While economic anomalies make for fascinating reading, their actual significance is questionable. Nobel laureate Richard Thaler, alongside his associate Alex Imas, conducts a thorough examination.

If you're anything like us, you find anomalies fascinating. Anomalies are occurrences that differ from the usual and anticipated. In 1928, Scottish scientist Alexander Fleming returned from a holiday to discover that a quantity of mold had spoiled his meticulously prepared petri dishes containing Staphylococcus bacteria. However, something peculiar was observed: the bacteria surrounding the mold had perished. This unusual finding resulted in the discovery of penicillin, the planet's inaugural commercially available antibiotic.  

Anomalies are typically significant in scientific discovery. The difficulty in reconciling planetary movements with An Earth-centered cosmic model ultimately led to the adoption of a Sun-centered one. Economic anomalies could similarly enhance the reliability of economic theories.  

Economic peculiarities have captivated the senior team member's interest (perhaps even to an extreme) since his graduate studies. Much like discovering that celestial bodies don't revolve around our planet, identifying economic anomalies involves uncovering empirical observations that defy straightforward explanation by the conventional economic framework, which assumes individuals make optimal choices without recurring errors.  

However, caution is advised. It's perfectly acceptable if one individual favors the coffee at Joe's while another prefers the brew at Bob's; preferences vary. But it becomes peculiar when someone claims to prefer Joe's coffee yet is willing to spend more for a cup from Bob's. In economic theory, the degree to which you value something is defined the amount you're prepared to spend on it. Nevertheless, experiments conducted by psychologists decades ago revealed participants frequently made decisions that amounted to stating they liked option A more than B, but would still pay a higher price for B.  

Richard began his pursuit in the 1980s, documenting this behavior in articles titled Anomalies. His aim was to irk rigid traditional economists and, more effectively, draw in receptive young economists, such as his current collaborator Alex. (This endeavor with Alex was a lengthy one, as Alex was still in preschool at the time.)  

We've co-authored a new book that revisits the significance and resilience of the economic anomalies forming the foundation of behavioral economics. It explores how initial discoveries have endured and the field's evolution over the last thirty years.  

From lab to high stakes

A crucial aspect involved verifying if unusual conduct observed in low-stakes laboratory settings would also manifest among professionals making high-stakes professional judgments. The Winner's Curse was one of the initial phenomena that passed this examination. This curse, unrelated to supernatural forces, describes how in specific auction types, the victor overpays for the item being auctioned.  

It's simple to show this in a classroom setting. Put coins in a jar and ask students to join an auction where the highest bidder receives the money from the jar (in cash or via Venmo, not coins). What occurs? The average bid in the auction is significantly less than the jar's contents (the students are risk-averse). Averse) but the winner of the auction almost always overpays.  

Experts also err when the stakes are high. In reality, engineers employed by the oil firm Atlantic Richfield initially identified this anomaly. 

During the 1950s and 1960s, oil firms were asked to submit bids for the privilege of extracting oil from designated areas, such as the territory we'll continue to call the Gulf of Mexico. The company's engineers observed that after winning one of these bidding processes, they were typically underwhelmed by the quantity of oil discovered. What was the reason for this? Their crucial realization was that the auctions they won didn't represent a random selection of their submitted bids. By their nature, they only secured the auctions where their bids were the highest, indicating the locations where their geologists held strong optimism about potential oil reserves. They created the term “the winner’s curse” to label this occurrence.  

Economists considered it major heresy that large firms with experts would fall into the trap of bidding in auctions where the winner is cursed to lose. Theorists could prove this wouldn't occur if bidders were rational. Nevertheless, it happened, not just in oil lease bidding but also when publishers bid for a hot new “tell all” book from a former White House advisor, or when professional sports teams bid for the rights to hire a star player. Recent research indicates a similar curse affects National Football League teams vying to acquire one of the top picks in their annual draft of new players. Teams that “trade up” to secure the first pick are, more often than not, left disappointed.  

Efficient Markets Theory

Of course, drilling for oil and professional sports leagues are high stakes domains, but skeptics might well ask what if there is “real money” at stake? Not just millions of dollars, but billions or trillions such as in the stock market. Can you find anomalies on Wall Street? Again, economists will be fussy about what can be called an anomaly. During the technology boom of the late 1990s, the stock prices of tech firms soared to what seemed to be crazy prices, and then crashed. Case closed? Hardly.  

