Santa Clara Professor Hersh Shefrin, fellow economist Richard Thaler, and the beginning of the fight to have behavioral economics taken seriously. There was yelling involved.
Santa Clara University finance professor Hersh Shefrin could not be prouder that Richard Thaler, the man he worked with for more than 15 years to bring psychological and behavioral insights into mainstream economic models, won the Nobel Prize in Economic Sciences in 2017. Shefrin also happens to be one of the few people who remembers that this world-changing work didn’t start out auspiciously. In fact, it started with yelling.
“I knew in the ’70s we were breaking new ground,” recalls Shefrin of the work that he and Thaler first embarked on as junior faculty at the University of Rochester. “But when Dick and I would speak to our faculty colleagues in seminars, the hostility was very strong. Yelling, displays of temper, people telling us that what we were doing was crazy.”
Their crazy notion? The idea that traditional, or “neoclassical” economics, had for decades wrongly assumed that people would always behave in ways that best served their overall self-interest. If people know they must save for the long-term, for instance, neoclassical models presumed they would coolly assess their income, assets, and spending, and put aside the optimal amount to accumulate assets over their lifetime.
The two upstart junior faculty members argued otherwise. They believed neoclassical economics was failing to factor in the reality that—due to psychological influences such as self-delusional behaviors—humans quite often behaved differently from the norms assumed by traditional economic models. And, they argued, that reality had serious implications—as more and more Americans were being put in charge of their own long-term financial well-being, with the decline in traditional pensions and an uncertain Social Security safety net.
It took quite a while to be treated seriously. In early 1985, one of the most influential economists at the time, future Nobel Prize winner Franco Modigliani, spent two long phone calls arguing to Shefrin that his and Thaler’s work on self-control and spending was “valid, but very minor.” Shefrin’s work with both Thaler and later Santa Clara colleague Meir Statman directly challenged the Modigliani-Miller principle, named after Modigliani and University of Chicago academic (and also future Nobel laureate) Merton Miller. Their principle stated that psychological imperfections do not prevent people from rationally seeing financial truth. The University of Chicago hosted an entire conference on behavioral economics and finance—with the clear aim of debunking it, but without inviting Shefrin or Statman to speak. Instead, Miller gave a talk saying that behavioral finance was about interesting “stories,” not fundamental forces.
A Brief Behavioral History
“My first solo book, Beyond Greed and Fear, was published in 1999. I wrote it to explain how psychology, including imperfect self-control, influences investor behavior. Rather than writing in a highly academic, abstract way, I focused more on stories about real people to bring the psychological issues to life for readers. At the same time, my interactions with executives from Financial Executives International provided me with a window on how corporate managers make judgments and decisions at their companies. I was noticing the same psychological issues that impact investors also impact managers, such as vulnerability to excessive optimism, overconfidence, confirmation bias, and aversion to a sure loss. The result was my 2006 book Behavioral Corporate Finance.”
Shefrin and Thaler had some support at Rochester from their colleague Tom Russell, now professor emeritus of economics at Santa Clara, who arrived at SCU at the same time as Shefrin; he also published a paper on behavioral economics with Thaler. He would later conduct award-winning research on catastrophe risk and insurance.
Shefrin and Thaler shook off their numerous critics and spent the subsequent decades studying many fascinating questions about how psychology impacts financial and economic behavior. Among the descriptions of Thaler’s accomplishments in the Scientific Notes accompanying the award by the Royal Swedish Academy of Sciences were numerous mentions of the foundational work he co-authored with Shefrin, now SCU’s Mario L. Belotti Professor of Finance.
PLANNERS AND DOERS
Shefrin and Thaler’s early, seminal paper titled “An Economic Theory of Self-Control,” sought to model the concept of temptation in a formal way, “something that was totally absent from the economics literature at that time,” recalls Shefrin. The paper discussed “simultaneous internal conflict” involving two parts of the brain, in which people know they want to do something but can’t get themselves to actually do it.
At Thaler’s suggestion, they called the part of the brain that wants to do something “the planner” and the other part “the doer.” The “planner-doer” model became a highly influential way of approaching economics, and would later be credited with substantially helping to increase the rate at which Americans save.
Thaler and Shefrin’s fascination with behavioral economics had different origins for each of them. Thaler, who taught in the University of Rochester’s business school, became intrigued after a dinner party at his home, when guests implored him to take away some cashew nut hors d’oeuvres, lest they spoil their dinner. The classically trained economist in him wondered, “‘Well, if you’re rational, you simply choose to stop eating,’” at some optimal point, Shefrin explains. But guests felt helpless to do so. So Thaler “asked the question, ‘What’s going on in our heads, and why is it that people don’t behave rationally in these kinds of situations?’”
