PIMCO Education

From The Experts: Dr. Richard Thaler on Two Behavioral Concepts

PIMCO CEO Emmanuel Roman and Nobel laureate Dr. Richard Thaler discuss mental accounting and nudge versus sludge – and how these behavioral concepts can affect investors and the world around us.

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Text on screen: PIMCO

Text on screen: PIMCO Education: “Behavioral Science: Mental Accounting and ‘Nudge not Sludge’” with Dr. Richard Thaler and Emmanuel Roman (6 minutes)

Text on screen: Today’s Behavioral Science Learning Objectives; 1. Mental Accounting: When people treat various sums of money differently based on where these sums are mentally categorized; 2. Nudge, not “Sludge:” Helping people make better choices as judged by themselves.

Text on screen: Emmanuel Roman, Chief Executive Officer

Manny Roman: Good morning and good afternoon. It is my pleasure to have with us Richard Thaler, who is the Charles Walgreen Distinguished Professor of Behavioral Science and Economics at the University of Chicago, a Nobel Prize winner in 2017, a senior advisor to PIMCO, and, I must add, a close personal friend.

Richard Thaler: Good to see you, Manny.

Manny Roman: So I'm going to start with a very simple example. You and have talked quite a bit about it. We called it the Roman Weil theorem. And a lot of financial advisors may relate to this. You find in your cellar a bottle of wine that you bought 10 years ago for $20. And just to pick a number it's worth $200 today. And the question is, are you drinking a $20 bottle of wine, or are you drinking a $200 bottle of wine? Does the acquisition price matter? And so on and so forth?

Text on screen: Richard Thaler, Distinguished Service Professor of Economics and Behavioral Science at the University of Chicago’s Booth School of Business

Richard Thaler: This is one of the first examples that caught my mind, even before you saw me at that conference. I had a professor, when I was in graduate school at the University of Rochester, Richard Rosette, who later went on to be the dean at Chicago Business School.

And he had bottles like that. And he would drink bottles like that occasionally, but he would never buy them. Never buy a wine that expensive. And I asked him about this. And he couldn't really justify it. But, of course, economic theory says that the price of the wine is the opportunity cost. And if you can sell the wine for $200, then that's what it costs you to drink it.

Text at left on screen: Mental Acounting: Bullet one: When people treat various sums of money differently based on where these sums are mentally categorized; Bullet two: Risk averse investors prefer to segregate assets in safe “buckets. Graphic at right of screen: Text – If all money is as “safe” then could lead to suboptional returns. Under text there are six blue buckets with the word “Safe” on all of them. 

So this is a good example of what we call mental accounting.

It's the way people are keeping track of financial transactions and everything they do in life. And it violates all kinds of axioms of economic rationality, especially fungibility. Fungible is the word we use to say that money shouldn't have labels on it. But of course it does, in people's heads. So people put money aside for college education or for retirement or to buy a house or to go on a vacation. And they act like you can't spend money from one pot on something else. And that may or may not be sensible, but people do it.

Manny Roman: Can we talk about sludge? You and I have talked about sludge. "A," it's a wonderful world, because I like the word "sludge." But "B," you have a wonderful example about a tax return, something that everyone who is going to watch this video is quite familiar with.

Text on screen: “Nudge not Sludge;” Sludge can take two forms, It can discourage behavior that is in a person’s best interest… and it can encourage self-defeating behavior. – Richard Thaler

Richard Thaler: Yeah, so what is sludge? Twelve years ago, I wrote a book called "Nudge." And whenever everybody asks me to sign it, I always sign it, "Nudge for good."

Text on screen: “Nudge not Sludge;” The goal is to help people make better choices as judged by themselves. But what about activities that are essentially nudging for evil? This “sludge” just mucks things up and makes wise decision-making and prosocial activity more difficult. – Richard Thaler

But I'm aware that people don't always nudge for good. A public policy example is the following. My colleague here, Austan Goolsbee, proposed – back in 2006, I think – the automatic tax return.

And what it means is anybody who takes the standard deduction, the IRS knows everything they need to know to complete your return. Your W-2 forms are in. Your 1099s. The interest, if they're earning any interest. So what they could do is send everybody a prepopulated tax return that they could file by text message. That's the way people file their tax returns in Sweden. We think of Sweden as some big bureaucracy. It's actually much more efficient on this front than the U.S. So there was a bill proposed early in the Obama administration, to introduce this. It was defeated because of lobbying from the tax return industry,that actually got a law passed saying the IRS is forbidden from doing this.

And in return, the tax return companies promised to give free returns. Although, as you can imagine, if you go in there and ask for a free return, they're likely to try to sell you something else. Now, the interesting thing is now, thanks to the recent Trump tax cuts that increased the standard deduction, I think 89% of taxpayers are claiming the standard deduction. So we could end doing tax returns for almost 90% of the population, simply by sending out this form. It could be a one-page bill in Congress. I don't see any reason why Democrats or Republicans would oppose this.

It would make a lot of people who don't do tax returns for a living happy. And that can't be the most interesting job in the world, so I think we can probably find something more interesting for them to do as well.

Manny Roman: Thank you, Richard. It's always a pleasure to talk to you. And I look forward to being able to get together soon and be able to share a bottle of wine. Thank you again.

Richard Thaler: Me as well. Always a pleasure to talk to you, Manny. My best to everybody in Newport Beach.

Manny Roman: Thank you.

Text on screen: For additional educational resources on the topic visit pimco.com/advisoreducation or pimco.com/behavioralscience

Text on screen: PIMCO


Please note that this material contains the opinions of the participants as of the date noted and may not have been updated to reflect real time market developments. All opinions are subject to change without notice.

PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.  Any tax statements contained herein are not intended or written to be used, and cannot be relied upon or used for the purpose of avoiding penalties imposed by the Internal Revenue Service or state and local tax authorities. Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the current opinions of the participants and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.

Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2020, PIMCO.

Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626.


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