The conventional wisdom among financial economists was captured by the term coined by our colleague Eugene Fama: The Efficient Market Hypothesis. The idea has two components. 1. No matter how smart you are, it is impossible to beat the market over any extended period. 2. Stock prices reflect the correct or “intrinsic” value of companies. The first principle is at least approximately true. For example, a majority of mutual funds fail to outperform a simple index fund that buys every stock in proportion to its size. It may be possible to beat the market, but it is hard. 

But what about that second component? Are asset prices “correct”? How would we ever know? You might think that Bitcoin is obviously priced too high, and we might agree, but we would have to admit that we thought the same thing when it was selling for a tenth of its current value just eight years ago. The current high price does not prove that the previous lower price was correct.  

The Law of One Price

However, there are some special cases when we can say for sure that an asset price is “wrong.”  The most fundamental principle in financial economics, really the building block of all theoretical treatments is called “the law of one price”, or just The Law. Basically, is says that the same asset cannot sell for different prices at the same time. No matter where you want to buy a share of Tesla, a gold bar or a single Bitcoin, at any one time the prices have to be the same. Why? If the prices differed, smart traders would start buying where the asset was selling for a low price, and selling it at the high price. In so doing, they will either get infinitely rich, or, more likely, drive the prices back to equality, as the law of one price dictates. Because asset price markets are so liquid and efficient, any violations of the law of one price should be eliminated almost instantaneously. In fact, there are large asset pricing firms that make billions each year by being the fastest traders to exploit even tiny departures.  

We refer to substantial breaches of the law of one price as “smoking gun” anomalies. These indicate beyond a reasonable doubt that a transgression against efficient markets has occurred. It's unlikely there are many such instances, wouldn't you agree? In fact, a lengthy history of them exists.

Young Benjaman Graham, who later co-authored a seminal investment book and mentored Warren Buffett, found an early instance of this. In 1923, Graham observed that while DuPont held a significant amount of General Motors (GM) stock, the overall worth of DuPont's shares was comparable to the value of its GM holdings. This was notable because DuPont was a prominent American industrial company with other valuable assets. Graham purchased DuPont stock, initiated a short sale on GM shares (anticipating a price decline), and reaped profits when DuPont's value increased thereafter.  

The Palm example

A similar story arose during the technology boom of the late 1990s. In 1999, a Silicon Valley technology company called 3Com felt that the stock market was not giving their shares proper respect, despite 3Com owning the Palm division, maker of the then hot, new handheld computer called Palm Pilot (an iPhone predecessor). So, 3Com decided to spin off its Palm division, presumably to “unleash” its true value. Notice that this action in and of itself is suspicious from a Law-abiding perspective: If the same cash flows always have the same price, why should bundling or unbundling securities change value? 

3Com initiated this separation through a two-phase approach. The initial phase involved a “equity carve-out,” where 3Com divested a minor stake in Palm via an initial public offering (IPO). The subsequent phase, the “spin-off,”, was scheduled to occur approximately six months afterward. At that juncture, the remaining equity would be allocated to 3Com's stockholders. Upon the completion of the spin-off, every 3Com shareholder would be issued 1.5 Palm shares. In this scenario, legal mandates require investors to adhere to a specific condition—that after Palm shares commence trading, 3Com shares must be priced at or above 1.5 times the price of Palm shares. 

On the day before the IPO, 3Com was selling for $104. The Palm shares were sold to the public at $38 a share, but ended the day selling for $95 (after trading as high as $165!). During this same day, the stock price of 3Com actually fell 21% to $82. To see how ludicrous this price is, consider the stub value of 3Com, which is the implied value of 3Com’s non-Palm assets and businesses. To compute the stub value, one just has to multiply the Palm share price by 1.5 to get $145 and then subtract this from the value of 3Com, obtaining the novel result of a valuation of minus $63 per share (using the precise ratio of 1.525). Indeed, the market was valuing the remaining (profitable) 3Com business at minus $22 billion! To add insult to injury, 3Com had about $10 a share in cash! Investors were willing to pay over $2.5 billion (based on the number of Palm shares issued) to buy expensive shares of Palm, rather than buy the cheap Palm shares embedded in 3Com and get 3Com thrown in. Call the Law of One Price police! 

In recent decades, we must report that asset prices haven't grown more compliant with regulations. Violations remain prevalent. However, there's a positive aspect: the anomalies have grown more amusing. A recent blog post by our associate Owen Lamont discussed how shares of the massive Taiwan Semiconductor Manufacturing Company (TSMC) trade at significantly different values in Taiwan and New York. His article is fittingly named: “TSMC: Totally Stupid Market Chaos.” 

We'd be delighted to share some of those with you, but doing so would contravene the Law. This article is accessible to you without charge, and to delve deeper into the fascinating realm of economic anomalies, purchasing the book is a necessity.