Another Nobel Prize for Advances in Behavioral Finance

The winner of the 2017 Nobel Prize in Economic Sciences is Richard Thaler of the University of Chicago Booth School of Business “for his contributions to behavioral economics”.  Thaler is not the first behaviorist to capture the prize. Others include Daniel Kahneman (2002) “for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty” and Robert Shiller (2013) for empirically analyzing asset prices as they relate to investor behavior. He joins a long list of University of Chicago faculty and alumni who are also Nobel laureates.

Behavioral Finance challenges a bedrock assumption of traditional finance that investors are perfectly rational utility-maximizers with access to complete information. Certainly, we humans are subject to behavioral foibles that prompt us into sub-optimal decisions such as harvesting capital gains instead of losses due to the disposition effect. In our opinion, the most important of all the behavioral pitfalls is overconfidence which may result in potentially catastrophic market-timing and security-picking. Interestingly, when asked for investment advice, the behaviorists (including Thaler) advocate a highly-diversified, low-cost portfolio that is traded primarily for rebalancing purposes only, as made clear in this humorous MarketWatch video. This is the same advice given by the traditionalists

One of Thaler’s examples of the limits to perfect rationality is his theory of mental accounting, which describes how most of us think about our finances in separate buckets, and we tend to make individual decisions on the basis of their effect on each of these accounts rather than on our total assets. One example of a mental account is gambling money, and we often see how people who win a few bets become more audacious in subsequent bets, which Thaler refers to as the “house money effect”. Mental accounting can lead to unnecessary costs such as taking on credit card debt for short-term expenses rather than paying them out of long-term savings. Mental accounting encourages the use of reference points to help make decisions. For example, a stock bought at $10 per share and now worth $5 will not be sold until it returns to $10 which may never happen. We call this “anchoring”.

Another term coined by Thaler is the “endowment effect” which describes how we tend to value assets we own more highly than similar assets we don’t own. If you want to see this in action, ask any business owner what his business is worth, and then ask what he thinks his competitor’s business is worth. Thaler explains the endowment effect in terms of loss aversion where people tend to experience the negative feeling of a loss more strongly than the positive euphoria of an equally large gain.

While we have only scratched the surface of Thaler’s contributions to our understanding of behavioral finance, it is his contributions to real world investor outcomes that must not be overlooked. As his fellow researcher Shlomo Benartzi has estimated, the safe harbor retirement savings plan requirements (auto-enrollment and auto-escalation) based on Thaler’s work have resulted in an additional $30 billion of savings in retirement accounts. If your current retirement plan does not incorporate these provisions or you are looking to establish a new plan, please call us at 800-345-4635 or email us at info@clarityca.com.