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A behavioral economist illuminates the human side of investing

October 29, 2015

What if Adam Smith had collaborated with Sigmund Freud? They might have developed the academic discipline that is known today as behavioral economics. Instead, it fell to Richard Thaler and other researchers to launch the discipline, which uses insights from psychology to explain our economic decisions.

Professor Thaler teaches behavioral science and economics at the University of Chicago Booth School of Business and has written widely on the subject. His latest book, Misbehaving, intelligently and humorously describes his adventures in helping to develop a new and, in the eyes of some academic colleagues, subversive branch of economic research. He also explains how applying psychology to economics can help people make better financial decisions.

We recently interviewed Professor Thaler about the beginnings of behavioral economics and how investors might recognize and try to correct their own financial misbehavior.

Your new book chronicles your challenge to the assumption that, in general, we make rational economic decisions. When did you first realize that this assumption might be wrong?

Richard ThalerI began to have economically deviant thoughts in graduate school. The economic agents I was studying in my textbooks (whom I like to call Econs) did not resemble anyone I had ever met. These creatures in economic models were as smart as the smartest economists, had no emotions or self-control problems, and were completely selfish.

Most people I knew had trouble balancing their checkbooks, did stupid things when they got angry, ate too much, and saved too little, but were much nicer than economists gave them credit for. For example, real people, but not Econs, leave tips in restaurants, even if they never intend to go back. No Econ would do such a thing.

Which of our behavioral biases do the most damage to our financial well-being?

There are many failings that get us into trouble financially, as I describe in Misbehaving, so let me focus on just two.

The first is loss aversion. Losses have about twice the emotional impact of an equivalent gain. Fear of losses (and a tendency toward short-term thinking—I'm sneaking in a third one here) can inhibit appropriate risk-taking.

For example, investing in the stock market has historically provided much higher returns than investing in bonds or savings accounts, but stock prices fluctuate more, producing a greater risk of losses. Loss aversion can prevent investors from taking advantage of the long-term opportunities in stocks.

The second bias that causes a lot of trouble is overconfidence. Most people think they are above-average investors, and as a result they trade too much and diversify too little. Overconfidence can also lead people to invest during what appears to be a bubble, thinking they will just get out faster than others. