Where Markets Reveal Human Error ft. Alex Imas

[00:00:07] Alex

There are always other explanations for things that look like violations of law of one price, and they probably are violations, but you can’t prove it as well as you can when you know there are really no limits to arbitrage, like, for example, the 3M case. It’s just a smoking gun.

The way to kind of think about it is that, yes, these are stories, but these are kind of the most conservative sort of benchmarks that you can think about because you’ve been able to strip every other explanation away.

And so, if you are seeing this violation in this very, very clear-cut case, these sorts of violations are probably living all over the place where they can’t be identified as clean.

[00:00:47] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we’ll have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also, understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions.

Here’s your host, veteran hedge fund manager Niels Kaastrup-Larsen.

[00:01:42] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary people from all around the world. In this series, I have invited one of them, namely Kevin Coldiron, to host a series of in-depth conversations to help uncover and explain new ideas to make you a better investor.

In the series, Kevin will be speaking to authors of new books and research papers to better understand the global economy and the dynamics that shape it so that we can all successfully navigate the challenges within it. And with that, please welcome Kevin Coldiron.

[00:02:20] Kevin

Okay, thanks Niels, and welcome everyone to the Ideas Lab podcast series here on Top Traders Unplugged. We’re starting off 2026 by discussing, for me, one of the most influential and entertaining books in economics over the last few decades, The Winner’s Curse. It was originally published in 1994 by Nobel Prize winning economist Richard Thaler, and a new updated version has just been released by Richard and his new co-author and today’s guest economist, Alex Imas.

Alex is a professor at the University of Chicago where he writes and teaches about behavioral science, economics, and applied artificial intelligence.

Alex, happy 2026. Thanks for joining us and welcome to the show.

[00:03:06] Alex

Thank you, Kevin. I’m excited for the conversation.

[00:03:09] Kevin

All right, well, you know, I imagine it must have been a great honor and a pleasure to work with someone like Richard. And I know you’ve known him for a long time, so I thought maybe we could just start a little by talking about your own personal path to working in behavioral economics.

You said you were originally on a pre-med track and you’d graduated from university, but then you were on this kind of cross-country road trip and found yourself getting hooked on behavioral economics. Could you tell us a little bit about what happened to you on trip?

[00:03:44] Alex

Yeah. So, that wasn’t the first time I heard of economics, obviously. So, I was pre-med and an undergrad. I’m an immigrant from Moldova. I came in when I was about nine years old. And as any immigrant kid, my parents were like, you’ve got to be a doctor. If you can be a doctor, you have to be a doctor.

I didn’t know what else to do. So, you know, I was a pre-med, even though I just hated the whole thing. It was very difficult for me intellectually and I was super bored of it. I’m glad there are doctors out there, but I was not going to be a good doctor. But to increase my GPA, because these classes were hard, I started taking economics classes because these were much easier for me.

And so, you know, I liked it a lot. But I was like, this is kind of science fiction, like, you know, these hyper-rational agents doing all sorts of stuff.
I did well in the classes, but I just didn’t really connect with the material much because I just thought it was very divorced from what I was seeing in the real world.

But I was taking a lot of psychology classes as part of the pre-med program. And during this road trip, basically, with my friend, I was listening to the radio. It was around the time Nudge came out and guess who was on the radio? It was Richard Thaler talking about behavioral economics when he was talking about the Nudge book.

So, I had never heard of this topic. So, I was like, what, you could combine psychology and economics to kind of make these models more realistic? I thought it was completely fascinating. So, the second I got to LA, I kind of logged into my computer, figured out what behavioral economics was, and then I instantly started applying for PhD programs in economics.

And you know, I was lucky in so many ways in my life. But one of the lucky things that happened to me was that I only got into one PhD program, which was UC San Diego. And the reason this was lucky is because even though Richard is a professor at the University of Chicago, where I am now, he spent all every winter and a lot of the summer in San Diego. And his office was in the business school where my office was and was just basically adjacent to mine.

And I was a huge fan. At first, I was just kind of afraid to talk to him, as would be expected at that point, I was a graduate student. But then he was just kind of around. His door was open. So, at some point I’d get an idea and I’d kind of like, hey, what do you think about this?

And he was always willing to talk. So, we’d spend a lot of time, like, you know, getting coffee and walking around chatting. So, it was just an incredible opportunity. That’s kind of how we met up and, you know the rest is history, as they say.

[00:06:23] Kevin

That’s such a fun story. In fact, I really had to chuckle when I read that because we had Daryl Fairweather on the show earlier this year. She’s the chief economist at Redfin. I think Richard was her PhD adviser at Chicago.

[00:06:37] Alex

She’s a friend of mine.

[00:06:39] Kevin

So, you know, one of the first stories in her book is like, hey, I was on my way to becoming an engineer, I’m on a cross-country trip, and I read Freakonomics. And by the time I was done with the trip, I wanted to do behavioral economics. So, there’s something about these cross-country road trips that is a good recruiting tool for you guys.

