October 15th, 2017 | by Gregg S. Fisher, CFA, "Invest with Reason"
Richard Thaler’s Well-Deserved Nobel Prize
Whenever I think about Richard Thaler, who was awarded the 2017 Nobel Prize in Economics on October 9 for his contributions in the field of behavioral economics, my mind flits to the Giant Blue Whale in New York’s American Museum of Natural History. In November 2008, amid financial panic and cratering stock markets (the S&P 500 Index was already down 45% from its October 2007 high), this pioneer in behavioral finance spoke to our clients at an event we held beneath the blue leviathan. Drawing from research for the just-published best-seller he had co-authored, Nudge: Improving Decisions About Health, Wealth and Happiness, the University of Chicago economist discussed how the principle of “choice architecture” can be used to nudge individuals to make decisions that are in their own best interests. Our goal for this memorable event (entitled Managing the Fight or Flight Reflex: Keys to Staying Rational in an Irrational Market) was to explore some of the common behavioral traps into which investors can fall– and to equip our clients with the information they need, particularly during times of crisis, to make more-informed and rational decisions.
At Gerstein Fisher, we have been huge fans of Thaler’s work for many years, devouring all of his research papers and incorporating elements of his findings into our investment strategies and financial advice for clients. As money managers for real people since 1993, so much of his research—which demonstrated that investors aren’t always rational and do not behave as assumed in modern portfolio or efficient market theory—rhymes with what we have observed in the real world. One of our guiding investment beliefs is: “Markets are efficient, but investors are human,” which means that, while investment markets are mostly efficient, they’re not perfectly efficient, due in large part to emotions and judgmental biases of human participants in those markets.
Beliefs such as this seem almost like common sense today, but in his lively, saucy 2015 book Misbehaving: The Making of Behavioral Economics, Thaler recounts his long, often caustic struggle with a rather dogmatic economics establishment (including in his University of Chicago economics department), whose economic models (wrongly) assumed that investors were “cold-blooded optimizers,” utility-maximizing machines who made decisions (wrongly) assumed to be unbiased. He writes: “Financial markets were thought to be a place where foolish behavior would not move market prices an iota.” The title Misbehavior relates to his description of human (and investor) behavior that is “inconsistent with the idealized model of behavior that is at the heart of what we call economic theory.” In fact, due to human frailties such as overconfidence, impulsiveness, shortage of knowledge or attention span, excessive envy, and lack of self-control, we make biased, suboptimal choices—and commit errors that are quite predictable all the time.
In Thaler’s world (and in our own as money managers), investors are often emotional people who save too little for retirement and need to be nudged to boost savings rates; investors believe they can predict the future and trade too much due to “overconfidence bias”; they hesitate in cutting losses on investments declining in value because of reluctance to admit error; they value what they already own—“endowment effect”—too highly; they overreact to recent news or market action (“recency bias”); they are prone to greed, fear, and herding behavior that leads them to buy high and sell low in the markets; they exhibit “status quo bias,” or inertia, and fail to rebalance portfolios; they place money, which is fungible, into different buckets due to “mental accounting.”
Interestingly, Thaler relates that well before the rise of efficient markets orthodoxy in the 1960s and 1970s (Thaler’s Chicago nemesis, efficient- market theorist Eugene Fama, was awarded a 2013 Nobel Prize in Economics for his research in the 1960s-1970s), the great British economist John Maynard Keynes spoke of the human emotions, or “animal spirits,” that played a crucial role in investment decision making. Thaler writes: “If everyone believed that every stock was correctly priced already—and always would be correctly priced—there would not be very much point in trading.”
“Econs” vs “Humans”
At Gerstein Fisher we brought this pioneering thinker into our world long ago. We understood that one of the chief roles of an investment advisor is to help (often emotional) investors make sound, healthy decisions. We believe that markets do a good job of pricing risk, but that investors, as humans (as opposed to the “Econs,” as Thaler dubs the cold-hearted optimizers), often hurt themselves owing to decisions that deviate from reason as assumed by economists. For instance, mutual fund investors typically trail the performance of their funds’ net asset values by a sizeable 1-2 percentage points annually due to poor market-timing decisions. I explored harmful investor behavior such as this in a paper I co-authored with my friend Phil Maymin, who was a graduate student of Thaler (“Past Performance is Indicative of Future Beliefs”).
In fact, psychological insights from Thaler, other academics, and from our own research permeate our investment thinking and portfolio strategies. For example, as quantitative Multi-Factor® investors, we believe that the long-term outperformance of security characteristics, or “factors” such as momentum towards which we tilt equity portfolios, has a strong behavioral explanation.
Here are some more examples: An Econ might hold only small-cap value stocks, the best-performing asset class in the US market since 1926, but we know that due to small caps’ high volatility and lengthy cycles when they’re out of favor (including the present: see our recent research on this, “After a Decade of Strong Large Cap Growth, is there a Place for Small Value?”), Humans are unlikely to stick with the plan. On the other hand, commodities are both volatile and have long-term returns inferior to those of stocks, yet for investor-behavior reasons we think they still merit a small weighting in a globally diversified portfolio (“Is There an Investment Case for Down-and-Out Commodities?”). For that matter, the expected return of short-term, high-quality fixed income is quite low, yet again, for behavioral reasons, we believe they deserve a significant allocation in most portfolios. In short, the “right portfolio” for Econs is not the right portfolio for Humans if they are unable to stay invested in it for the long term.
In closing, I would like to reiterate that this is a well-earned Nobel Prize. Congratulations, Richard!