I recently had the privilege of sitting down for a chat with Richard Thaler, professor of the Booth School of Business at the University of Chicago. Thaler is widely recognized as the father of behavioral economics. He is perennially on the short list for a Nobel Prize in economics.
His observations about how people behave in the real world are a welcome change from the basic assumptions of most economists. Thaler breaks down the world into two sorts of people: Econs, the artificial constructs of how people are supposed to behave. They are perfectly rational, have great self-control, calculate like machines and know exactly what is best for themselves.
Then there are Humans, who do all of the things that traditional economic theory suggests they should not. They react emotionally, lack patience, fail to consider consequences and seem to be flummoxed by mathematics. They are filled with all manner of biases and judgment errors. How the Humans get through each day must appear to be a minor miracle to the Econs.
Thaler tells the story of how behavioral economics developed in his new book, “Misbehaving.” Thaler’s great insight — that people do not behave like Econs — is what the title is referencing. This has all sorts of fascinating implications, perhaps none greater than how irrational human behavior is when it comes to investing.
Let’s look at how these behaviors manifest themselves for investors — and what you can do about them.
• Endowment effect: In one of Thaler’s early experiments, people were given mugs with a school’s logo — essentially worthless baubles. People turned out to be willing to pay far less to buy them than they were willing to sell them for. In other words, they attached a higher value to an asset they already owned than ones they didn’t.
The impact of this is significant for portfolio management. Investors tend to think more highly of the holdings that are sitting in their accounts than the rest of the investable universe. This is true for stocks, mutual funds, alt investments and exchange-traded funds (ETFs).
Perhaps this explains why so many people have a hard time “cutting their losers.” They believe their own holdings are more valuable than what the market is telling them.
• Sunk cost fallacy: Imagine you are in a restaurant, and you order an expensive dessert. You do not especially like it, despite (or perhaps because of) the 1,000 calories it contains. You eat it anyway — after all, you already paid for it!
This is a perfect example of the sunk cost fallacy. Thaler suggests what you should be thinking is: “Since I have already paid for this, why should I suffer the caloric consequences of eating something I don’t like? It’s paid for whether I eat it or not!”
Now think about a stock or fund you own (endowment effect included). You have paid for it, but more than that, you invested time and energy into it: You researched the company, you know who the senior management is; you have kept up with all the news about the firm, its latest products, quarterly earnings, conference calls, etc.
You have substantial sunk costs, even if it the company turns out to be a dog. The proper response is that those costs are already gone, never to be recovered. Hence, you should not stay married to a holding simply because of those already incurred expenses. The same is true for any holding, be it a hedge fund, private equity or ETF.
• Loss aversion: Perhaps the most important insight Thaler discusses is our tendency toward loss aversion. As it turns out, people feel the pain of loss about twice as much as they derive pleasure from gains. There are lots of possible reasons for this, but perhaps the simplest is that gains seem temporary — eventually, they are spent or otherwise fade into the background. Losses, on the other hand, are permanent.
Loss aversion is why investors become timid after stock market crashes. Look at any portfolio — your own included — since the great recession and market crash of 2007-2009. You probably have less equity than you should. Assets perceived as less risky are probably over-weighted. This will reduce the volatility of your investments — but it will reduce their performance as well.
• Hindsight bias: You saw the 2008 collapse coming, right? It was so obvious, you could not miss it. Housing peaked in 2006 — you saw that, too. And the dot-com collapse — weren’t you warning your friends about the ridiculous valuations?
Sure you were! A tiny number of people were warning about those things — and they were mostly ignored as cranks. But in your own memory, knowing what you know now, of course, you were cautious then! That cognitive error is attributable to hindsight bias. You recall — quite incorrectly — being on the right side of those collapses when (statistically speaking) you most certainly were not.
One of my favorite speeches to make at conferences is called “This is your brain on stocks.” To demonstrate hindsight bias, I ask “How many of you knew the market was going to collapse in (fill in the crash)?” About half the hands go up. “Think back to the trades you made then. How many of you shorted Lucent or Cisco or Yahoo or Sun Micro in 2000?” Almost all of the hands go down. “Did you sell the home builders short in 2005 or the banks in 2006?” No hands are still raised.
If you were so confident that you saw it coming, why did you fail to profit from it? The answer is — despite what your brain is telling you today — that you never saw it coming.
• Doers vs. planners: Everybody wrestles with conflicting impulses. Your desire to enjoy things now runs headlong into your understanding that you must anticipate future needs. Thaler named these impulses the Doer and the Planner.
The ramifications of giving in to the Doer are many. We are couch potatoes watching TV instead of doing the exercise we know is good for us. We order the bacon cheeseburger instead of the salad. When it comes to saving for retirement, the Doer spends much more of his income than the Planner would like.
The key takeaway from Thaler’s research is as obvious as it is disturbing. We cannot trust ourselves to think clearly, to plan patiently or to make the right decisions on a consistent basis.
Rather than assuming your brain knows what’s best for you, you need to make better decisions insulated from cognitive foibles. That three-pound brain has 200 billion neurons and 125 trillion synapses and is a marvel of biomechanical engineering. It evolved to keep you alive on the savannah. It’s less successful at surviving risk-reward decisions in the capital markets.
Hence, why I advise you to not let your wetware interfere with your investment process. Outsmart your brain. Own a broad asset allocation of diversified low-cost ETFs, rebalance regularly — and stay out of your own way.