[00:06:58] Alex

Well, you know, there are a bunch of songs about road trips and, like, being on the road and in the car. And I think the magical thing is that you just don’t really have a lot of distractions. You can’t be on your phone, otherwise you’re going to die. So, you’re not on your phone, hopefully. So, you’re listening to the radio, you’re listening to podcasts, and your mind is just kind of wandering.

I find road trips, long drives to be just like the best time to think. And I think, you know, your mind is just kind of open to ideas. I think if I listen to, like, literally the same story in any other context, it wouldn’t have hit. I wouldn’t have been like, hey, this is the way my life should go from now on.

So, I think, yeah, I agree with Daryl. It’s a great time to change your life completely.

[00:07:45] Kevin

So, the book has 13 chapters and kind of mirrors the original book. Each chapter can kind of be read as a standalone and is a sort of little puzzle. So, I thought, given that, maybe we could start with the chapter that helped you get your first job at Carnegie Mellon, the one on mental accounts. So, could you just tell us what mental accounts are and why they matter for us?

[00:08:15] Alex

Yeah. So, basically, mental accounting is this idea that, look, the underlying assumption for why money is valuable in the economy is because US$1 is worth US$1. It doesn’t matter how you got it. If you got it as a bonus from your job, you found it on the street, somebody gave it to you as a gift for your birthday, it really doesn’t matter how you got it. You go to the store, you buy the same thing with it. The source doesn’t matter.

And mental accounting basically says that people have a hard time kind of keeping track of all of the money that they have. If I’m at the grocery store, and I’m thinking whether to buy a pack of gum, I’m not thinking, okay, so I have this much money in the bank. I’m in school, so my future earnings are this. Can I afford the extra 20 cents from like the premium gum to like the cheaper gum? That is this assumption in the standard economic framework, that people are constantly solving this super complicated optimization problem, taking all of their sources of wealth into account.

Mental accounting basically says that, like, look, I keep my money mentally in different accounts. So, I’m in the grocery store, I’m thinking, you know, how much spending money do I have? How much walking around money do I have? It’s probably like US$20, US$30 a day. I have some extra bandwidth with which could be spending money.

If I spent US$15 and that something costs US$6 and my budget is US$20, I’m not going to buy that thing, even though I may have way more money in the bank. So, it’s this idea basically that, look, the actual way that you should treat your money is very complicated. And people, because of their bounded rationality, can’t really go through that optimization problem.

So, they solve a much easier problem where they take money, depending on its source, whether it’s, you got some money as a bonus at work, oh, maybe I’ll treat myself to a new TV or something like that. Whereas if I’m getting the same amount of money as gains on my 401k, even though technically that’s still part of my wealth, it’s the same thing. I’m going to be treating that very differently.

And this has a lot of implications for basically how people spend money. Just as a general question.

[00:10:25] Kevin

There are a number of interesting things in that chapter, particularly the housing equity I thought was super interesting. Could you, maybe, tell us a little bit about that and how it relates to mental accounts, how people’s behavior with regards to their home equity kind of reflects what you’re talking about here?

[00:10:45] Alex

Yeah, so the idea is that you have different pots of wealth. So, you have your income from your job, you have bonuses that you get at your job. Then you have other pots of wealth, such as, for example, your stock market portfolio. And then there’s real estate. And then you could kind of order these things based on the marginal propensity to consume from that wealth.

What that means is that if your portfolio went up by 20%, how much of that 20%, or how much of your portfolio wealth, are you going to be spending on various things in your life? And if you get a bonus at work, that’s kind of your highest marginal propensity to consume. Unless it’s very, very, very large, in which case it kind of goes into your savings account right away. You’re usually spending that on something.

Whereas real estate is kind of on the other end of the equation where people really don’t spend out of that portfolio. That’s kind of your most illiquid, your lowest marginal propensity to consume.

And there’s a lot of really interesting work in economics by David Laibson and he’s got this Golden Eggs paper, that was extremely influential in the second half of the ‘90s, basically saying that people actually potentially use these sorts of illiquid mental accounts as a way to solve their self-control problems.

So, one might want to buy a house or something like that to invest your money rather than parking it somewhere else, is that you know that your marginal propensity to consume from that pot is going to be very low. So that’s going to be good for saving, for retirement and things like that.

[00:12:16] Kevin

Yeah. And what was fascinating…

There are kind of two things I’d like to explore there. One was that people, even when they sell their house and move somewhere else, they don’t extract the equity from it. They kind of have in their mind that I want a certain amount of equity in my home. And even when they’re given the opportunity to take some out, they don’t do it.

[00:12:42] Alex

Yeah, so, that’s kind of the idea of rolling mental accounts where like, look, I sold this money. Technically, you know, it’s no longer house money, but I kind of roll it over into the next house, to the next real estate purchase that I want to buy. So, my marginal propensity to consume from that kind of remains the same.

There’s a great paper by Cary Frydman and co-authors, actually, called Rolling Mental Accounts, of basically looking at stock market decisions of people. You know, when I buy a stock that basically opens a mental account with respect to my earnings on that asset.

And what they show is that people kind of roll over those mental accounts. If I sell and then buy a stock right away, I treat that money as if they were in the same mental account. So, I basically roll it over and then my marginal propensity to consume from that amount is pretty constant. It doesn’t become higher or lower necessarily.

