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Insights for Investors From a Founding Father of Behavioral Finance

There are more things in heaven and earth, Horatio, 
Than are dreamt of in your philosophy.
-- Hamlet

In Misbehaving: The Making of Behavioral Economics, Richard Thaler shares an amusing anecdote that has much wider implications for ordinary investors.

Over dinner with a small group of academics, a famous economist --- who believed strongly in the efficiency of financial markets -- joked about the ridiculous economic decisions made by his wife. For example, she once bought an expensive car and then refused to drive it for fear of denting it.

The economist also laughed about his students who were incapable of understanding even the most basic concepts. Thaler notes that the stories became even funnier as more wine was consumed.

After a while, a leading psychologist who was present asked the economist:

You seem to think that virtually everyone you know is incapable of correctly making even the simplest of economic decisions, but then assume that all the agents in your models are geniuses. What gives?

The economist responded with a lot of hand-waving and vague remarks about how the market eventually sets everything right. Thaler now calls this argument the "invisible handwave," since it combines a lot of hand gestures along with a mysterious allegiance to Adam Smith.

In theory, we're all like Mr. Spock
This lighthearted story provides a useful illustration of Thaler's contrarian thinking on traditional economics. According to economic theory, each of us chooses the very best goods and services we can possibly buy, according to our budget. We are all, theoretically, effective optimizers.

Thaler has devoted much of his career, however, to showing that the theory is often wrong in practice. "Econs" -- as he calls these theoretical optimizers -- might consistently make rational decisions, but ordinary "Humans" do not. For proof, just look at all the studies showing the poor choices people make when saving for retirement or selecting stocks for their portfolios.

And the notion that people can just hire experts to help with their decision making doesn't quite bridge the gap between theory and reality, either. Thaler notes:

It is illogical to think that someone who is not sophisticated enough to choose a good portfolio for her retirement saving will somehow be sophisticated about searching for a financial advisor, mortgage broker, or real estate agent.

In his wise and entertaining book, Thaler urges that we stop assuming the models are correct. Instead, we need an economics with "strong injections of good psychology and other social sciences."

Why you shop at Costco
Richard Thaler, along with Daniel Kahneman and Amos Tversky, helped develop the emerging field of behavioral finance. Once a Young Turk in the economics profession, Thaler is now the president of the American Economic Association. Robert Shiller, another behavioral economist, takes over as president next year.

This book might sound overly academic, but it's actually very lively. Thaler recently tweeted, "The reason Misbehaving took so long to write was figuring out how to make it fun." He definitely succeeds in his goal.

He has included a lot of illustrations of important concepts like "opportunity costs" and the "endowment effect." Why do rich people like to shop at Costco? Because they're benefiting from "transactional utility." Why would someone with tickets to a basketball game brave a snowstorm to attend? Because he or she is ignoring "sunk costs." What happens when a bunch of economists have to allocate offices in a brand-new building? The results are just as petty and chaotic as a behaviorist might predict. Apparently, not even economists are "Econs."

Can "Humans" beat the market?
I was, of course, particularly interested in what Thaler had to say about investing. For most of us, he recommends simplicity:

Whenever anyone asks for investment advice, I tell them to buy a diversified portfolio heavily tilted toward stocks, especially if they are young, and then scrupulously avoid reading anything in the newspaper aside from the sports section...watching cable news networks is strictly forbidden.

Thaler's take on markets is somewhat nuanced. He doesn't think markets are particularly efficient, so there's possibly room to take advantage of anomalies. The problem, though, is that even though prices might be wrong, they can "still stay wrong, or even get more wrong." Investors should be wary if they think they can "exploit apparent mispricing." His conclusion, after decades of studying the markets, is that it's "possible to make money, but it is not easy."

In a footnote to the section on investing, Thaler discloses that he's been a partner in a money management firm called Fuller and Thaler Asset Management since 1998. The firm looks for situations "where investors' behavioral biases are likely to cause mispricing." And he jokes that "The fact that we are still in business suggests that we have either been successful at using behavioral finance to beat the market, or have been lucky, or both."

The investing expert Larry Swedroe recently took a closer look at the performance of Fuller and Thaler Asset Management, and wasn't able to find much evidence supporting their ability to outperform the market, alas.

The demise of the rational fool
Regardless of his investing abilities, Thaler has certainly transformed the fields of economics and finance. He quotes the great economist Amartya Sen who said, "The purely economic man is indeed close to being a social moron. Economic theory has been much preoccupied with this rational fool." Very few people nowadays have faith in the rational fool. And Richard Thaler deserves a lot of the credit for that. I highly recommend that you read this fascinating and entertaining book.

Find this article informative?
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