Predictably irrational: investor lessons from Nobel winner Richard Thaler

Investors can learn a lot from the work of Richard Thaler, the father of behavioural finance, who was last week awarded a Nobel Prize in economics for four decades of research into the quirks that govern people's financial decision-making.

Don’t look at your portfolio

Thaler often relates how Nobel economist Paul Samuelson once asked a colleague if he would accept a bet with a 50 per cent chance of losing $100 and a 50 per cent chance of gaining $200. He refused, saying he would "feel the $100 loss more than the $200 gain".

People have a strong aversion to losses; the pain of a euro lost is roughly twice as great as the joy of a euro gained. Thaler noted people who frequently check their portfolio balance were more likely to experience the pain of paper losses. Might this cause them to get spooked? Yes – people who saw their results eight times a year put only 41 per cent of their money into stocks; those who checked their results annually allocated 70 per cent towards stocks.

Pensions auto-enrolment

We’re lazy and we procrastinate. Accordingly, says Thaler, “if you want to get people to do something, make it easier”.

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That's the thinking behind his most famous policy nudge: automatically enrolling people into pension schemes. People can opt out, but the default option should be enrolment, coupled with auto-escalation – automatically raising contributions over time. Much more effective than tax subsidies, auto-enrolment resulted in UK pension participation rising from 42 to 73 per cent between 2012 and 2016. Auto-enrolment will be a reality in Ireland by 2021, Taoiseach Leo Varadkar said last month.

Mental accounting

A couple have saved $15,000 towards their dream holiday home, which they hope to buy in five years. The money sits in a low-yielding bank account. They just bought a car for $11,000, having taken out a three-year car loan at 15 per cent.

To an economist, this is completely irrational. A dollar is a dollar: they should have used their savings to buy the car rather than getting a high-interest loan. Thaler noted that most people, however, consider it normal to categorise money into different mental accounts – that $15,000 was specifically earmarked for the home down-payment.

Similarly, a casino gambler who wins some money might “take the money he has won and put it in one pocket, and put the money he brought with him to gamble that evening (yet another mental account) into a different pocket”, writes Thaler (house money, as gamblers call it).

Mental accounting also affects investors: it contributed to the 1990s internet bubble, with investors taking on more risk as they felt they were “only playing with their gains from the past years”.

Endowment effect

Thaler often relates how a wine-loving economist once bought fine Bordeaux wines at low prices. Over time, the price rose from $10 to $200. The economist wouldn’t buy an additional bottle at that price, but nor would he sell it for $200 – he was too attached to his purchase.

This inspired Thaler to investigate the endowment effect: people’s tendency to overvalue what they own. In one experiment, half the participants were given free coffee mugs, which they were then free to sell. The owners’ estimate of their worth was twice as high as non-owners.

The combination of the endowment effect and loss aversion, says Thaler, means investors “tend to hold on too long to stocks that have gone down, hoping they will rebound so they can sell without realising a loss”.

High stakes

Not everyone appreciates Thaler's ideas. British economist Ken Binmore has argued behavioural studies rely on artificial experiments involving low-stakes decisions. In real life, people get it right when making high-stakes decisions, said Binmore.

The opposite is true, replied Thaler. We learn how to do the “small stuff” – buying milk, lunch, clothes – through regular practice, but we don’t get many opportunities to learn when choosing a home, a mortgage, or a job.

“And when it comes to saving for retirement, barring reincarnation we do that exactly once.”

Binmore’s theories, he acidly concluded, were good for “buying milk”.

Irrationality in markets

People may be occasionally dumb but that doesn't mean markets are dumb, says efficient market theorist and fellow Nobel economist Eugene Fama, who argues smart investors keep market prices in line with reality. That's not always true, says Thaler. In one paper, "Can the Stock Market Add and Subtract?", he pointed to many cases where investor exuberance drove stocks to mathematically illogical levels.

More recently, he referred to the Cuba fund, a closed-end mutual fund made up of mainly US stocks. The fund's holdings were largely unchanged after Barack Obama announced he intended to relax relations with Cuba in 2014, but the share price of the fund soared, trading at a 70 per cent premium to their underlying value.

CEO pay

Despite the presence of smart investors and short sellers, financial markets can go loco. Why then, asks Thaler, should we be confident about markets where there is less information and no arbitrage opportunities?

In 1965, US chief executives were paid 20 times as much as the average worker; by 2014, that ratio had swollen to more than 300. Some economists argue this reflects growing CEO productivity, but Thaler is sceptical.

Executive pay is determined by directors who rely on consultants who partly base their recommendations on the pay of other CEOs – an inefficient and “self-fulfilling” process, he argues.

“If stock prices can be off by a factor of two, why should we be confident that other markets do not diverge by that much, or more?”

Buy value stocks

Cheap value stocks have historically outperformed growth stocks. Efficient market theorists argue this is because such stocks are riskier. Thaler’s research suggests otherwise. Rather, investors simply overreact to bad news; out-of-fashion value stocks become underpriced, setting the scene for future outperformance.

Don’t let cash pile up

It's human to procrastinate. "If you build up a lot of cash and have to make a decision about what to do with it all at once," Thaler once told author and Wall Street Journal columnist Jason Zweig, "that's much scarier than moving the same amount of money in many smaller pieces." Accordingly, set a ceiling for your cash: whenever it exceeds a designated percentage of your total assets, invest the excess into stocks or bonds.

Diversification bias

If asked to buy six weeks’ worth of breakfast cereals all at once, you’ll probably buy a variety of cereals. However, if you do six weekly shops, you’ll probably buy the same cereal – your favourite – every week. Psychologists call this a diversification bias or naïve diversification – the tendency to diversify when asked to make several choices at once.

Investors are no different. Thaler’s research shows the asset allocation chosen by investors depends on the funds offered in their retirement plan. In a plan offering one stock fund and one bond fund, the average allocation will be 50 per cent stocks. Add another stock fund to the mix and the average stock allocation would jump to two-thirds. An investor offered a choice of four stock funds and one bond fund will opt for a much greater equity mix than an investor shown four bond funds and one stock fund.

Needless to say, this is not a rational way to plan your retirement.

Learning about biases doesn’t cure them

Once a niche field, behavioural economics is decidedly mainstream these days. Bestselling books such as Thaler's Nudge and Daniel Kahneman's Thinking, Fast and Slow mean its lessons are increasingly well-known, but the field won't disappear, says Thaler. Alas, you might be less overconfident and more willing to increase your retirement savings, "but reading a book isn't going to give you great willpower all of a sudden".