[00:13:37] Kevin

You quote some research in that chapter, I think out of Norway, where they said, hey, if you look at, I guess, the savings behavior of kind of wealthier people versus people lower on the income spectrum, that in terms of their propensity to save of out their income, there’s not much difference. And the real difference is that wealthier people own stocks and people don’t spend the capital gains.

So that it’s not like wealthier people are, in some sense, kind of more frugal. They have wealth in a particular account that people don’t tend to spend out of. Is that right?

[00:14:21] Alex

Yeah, yeah, exactly. So, it’s like some of the various heterogeneity and differences that you might attribute to people being from different demographics or different sorts of wealth brackets. A lot of that just comes from how their wealth is managed and what accounts that wealth is in, in their heads, essentially.

Because, you know, on paper, if you write down a standard economic model, it doesn’t really matter where this money is as long as it’s not kind of like locked up in something like Social Security. But depending on where that wealth is, if it’s in stocks and it’s kind of capital gains, the marginal propensity to consume is going to be super low. Whereas people who don’t have as much money in the stock market, the marginal propensity to consume that is much higher. So, their spending is just going to vary very, very differently. And you could attribute it to differences in wealth, but the real factor here is just this money’s coming from different sources and people have different marginal propensities to consume from those sources.

[00:15:19] Kevin

Does that have any implications for, I don’t know, like, if you are going to give money to your grandkids or something like that, instead of the US$50, or whatever, that you get from your grandma, should she just be buying you stock instead if you want to encourage savings?

[00:15:39] Alex

Yeah, so, this has huge implications. We’re talking about a grandma and her kids. I think with US$50 bucks, it doesn’t matter too much what you’re doing, but it starts mattering a lot when you’re like a policymaker and thinking how to stimulate the economy.

So, if I want to basically have a stimulus package, and my goal is not to get people to save that money, but to get people to spend that money so the economy can recover, that requires you to label and structure that package so that people are more likely to treat it kind of as a bonus rather than as an amount that they should save.

So, what that, for example, means is that it shouldn’t be a huge, huge lump sum. If the amount that you’re trying to stimulate the economy is large, it should kind of be differentiated from their paycheck, for example, because the paycheck has a lower propensity to consume.

So, for example, one thing that the COVID stimulus money was based on, it was basically people’s paychecks. And what that meant is that that’s going to have a pretty low propensity to consume. Because people are just treating that paycheck as a completely different mental account than a bonus that the stimulus was meant to do.

So, in some ways you could think of that if your goal is to stimulate the economy, you should structure your stimulus payment, or your refunds, or whatever you want to call it, with a specific goal. Now, on the other hand, if you want people to save, then you should do the opposite. You should put it into their paycheck.

[00:17:11] Kevin

I was thinking about that as well. Thomas Piketty has this idea (the author of Capital in the 21st Century) that we should give young people an endowment of capital. There are other things going on here. He’s trying to recirculate wealth.

But it struck me, as I was reading that chapter, that I guess the question is, if you open this kind of mental account for people when they’re young, say, give them some stock, does that increase their propensity to add to that mental account over their life? Because it’s like, hey, I’ve got this thing that otherwise they wouldn’t have had. Do you see what I’m saying?

[00:17:54] Alex

Yeah, so, I think that’s less of a kind of a mental account specific phenomenon. It’s more of like an attentional phenomenon. I mean, a lot of young people don’t even think to do it in the first place. So, there’s this thing in finance, which I’m sure you’re familiar with, the stock market participation puzzle. Given the returns on the stock market, a lot more people should have their money parked in the stock market given that, over the course of their lives, the money is definitely going to increase by a tremendous amount compared to parking it in the bank. So, why aren’t people doing it? I mean, a lot of it is people just don’t understand how to do it or really know what’s going on in that dimension.

If you kind of start people out with an account that they know how to use, a lot more people are going to be invested in the stock market. And especially, you know, I have some essays coming out and on my substack, going forward, thinking about, like, what’s going to happen with AI once labor starts being displaced more and more and gets automated.

I think the idea of giving people a stake in capital is going to be more and more important as far as both aligning the incentives between firms and consumers, and allowing consumers to kind of maintain their demand in the economy and keeping the economy running.

[00:19:08] Kevin

Okay, one last question on mental accounts. One of the roles, I believe, with mental accounts, one of the things people seem to be doing is kind of putting money where it’s safe from temptation. And we had Daniel Crosby on the show. He wrote a book called The Soul of Wealth, which is a series of very short essays on behavioral economics and how it relates to, kind of, I guess, just our daily lives.

But in that book, he quotes research that shows that the more salient a savings goal is, the more likely you are to fund it. So, in other words, don’t just set up an account for retirement. Imagine that retirement in the richest possible detail you can. And the more you make that, I don’t know, not just I’m going to buy a second home, but what does the home look like, where is it located, how is it furnished, etc.

What do you think of that research? Is that something that you agree with?

[00:20:15] Alex

I totally agree with that. I mean, this is really related to this point about attention. A lot of the reason why people don’t do certain things is because they’re just not attending to it. It’s not in the set that they’re… So, a lot of economics is based on the idea that you have your whole option set up in front of you, the whole potential option set. And so, what that means is that if a person isn’t observed doing something, that means they don’t want to do it.