Shefrin, then in the economics department at Rochester, had his own “aha moment” as his wife, a dental hygiene faculty member, was working on a research project which sought to help people with eating disorders make better health care decisions. Shefrin started thinking about eating disorders as an extreme example of people not acting in their own long-term best interest, and decided he wanted to study how nonrational behavior played out in economics.
Before long, he and Thaler found each other and began a 15-year collaboration, which continued even as Shefrin moved to Santa Clara University in 1978 and Thaler moved on to Cornell University. One such collaboration was a 1986 study of Santa Clara University MBA students, designed to investigate how individuals think about money differently based on how they acquire it.
The study’s central question: Is the way a person spends or saves money dependent on the source of the money—a paycheck vs. a home or investment vs. a windfall inheritance—or is the total value of their wealth all that matters? The students in the survey were presented with three scenarios, all of which were equivalent from a financial perspective but differed in how those finances were described. The survey results showed that even though acquiring money in each scenario increased their wealth by precisely the same amount, students were much more willing to spend certain kinds of wealth (especially from their paychecks) and inclined to save a far greater portion of certain other types of wealth (especially future wealth from an inheritance).
“Our Santa Clara students were the first to provide evidence in a systematic way that said it really matters in what form you get your wealth,” said Shefrin. The power of that concept—a special case of a phenomenon called “mental accounting”—loomed large in the Nobel Prize committee’s praise for Thaler.
Shefrin managed to infect Meir Statman, Santa Clara’s current Glenn Klimek Professor of Finance, with the behavioral bug, and the two began a decades-long collaboration, exploring how people save and invest, factoring in the impact of psychological phenomena. The Royal Swedish Academy mentioned the work of Shefrin and Statman in their Notes, pointing out that they “provided the first empirical evidence” of the so-called “disposition effect,” in which investors are loath to unload losing stocks.
The Santa Clara pair won the William F. Sharpe Award for Scholarship in Financial Research from the Journal of Financial and Quantitative Analysis for their work on behavioral portfolio theory, and the Graham and Dodd Scroll Award from the Association for Investment Management and Research for their paper “Ethics, Fairness and Efficiency in Financial Markets.” Notably, Shefrin and Statman’s joint work launched the literature in behavioral finance.
Shefrin’s book Beyond Greed and Fear was the first comprehensive treatment of behavioral finance. That was published in 1999 by Harvard Business School. He has also written several other books that focus on how the behavioral approach impacts organizations (see sidebar) and co-edited a volume on The Global Financial Crisis and Its Aftermath, with contributions from leading economists, including then chair of the Federal Reserve, Janet Yellen.
Thaler, meanwhile, continued his research into practical ways to mitigate the impact of low self-control on saving rates, the main issue at the heart of his work with Shefrin. Thaler’s subsequent ground-breaking work with his former graduate student, Shlomo Benartzi, on a program called Save More Tomorrow, would eventually be adopted by major investment firms such as Vanguard.
Shefrin has written a tribute to Thaler for the online publication Vox, noting that “Thaler’s academic work teaches us to beware of the limits of assuming that the world is populated by rational actors.” And he notes that Richard Thaler does one thing better than any other economist: “He constructs simple and incisive thought experiments. Most economists, including me, are trained to think in terms of formal models. Thaler is more of a qualitative thinker.”
Santa Clara University is helping to carry on Thaler’s legacy in another way as well: His granddaughter Hallie Friedfeld ’19 is a junior at SCU, double majoring in child studies and sociology, and recently returned from a study abroad program in Copenhagen. “I am very proud and excited to see the work that he has been developing for so long be acknowledged to the highest degree,” she wrote in an email about her grandfather.
Shefrin is also bursting with pride for his former research partner. Speaking as a theorist, he says he is proud of how his work with Thaler generated new insights into the interaction between human emotion and human cognition, and also set the stage for the emergence of neuroeconomics, which focuses on how brain structure impacts economic decisions.
“The fact that the work which Dick and I did together led to a system for helping people save more, is a source of pride for me,” he says.
And a source of comfort for those it helps.
DEBORAH LOHSE is assistant director of media and internal communications at SCU.
PAUL BLOW has illustrated work for The Guardian, BusinessWeek, The Independent, and others.