Savvy Nickel
by Steven D. Levitt & Stephen J. Dubner
Steven Levitt and Stephen Dubner apply economic thinking to unconventional questions — from sumo wrestling to real estate agents to crime. The most entertaining demonstration of how incentives, information asymmetry, and data analysis reveal hidden truths about human behavior.
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Steven Levitt is a University of Chicago economist known for applying rigorous data analysis to unconventional questions. Stephen Dubner is a journalist who could make economics entertaining. Together they produced Freakonomics — one of the bestselling popular economics books ever written. Its core insight: if you change the incentives, you change the behavior. Understanding this principle makes you a better investor, consumer, employee, and decision-maker.
| Attribute | Details |
|---|---|
| Title | Freakonomics |
| Authors | Steven D. Levitt & Stephen J. Dubner |
| Publisher | William Morrow |
| Published | 2005 |
| Pages | 256 |
| Reading Level | Beginner |
| Amazon Rating | 4.6/5 stars |
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Steven Levitt is the William B. Ogden Distinguished Service Professor of Economics at the University of Chicago. He won the John Bates Clark Medal in 2003 (awarded to the most promising American economist under 40). Stephen Dubner is a journalist and author whose previous books include Turbulent Souls. They continue to collaborate on the Freakonomics podcast and subsequent books.
Every human behavior is a response to incentives — economic, social, and moral. Understanding what incentives are operating in any situation is the key to predicting behavior.
The three types of incentives:
| Type | Description | Example |
|---|---|---|
| Economic | Direct financial rewards and penalties | Paying employees more for better performance |
| Social | Reputation and peer approval/disapproval | Being embarrassed to be caught cheating |
| Moral | Internal sense of right and wrong | Donating to charity even when no one is watching |
The cheating teachers experiment:
Chicago public schools implemented high-stakes testing in the 1990s — teachers' job security depended partly on their students' test scores. Levitt analyzed test score data and found patterns consistent with systematic teacher cheating: suspicious strings of correct answers in sequence, unusual jumps in scores followed by reversals the next year.
Why this matters for investors:
Corporate incentive structures determine executive behavior. A CEO paid primarily in stock options expiring in three years has incentives to maximize the stock price over three years — which may involve actions (cost-cutting, financial engineering, accounting flexibility) that harm the business over ten years. Analyzing executive compensation structures is a legitimate part of investment due diligence.
The real estate agent incentive problem:
Levitt's most directly investment-relevant finding: real estate agents do not maximize sale prices for their clients. They maximize their own time efficiency.
The math:
On a $300,000 house sale, the agent earns a 6% commission split four ways (listing agent, buyer's agent, each's broker): $4,500 to the listing agent.
If the agent holds out for $310,000, the additional $4,500 to the seller produces only $112.50 additional commission to the listing agent. The extra week of work to get the higher price is not worth the marginal commission gain.
What Levitt found in the data:
Real estate agents sell their own homes for 3.7% more on average than client homes — and keep them on the market 9.5 days longer. The agents know their incentives are misaligned with their clients', and they manage their own homes accordingly.
For investors: Before trusting any financial advisor's recommendation, understand their compensation structure. Fee-only advisors (paid by you, not by commissions) are better aligned with your interests than commission-based advisors.
Conventional wisdom is often wrong when actual data is examined. Levitt's contribution is finding the right data and the right measurement to test conventional beliefs.
The crack cocaine and crime example:
In the 1990s, crime rates in American cities fell dramatically. Most commentators attributed this to the specific policing strategies of the era (broken windows policing, increased incarceration, more police).
Levitt's analysis examined the timing of the crime drop more carefully and found it correlated strongly with a different variable: the legalization of abortion in 1973 (Roe v. Wade). Children born to mothers who would have sought abortions — who were on average poorer, younger, and less prepared for parenthood — were the demographic group most likely to commit crimes as young adults. Fewer such births in the mid-1970s meant fewer crime-prone young adults in the early 1990s, when crime peaked.
The investment application of data scrutiny:
Conventional investment wisdom is often wrong when examined with real data:
Seeking out the actual data rather than relying on conventional wisdom is one of the highest-value activities in investment research.
Information asymmetry — where one party knows more than another — allows the better-informed party to extract rent from the less-informed party.