The other type of model, that I think is way more realistic, is the one that you just mentioned. People just don’t think the choices exist in the first place. Even though me, as an economist, I know they exist. The person might not attend to their savings goal. They’re walking around their day, they have some money, and then they’re thinking about how they spend it. It doesn’t even come into their heads that, look, maybe I should save it.

If that savings goal is vivid and salient, they’re going to be more likely to consider it and make a choice that’s consistent with their long-run preferences. So, I completely agree with that idea.

My research agenda is very much currently in that direction, thinking about, look, what are people attending to when they’re making their choices?

[00:21:20] Kevin

I was going to ask this at the end, but I think this is a good time to ask it now, since you were attracted to behavioral economics through the book Nudge. So, how can we sort of nudge or push people in directions that would, say, increase savings or would make their behavior “better”?

And I guess people have mixed reactions to that idea. I mean, even people who might be listening to this podcast and would totally agree with some of the ideas, they still feel a little uncomfortable with the government sort of deciding, hey, we are going to nudge you in this direction or we’re going to nudge you in that direction. How do you think about that?

[00:22:07] Alex

My personal view, and I’m not speaking for Richard, it’s that the nudge term has been misused to such a colossal extent to almost be useless.

[00:22:18] Kevin

Okay, what do you mean by that?

[00:22:20] Alex

People call things nudges, which are not nudges, they’re pushes and they’re shoves.

[00:22:25] Kevin

Okay, what would be an example of that?

[00:22:28] Alex

You know, like a monetary incentive or a disincentive, some people say that’s a nudge. That’s not a nudge, that’s a price. Right? Other things are not nudges at all. They’re information, like me not knowing something and then you giving me information about it. That’s not a nudge, that’s just information. I didn’t know how to do this.

The classic idea of a nudge is the ones that, you know, Richard describes in the 401k process. It’s that people are reading a long-form about whether to set up a 401k, and they don’t know what a 401k is, and they might not take the time to read up on it. They see the option of ‘to do it’ or ‘to not do it’. The default is to not do it.

If they don’t know what ‘it’ is, maybe they think, look, my employer is giving me the recommendation not to do it, so I’m not going to do it. If you change that as the default to be, ‘hey, the default is to do it’. Hey, but if you know you don’t want to do it, don’t do it. Just switch it. Right?

It’s not the government nudging you to do something, as in pushing you. It’s more to say, look, if you don’t have a lot of information; if you’re pretty indifferent about it because you’re not reading the form to begin with, here’s a recommendation. And I think that makes sense to me.

Now, on the other hand, if you’re talking about nudges as, ‘look, we’re going to put a tax on something’, or ‘we’re going to keep you from doing this’, but call it a nudge, that’s not really a nudge, that’s a shove.

So, I think a lot of the things that people are uncomfortable with, with nudges, are things that really aren’t nudges to begin with in the way that kind of the book first started talking about it. So, my personal opinion is we should describe the policies as they are and then evaluate them one by one.

We shouldn’t say, do you support nudges? That’s not a useful term because it means absolutely nothing anymore. Maybe it did when the book was first written, but now it’s like you read a paper that came out, oh, we found this, and this effect from nudges. But this is a completely different policy than another paper that would be talking about nudges. So that’s kind of my personal opinion about it.

[00:24:51] Kevin

Since the book is called The Winner’s Curse, why don’t we talk about that? That’s the first chapter in this book as well as the first edition. And it’s fascinating a little bit. I don’t know. It’s not clear what the solution is to the winner’s curse or if there is a solution, whether we can actually do it in practice. But can you start off by explaining what it is?

[00:25:18] Alex

Yeah. So, the winner’s curse is this phenomenon that in auctions, often you end up losing money when you win, and it’s a specific setting. So, this is the setting. Let’s say you go into a bar, and you know, you have a jar of coins, and you say, look, whoever guesses right, the closest to getting the money from a first price auction, so, everybody bids for this jar of coins and essentially the winner with the highest bid gets the jar. You don’t have to take the coins. Nobody wants to walk around with the coins, I’ll just Venmo you the money.

So here are two things that happen in that setting. One, the average bid, it’s going to be below the amount of money in that jar. So, this is kind of risk aversion. This is the standard result from auction theory. But here’s the other thing that happens.

The person who wins the jar will pay more than the amount that’s in the jar. So that’s the winner’s curse. Let’s say there’s US$15 in the jar. The winner is going to be paying something like US$20, US$18. So, they’re going to be losing money because the jar has a certain amount of money.

So, the setting is a common value auction where the amount is the same for everybody. And this is a first price auction. That’s also a key result. So, in these settings, the winner’s curse is essentially the fact that, look, nobody really knows how much money is in the jar, right? So let’s say there’s US$15. A lot of people are going to say maybe US$13, US$10, US$11, something like that. Other people are going to be wrong in the other direction. Maybe they’ll think US$16, US$17, US$18.

