My Sunday Washington Post Business Section column is out. This morning, we look at the work of Richard Thaler, the father of Behavioral Economics. His findings are very applicable to investors.
The print version had the full headline You’re only human: How it hurts your investments; online its You’re only human: An economist explains how it hurts your portfolio.
The column uses Thaler’s work to illustrate the big disconnect between investing and human behavior. His work discerns how people behave in the real world versus the basic — and quite silly — assumptions of economics.
As it turns out, you Humans are not perfectly rational. You do all of the things that traditional economic theory suggests you should not. You react emotionally, lack patience, fail to consider consequences of your actions. You are often flummoxed by simple math.
We look at 5 of the bigger biases and judgment errors that Thaler has observed manifested in investing decisions:
1. Endowment effect
2. Sunk cost fallacy
3. Loss aversion
4. Hindsight bias
5. Doing vs. planning
Of course, the column recommends what you should do to avoid letting these cognitive errors impact your investing.
If you are more aware of your own foibles, it gives you at least a fighting chance to overcome them.
Source:
You’re only human: An economist explains how it hurts your portfolio
Barry Ritholtz
Washington Post, June 28, 2015
http://wapo.st/1HpiqCQ
Most likely, a vast majority of the investing public has been doing the “right” thing anyway; “holding” ( not trading ) mutual funds and large portfolios of individual stocks ( that bank investment representatives like to leave untouched as they like to do as little as possible for the management fees that they charge, so why trade ? ). Sounds like, over the last year or two, some regulatory prospects have been put into place and speculative trading divisions of banks have been eliminated, so that has removed some of the market volatility. So with the small universe of discretionary “traders” left, behavioral biases MAY be important, but then traders may be dealing with deeper issues such as addiction …..
Yeah, it’s funny that even though economists are finally seeing what everyone else already knows (people don’t behave according to economic theory) here’s still the tacit assumption that economics is right and people are wrong. I.e, people should adapt to the economics, rather than the other way around.
“Economists” is too broad a brush here. There are a great many respected economists (generally of the saltwater variety) who know that the entire rational behaviour model for humans is only supposed to be a way of thinking, i.e. doing thought experiments in an idealized way. They also know that idealized models should never be confused with real world behaviour. On the other hand, the freshwater (think “Chicago school of economics” types) very much hew to the”rational actors” nonsense. I’m not sure how much of that traces back to Ayn Rand, but the freshwater crowd by and large “knows” what they know and will stick to it always regardless of actual human behaviour and results.