The used car market (Akerlof's lemons):
Car sellers know whether their car is good or bad. Buyers cannot easily tell. This causes buyers to offer the average price for a used car of that type. Good-car sellers find the price too low; they withdraw from the market. Bad-car sellers find the price acceptable; they participate. This selection worsens average quality, which lowers prices further, which drives out more good cars.
The internet's effect on information asymmetry:
Levitt notes that the internet has dramatically reduced some information asymmetries that previously enriched middlemen:
Information asymmetries that remain are typically in areas of genuine complexity — medical diagnosis, legal advice, complex financial products.
Investment implication:
Information asymmetries that protect profitable businesses are a form of competitive moat. Companies that know more than their customers about pricing (airlines, insurance companies), know more than competitors about costs (proprietary manufacturing processes), or control unique data (credit bureaus, financial exchanges) earn persistent excess returns.
Much conventional wisdom confuses correlation with causation. Levitt's most entertaining examples demolish policies built on this confusion.
Swimming pools and guns:
Swimming pools in American homes kill far more children annually than guns. Yet policy and parental anxiety are heavily concentrated on guns. Why? The emotional salience of guns (dramatic, scary, news-worthy) disproportionately shapes perception relative to the statistical reality.
Investment application:
Economic correlations that are widely reported in financial media are often coincidental or causal in unexpected directions. The "Super Bowl indicator" (market rises if an NFC team wins) is a famous spurious correlation. Many technical analysis patterns that "work" historically are also spurious correlations in small samples.
Before relying on any investment correlation (sector rotation rules, seasonal patterns, market timing signals), require an economic mechanism that explains why the correlation should persist.
Lesson: Base rates matter more than salience. Investors overweight vivid, emotionally salient risks (a single company's fraud story) and underweight quiet but statistically significant risks (fee drag, inflation, sequence-of-returns risk in retirement).
Action: Calculate the actual expected dollar impact of each risk in your financial plan. Emotional salience should not drive portfolio decisions; expected value should.
Lesson: Every financial intermediary has incentives that may not align with yours. Understanding those incentives is a precondition for using their services wisely.
Action:
| Intermediary | How They're Paid | Implication |
|---|---|---|
| Commission broker | Per trade | Incentivized to generate trades; potentially churning |
| AUM advisor | % of assets | Incentivized to grow AUM; may favor complex/high-fee products |
| Fee-only advisor | Flat fee/hourly | Best alignment; incentivized to give good advice |
| Fund company | Expense ratio | Incentivized to grow AUM; index funds align with investor interests |
Levitt and Venkatesh analyzed the financial records of a Chicago drug gang. The finding: most street-level drug dealers earned below minimum wage, working 8-hour shifts for $3.50/hour, subsidized by other employment. Only the top tier of the gang hierarchy earned significant money.
The investment parallel: Most businesses have winner-take-most economics where the top performers capture disproportionate returns. In investment management:
This is one more argument for indexing — in a winner-take-most industry, finding the winners in advance is extremely difficult, and the cost of getting it wrong (paying fees to underperforming managers) is significant.
Freakonomics's most famous empirical claim — that abortion legalization reduced crime rates 20 years later — has been challenged by subsequent research. The finding has been replicated in some studies and contradicted in others. It illustrates that:
For investors: be appropriately skeptical of any single study claiming to have identified a powerful market signal or causal relationship. Replicate it in different time periods and markets before relying on it.
Several of Levitt's studies have faced methodological critiques from academic economists. His willingness to reach bold conclusions from limited data is intellectually exciting but occasionally outpaces the evidence. This is a feature (provocative thinking) and a bug (occasionally wrong).
Q: Should I read the sequels (SuperFreakonomics, Think Like a Freak)?
A: SuperFreakonomics is nearly as good as the original. Think Like a Freak is less impressive. Start with Freakonomics, read SuperFreakonomics if you enjoyed it.
Q: How reliable are Levitt's findings?
A: The incentive and information asymmetry analysis is sound and well-documented. The specific empirical findings (particularly the abortion-crime thesis) are more contested. Treat the framework as robust and the specific findings as interesting hypotheses.
Rating: 4.6/5
Freakonomics is the most entertaining economics book in print. Its incentive framework, information asymmetry analysis, and real estate agent study have direct investment applications. Every investor benefits from thinking more carefully about what incentives are operating in their financial relationships.
Paperback: Buy on Amazon
Kindle: Buy on Amazon
Audiobook: Buy on Amazon
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