The key result from the winner’s curse is that the winner is not random. It’s the person who overestimated what’s in the jar. Right? And because it’s not random, it’s the person who overestimates, that person is going to tend to pay more. And you know, you might think, oh, cute experiment, you know, jar of coins, it doesn’t matter.

Where was the winner’s curse first documented? It wasn’t in a bar, it wasn’t with students. It was actually by oil executives writing a paper basically arguing that, look, we have these very, very good engineers doing research on oil wells, and every single time we win, we end up finding less oil than we thought. Huh! What’s going on? And then they figured out the winner’s curse basically in this setting. And then behavioral economists went through and showed that actually it holds on a lot of different settings as well.

[00:27:36] Kevin

Yeah, and it’s interesting because it’s more (I believe this is right), it’s more prevalent the more people that are bidding. So, if you win an auction bidding against one or two other people, you might feel good. But if you win an auction bidding against 50 other people, then you might be like, hmmm…

[00:27:57] Alex

What does that mean? That means you overestimated over 50 other people. Right? That means, oh my God, were you wrong.

[00:28:05] Kevin

So, what I found a little bit frustrating (which is probably not the right word), or challenging about this chapter was how do you go about, let’s say you’re operating in the oil industry. A lot of people are operating in businesses where you’re having to compete on price. And it just feels like the only way to avoid the curse is never to be in business. Is it the case that anytime you win one of these auctions, you’re always going to lose money?

[00:28:41] Alex

It’s tough. So, you’re exactly right. What’s the alternative? It’s to not bid, and then you don’t get any oil. And then you would go out of business because you’re not drilling for oil. The interesting thing about that case is that the oil company that published the paper, they did something smart. One way to kind of temper the winner’s curse is to tell everybody about it, so everybody bids a little less. And then you know the winner, in that case, if everybody’s kind of following this strategy of accounting for the winner’s curse, there won’t be a winner’s curse.

So that’s one strategy is for people to know there’s a winner’s curse and adjust for it. So, that oil company was actually quite smart about publicizing it.

And that seems to be, as far as being in a competitive market and needing to win to stay in business, that’s essentially the only sort of heuristic you have is to publicize it or, if you have that power, to try to be in smaller pools of other people or to have some sort of other arrangement where you’re not competing at all.

[00:29:46] Kevin

Gotcha. Gotcha. So, with the winner’s curse, does that show up in the IPO market? Is that part of why IPOs tend to underperform? Is that a winner’s curse phenomena or is that something else?

[00:30:01] Alex

There’s been a bunch of papers about the sort of IPO phenomenon where they pop and then decrease in value. There are some sort of very rational reasons why that’s happening with the principal agent sort of framework, with the underwriters and what’s going on at that end. But I think the winner’s curse phenomenon is definitely something that takes place in the stock market because, again, essentially the way that you buy stocks is through some sort of background auction going on. And I think that definitely could be going on.

I think the data isn’t good enough in the sense that there’s not kind of this external true price of that stock for us to really be able to say, look, this is a winner’s curse phenomenon. The advantage of something like an oil field, or a jar of coins, or something like that, we know how much it’s worth. We know when a person overpays or not. With IPOs, it’s really hard to say. And then there’s a lot of other sorts of phenomenon going on, including just kind of very rational reasons why it would happen.

[00:31:03] Kevin

It seems like one area where the winner’s curse definitely shows up is these fundraising auctions for schools and stuff. Like, they kind of depend on that. You know, here’s a trip to whatever, a ski field, and we’ll open the bidding, and next thing you know, you’ve paid three times what you could have done on Airbnb.

[00:31:24] Alex

Yeah, I mean, we were just bidding on something, my wife and I were just bidding on in an art auction. We, essentially, got into this scenario where we’re like, if we bid on this painting and we win, how much are we willing to lose because of the winner’s curse? So, we were, like, going through that process. So, we were only bidding on things where if we lost, we’d be comfortable with it.

[00:31:51] Kevin

While you’re talking about that, do you have to shut off your behavioral economist mind, or is it always operating as you go through the day thinking about these things?

[00:32:03] Alex

It’s not always. I mean, I’m making mistakes all the time. It’s an active effort, in a sense, to know when I’m making mistakes. The simple process of planning for the day. So, my day starts with me looking at the plan that I came up with the night before.

And the key component of the night before is to know what mood I’m going to be in the beginning of the day. And that’s always very hard. And so, I need to basically… In the evening, what I used to do is like, oh, of course I’ll have all this time. Here’s every 15 minutes is planned out. And at the end of the day, when I’ve accomplished like 10% of it because I need to eat, I need to take a walk, basic things, I feel really bad about it. So, every single day I was like, oh, man, this sucks.

So now, in the evening, I’m like, all right, here’s what I’m going to plan for myself. But I’m going to decrease it by 50% just because I don’t want to make my next day self feel bad about himself.

[00:33:02] Kevin

So that’s a heuristic that works for you.

Since we touched on financial markets, in talking about the winner’s curse, maybe we could talk a little bit more about that. A lot of the people listening to this podcast are investors, either professional or personal. The law of one price is something that obviously is fundamental to economics, but particularly fundamental to financial markets.

