks traded on the New York Stock Exchange, De Bondt and Thaler found that the thirty-five stocks that had performed the worst over the past five years (the losers) outperformed the market over the next five years, while the thirty-five biggest winners over the past five years subsequently underperformed. Follow-up studies showed that these early results cannot be attributed to risk; by some measures the portfolio of losers was actually less risky than the portfolio of winners.

 

It is possible to go further and design institutions that help people make better choices, as defined by the people who choose. One successful effort along these lines is Richard Thaler and Shlomo Benartzi’s (2004) “Save More Tomorrrow” program (SMarT). Under the SMarT plan, employers invite their employees to join a plan in which employees’ contribution rates to their 401(k) plan increase automatically every year (say, by two percentage points). The increases are timed to coincide with annual raises, so the employee never sees a reduction in take-home pay, thus avoiding loss aversion (at least in nominal terms). In the first company that adopted the SMarT plan, the participants who joined the plan increased their savings rates from 3.5 percent to 13.6 percent after four pay raises (Thaler and Benartzi 2004).