I first heard the noted American economist and author Dr. Richard Thaler give a speech about something called “behavioral finance” over twenty years ago. It was my introduction to a new field of research in economics. I was so impressed with the concept that I prevailed on him to allow me to audit his graduate course “Managerial Decision Making” at the University of Chicago’s Graduate School of Business.
Well, behavioral finance has come a long way since then. It is now mainstream and is recognized as an important area to explain human behavior in the real world of decision-making. Prior to groundbreaking research by Amos Tversky and Daniel Kahneman in the 1970’s, the world of economic decision-making was based upon a theoretical “rational” man. This rational man made decisions based on all known information, without bias and without emotion. Interestingly, Tversky and Kahneman were from the field of psychology, not economics. Imagine my excitement when Dr. Thaler described “bias” and heuristics (rules of thumb). More often than not, that explained how my clients were making decisions.
It finally made perfect sense to me that even though it was logical to get a mortgage to finance the purchase of a new home, one of my clients demanded that he and his wife save enough cash to make the purchase—though it took them many, many years to reach that goal. As a child during the depression, he had seen his parents lose their home during the depression. His fear of losing his own home, while not rational, was understandable.
With each of Dr. Thaler’s classes my understanding of the often hidden and underlying bias that influences decisions was broadened. One example of a heuristic is mental accounting. We humans have a tendency to categorize, segregate, or name money in different ways. Money inherited from grandma is “Grandma’s Money” and therefore, not used for ordinary spending.
On the other hand, windfall money like tax refunds are often treated like found money and we spend it on trivial things without thinking. Mental accounting can be used in good ways as well—naming a college fund “Sara’s College” will almost always lead to meeting the goal for Sara. Mental accounting, however, can lead to problems if we discount the cost of our purchase when using credit cards. If we were required to count out dollars for each purchase, I’d bet that we would all be spending less.
It turns out that generally, we do not like loss and that is understandable. But loss aversion can be a very strong influence on future decision-making. Extreme loss aversion can keep us from investing in appropriate ways. There may be a tendency not to sell a stock or mutual fund that has lost money because we do not want to acknowledge the loss.
Loss aversion may increase our temptation to sell when there is a stock market downturn. These are only a few of the heuristics uncovered by behavioral finance. One of Dr. Thaler’s contributions to this body of knowledge is turning seemingly negative tendencies into “nudging” people to make decisions that are good for them.
The most notable example of nudging people to make better decisions is in the adjustment to how companies present options for joining their 401k plans. Traditionally, a new employee is offered the option of joining a 401k plan. They then are given the application to fill out with the list of investment options to choose. The rate of response was low.
In an effort to increase participation in 401k retirement savings plans, Thaler and Sunstein were instrumental in getting companies to rearrange the offering. The new employee was enrolled automatically in the plan unless they did not want to participate, in which case they were required to fill out the paperwork to “opted out.” Enrollment in 401k plans increased substantially. Employees were “nudged” to make a decision that was in their best interest.
In his book Misbehaving2, Thaler is calling for an “enriched approach to doing economic research, one that acknowledges the existence and relevance of humans. Dr. Thaler asserts that we humans, consumers and investors alike, do not act rationally, but economists have pretended that we do.
Back to Dr. Thaler’s class twenty years ago: Dr. Thaler presented the tension between traditional market theories this way (please give me license; my notes are from twenty years ago):
* Market Efficient Zealot
-Security prices are always equal to intrinsic value
-It is impossible to predict security price movements accurately
* Behavior Finance Zealot
-Stock prices only depend on market psychology
-It is easy to predict price stock movements
* Sensible Middle Ground
-Security prices are highly correlated with intrinsic value, but sometimes diverge
-It is sometimes possible to predict movement a little.
My conclusion: develop a long-term, evidence-based investment philosophy, document it, and follow it when making decisions. Then, revisit that philosophy with some regularity to check for human error.
Books by Richard H. Thaler: ”Nudge” with Cass R. Sunstein; ”Misbehaving”; “Quasi-Rational Economics”; “The Winner’s Curse: Paradoxes and Anomalies of Economic Life”
This article was reprinted at forbes.com on 4/6/17. Click here to read
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