Could you talk a little bit about that? First of all, just what is the law of one price, and then where we see that violated in the markets? I mean, there are a couple examples in that chapter that I think it’d be fun to kind of talk through.

[00:33:45] Alex

Yeah, so, the law of one price is just kind of a fundamental property that we think financial markets should have. If you have an asset that’s worth US$5 in one market, it shouldn’t be worth US$7 in a different market, where it’s very easy to kind of switch between those two because obviously there’s a huge arbitrage opportunity there. Things that are the same should be worth one price. That’s the idea. Kind of obvious, right?

And the reason that the law of one price became, for Richard and coauthors, a topic of study is because it’s quite hard to find behavioral anomalies like these smoking-guns in financial markets because, you know, there are so many things that determine prices. It’s hard to say this price is wrong. And somebody could say, well, you don’t really know what the risk profile of this asset is. You don’t really know kind of what liquidity constraints traders are in. All of these sorts of things affect the price. So, it’s hard to say, look, this is a mistake. The law of one price is a clear mistake.

So here, here’s one of my favorite examples in the book, it’s 3M which some of your listeners might be familiar with. It was a big company in the ‘90s, is still around, I believe. They used to have Palm Pilot as part of their products. So, Palm was kind of like an early iPhone you could think of. It had buttons, but it was way worse than an iPhone. But it was very popular. People really liked it.

So, 3M smartly said, like, let’s roll this out as a separate thing. And it rolled it out as a separate thing, issued shares for Palm. But the key thing is, is that every person who had a Palm share also had a 3M share.

So, what is the law of one price? Shares of Palm cannot be worth more than shares of 3M. And what you found is that this law of one price was completely broken. And you know, if you did the math, 3M on its own, the separate 3M stock, was worth something in the negatives. I don’t remember the exact number. You’d have to pay people to get rid of these stocks, which is obviously, you know, crazy.

That’s just one of the examples. There are other examples. Like, there’s a fund called the Cuba Fund, C U B A. this fund essentially had a bunch of assets in the Caribbean. You can’t invest, just FYI, you can’t invest in Cuba. So, it’s a Cuba fund. But there was no Cuba stocks.

And when you look at the graph of Cuba you see this bump at a certain date. Why did that, why did that fund just skyrocket in price? And you look, and President Obama, at the time, had said he’s willing to start liberalization of trade with Cuba.

And people obviously thought, oh, the Cuba Fund, I’m going to buy these Cuban stocks which have become more expensive. But there are no Cuban stocks. So, things like that, that’s kind of like these kind of smoking-guns for incorrect pricing in the financial markets.

[00:36:50] Kevin

I mean those are kind of, those are fun and kind of head scratching examples. Is it really just that it’s expensive and risky to kind of arbitrage those situations away? So, they kind of exist because, you know, people like what I used to do, you know, it’s expensive, it’s risky to kind of take the other side and eliminate those differences.

[00:37:17] Alex

Yeah, so, I mean this is the limits to arbitrage argument. So, there are many, many different factors that keep arbitrage opportunities from being the sort of disciplining opportunities that they should be. So, for example, risk is a big part. What’s the quote? ‘People can be stupid for much longer that I can remain liquid.’ So, that’s the main limit to arbitrage. There are also differences in risk. Sometimes there’s just like barrier, transactional barriers. So, one market… you just can’t buy and sell between two markets for whatever reason, because of passport issues or something like that.

So, there are lots of reasons why in many cases you’re seeing these sorts of violations of the law of one price. So, this is why the focus is on something like 3M where, you know, there are always other explanations for things that look like violations of law of one price and they probably are violations, but you can’t prove it as well as you can when there’s really no limits to arbitrage. Like for example, the 3M case. It’s just a smoking gun.

The way to kind of think about it is that, yes, these are stories, but these are kind of the most conservative sort of benchmarks that you can think about because you’ve been able to strip every other explanation away. And so, if you are seeing this violation in this very, very clear-cut-case, these sorts of violations are probably living all over the place where they can’t be identified as clear.

[00:38:50] Kevin

So, if that’s the case, then, you know, when we talked about mental accounts, there were clear reasons that people have these mental accounts and they kind of made sense. There’s complexity of decisions. It’s like we’re going to try to simplify things.

What’s the reason… If we set aside the differences for arbitrage, that’s an explanation in many cases, but not all cases. What’s the explanation for these remaining cases, the 3M Palm Pilot case? Or is it just that it’s still an open puzzle?

[00:39:32] Alex

Yeah, so, I don’t think we get into it in the book about sort of the explanations for the law of one price violation. So, I think a lot of that comes from people thinking that other people will be fooled.

So, for example, with the Cuba Fund, the entire kind of effect could be driven by people knowing that there’s no Cuba in that fund, but thinking that other people are kind of think that there’s Cuba in that fund and then just buying the fund. That would generate the same sort of bubble where nobody actually thinks there’s Cuba in that fund, but they’re acting as if they do.

So, still people are wrong because they think that there are people who think that there’s Cuba in the fund, but there aren’t. But the mistake is kind of fundamentally different. So, it’s really hard to identify the specific source of these mistakes.

So, in financial markets, as typically is the case, the first thing to do is to just kind of document the anomaly. And then afterwards, if it’s possible, there’s a series of papers that follows which tries to say, like, look, we think that this is the explanation.

So, something like loss chasing and escalations of commitment, this was first kind of established as a phenomenon. And then afterwards there were a bunch of different papers that say, look, this is consistent with something like prospect theory.

[00:40:53] Kevin

Gotcha, yeah, that’s something that I try to tell my students is, hey, you see these violations, they look like arbitrage, but let’s walk through what’s actually required to take advantage of it. Oftentimes you have to have a huge amount of leverage. And if you’re leveraging something up, that means you’re borrowing money, you’re dependent on the funding cost, but also kind of fates out of your control. The lender can close that position if it goes against you. When do the lenders get really nervous?

Well, they get nervous in bad times when the market does poorly. So, if you can walk through the logic, you end up with a trade that starts off looking like it’s market neutral, because you’re long one thing and short another thing that are essentially the same, but that trade will end up going wrong when the market does poorly because that’s when the lenders get nervous.

[00:41:49] Alex

And then they start calling…

[00:41:51] Kevin

Yeah, and there’s embedded beta. These trades are not market neutral, so they end up being, essentially, a directional trade, not all the time, but at the worst possible time.

[00:42:01] Alex

Right, right, exactly. So, when you’re thinking about a diversified portfolio, these are very, very “undiversified” trades.

[00:42:10] Kevin

Yeah, and they fool you because, if you look at a particular time window that doesn’t have a bad market event in it, then it looks like, hey, this thing is really diversifying. But in fact, it’s actually amplifying your risk at just the wrong time.

Anyways, we’re good. That’s something that I like to pound the table about.

So behavioral economics has obviously been around a long time, and the first version of this book was published in 1994. We see many, many popular books like yours, like Hate the Game by Daryl Fairweather, etc. You have this really fascinating section toward the end where you say, hey, go through an economics textbook, introductory, even graduate textbook, and the sort of examples and stories that you’re talking about don’t show up. Or if they do show up, it’s kind of like in a little box to the side saying, oh, by the way, you should be aware of this.

So, it’s not embedded in the teaching of economics. And my question is why? And you address this in the book. But I think the listeners are probably like, okay, well, why? All this makes sense, why isn’t that part of what you learn as an economic student?

[00:43:26] Alex

Yeah, I mean, the very straightforward answer is that economists are human beings, and behavioral economics is just much harder to write down kind of a parsimonious model. You open up an economic textbook and it’s fundamentally different than a psychology textbook. A psychology textbook, every chapter is kind of a new phenomenon, new explanations, these are a bunch of different phenomenon that you should be aware of. Economics is very different because you start with a basic structure, and then you build from that basic structure.

You take utility maximization. You show, what is utility maximization in asset markets? How does this apply to the macro economy? Macroeconomics used to be a completely different thing than microeconomics. And then Bob Lucas said, no, actually you can use microeconomics and just put an integral in front of it, and now it’s macroeconomic economics. So that’s the advantage of economics, is to have a cohesive framework.

But this is why it’s very difficult to write a textbook with behavioral economics, because now you kind of have to start thinking about, okay, in this context, the model is going to be different. In that context, the model is going to be different. In this other context, you know, it’s going to be different still. And so, it’s much more difficult and laborious to write that sort of framework because you’re basically going to have to be writing down fairly different models in each chapter.

And given the economics tradition, that’s just like not something that textbook writers want to do. They want to present a coherent, single general framework. And it’s hard to fault them for that because the reason that economics has been so successful is partly because of the fact that there’s a unified framework.

And so, part of what’s going on in behavioral economics now, like the kind of the forefront of behavioral economics (and we talk about this in the epilogue) is trying to do something like that; is to say, look, we have these phenomenon in behavioral economics, they may look different, but actually there’s an underlying process that unites them.

So now we go from two to one. And trying to do that as much as possible, I don’t know the extent to which will be successful. That is one of the efforts. And maybe, in the future, we will have something like a textbook, real textbook treatment of behavioral economics.

[00:45:51] Kevin

I liked, at the end of the book, where you said if we could pose one question it would be what makes a choice difficult? And when I first read that, I’m like, why is that such a profound question?

And then you say, of course, anyone can choose between a bottle of water that costs US$1 and a bottle of water that costs US$1.50. That’s an easy choice to make. But as the choices get more complex, then we have to start leaning on these heuristics. And that’s when these “anomalies” start emerging.

So, it turns out that what makes the choice difficult actually is a profound question because it’s really, like, when do you start wading into this world of heuristics and anomalies? So, what’s your take on that? How do you think about what makes a choice difficult?

[00:46:53] Alex

There are some things that clearly make choices more difficult. So, when choices have more options, they’re more difficult, when choices are high dimensional. So, let’s say you’re choosing between two different options, but each of those options differs in like 20 different dimensions. When you increase the dimensionality, that increases complexity. That’s true.

And so, when you’re seeing high dimensional choices, when you’re seeing large option sets, when you’re seeing areas where people are kind of unfamiliar with how to start doing the problem in the first place, it’s complex. And this is where biases kind of come in.

So, part of my research agenda is showing that, you know, when a choice is high dimensional, people are going to be ignoring things that may be relevant. And if you can predict what they’re ignoring, you can start explaining their behavior a lot better. So, this is the research agenda that I’m in.

And it’s to say that, look, we could still kind of think about utility maximization, but instead of taking people’s choice sets as the economist sees it, and taking these choices as the person sees it, we can probably explain behavior a lot better. And so, this is part of complexity, reducing that dimensionality.

Other parts of complexity are just much more difficult to think about. So, one example is the bat and the ball problem and these related problems. So, a bat and the ball cost US$1.10 each. There’s a US$.10 difference between them. How much does the bat and the ball cost?

So, a lot of people say US$1.10, and that’s the wrong answer. And you pay people a lot of money, like US$20.00, get it right. Nothing, they still get it wrong. You tell them this is a tricky question, they still get it wrong. But if you ask them to actually write down the math and solve it, and then they get it right.

This is a very fascinating thing because it’s not that people don’t know how to solve the question. They know how to solve it, they’re incentivized to solve it, and they still get it wrong.

[00:48:57] Kevin

That’s a really good example because that was going to be my follow-up question. Like, okay, you’ve got, in your own mind, a pretty good view of what makes a choice difficult. But what’s the lesson for us individually?

Like okay, I realize I’ve got this difficult multidimensional choice. What do I do? And so, you’re saying, in this case, the thing to do is just step back and kind of write down the math.

[00:49:25] Alex

To be honest, I think that’s the answer to a lot of these things.

The way that I think about the 401k problem, why people do not invest in the 401k, I think many people that do not invest in the 401k (at least before this sort of like opt in thing was happening), I think they just didn’t take the time to figure out what it was. And the reason this is mysterious is because one, taking the time would have been very worth it. So, you can’t explain it through like search costs or information processing costs. And two, people would know how to do it if they tried to.

So, to me, the 401k example is much closer to the bat and the ball problem than it is to, you know, I don’t know how to do this, I’m confused, or something like that, and I will never be able to solve it, and the incentives are not there to do it.

The incentives are there. People know how to do it. They weren’t doing it. Why is this a difficult problem for them? And I think we have a lot less research on that dimension much.

[00:50:28] Kevin

There was, in that section of the book where you talk about the bat and the ball problem, there’s another one where you say, what are the words… name a word in the English language that ends in ‘eny’, I think. Right? And I actually got that one right, but I got it right for the wrong reasons. I immediately thought, oh, larceny, which is actually correct. But it’s much easier to just, as you say, go through and say, well, is there a word Aeny? No. Is there a word Beny, etc. And you get to Deny, and yes, deny the fourth letter of the alphabet. So, I don’t know what that says about my brain that I immediately thought larceny as the answer.

[00:51:08] Alex

Yeah, no, it’s a… So, like, this is another very important heuristic, is availability, which is like, what comes to mind, and how memory works, and how attention works. This is a standard sort of problem that people have access to this information in their brain. If you incentivize people, they will still get it wrong.

And what’s going on is like, the way that the brain associates things is in a biased way. The things that come up in memory, the things that people attend to. So, once you put structure on that and figure out what’s actually going on in the brain that leads to these mistakes, I think you get a lot of mileage for that. Not just in terms of helping us understand or the phenomenon, but I think that model will look very similar to utility maximization.

[00:52:01] Kevin

I mean, it’s. It’s interesting because, you know, what you just said about incentives. I mean, sometimes it’s said that the golden rule of economics is, “incentives matter”. And what you’re saying is that, well, they don’t always matter I mean, or they might not always be decisive.

[00:52:21] Alex

I think my takeaway is that they matter, period. But your model of how they matter could be wrong.

[00:52:31] Kevin

Okay, okay.

[00:52:32] Alex

Given the objective function of the person, incentives always matter. But sometimes the objective function is such that incentives will matter in a way that looks wrong to you.

[00:52:47] Kevin

I gotcha. I gotcha. Okay.

Well, listen, Alex, I think that’s a good place to wrap up today. I really, really appreciate you joining us. Thanks for taking the time. Good luck with the book and your research.

[00:53:01] Alex

Thanks. Thanks so much, Kevin. It was a pleasure.

[00:53:04] Kevin

Okay, everyone. Well, the name of the book is The Winner’s Curse. And really, this is a book that I think everyone should read. It’s accessible, it’s relevant and it’s fun and we literally just scratched the surface. We only talked about a couple of chapters, so please go out and get a copy of the book and make sure to follow Alex’s work because I think, as you can tell from the conversation here, a lot of these topics are not being discussed enough on mainstream media. So, for all of us here at Top Traders Unplugged, thanks for listening and we’ll see you next time.

[00:53:39] Ending

Thanks for listening to Top Traders Unplugged. If you feel you learned something of value from today’s episode, the best way to stay updated is to go on over to iTunes and subscribe to the show so that you’ll be sure to get all the new episodes as they’re released. We have some amazing guests lined up for you and to ensure our show continues to grow, please leave us an honest rating and review in iTunes. It only takes a minute and it’s the best way to show us you love the podcast. We’ll see you next time on Top Traders Unplugged.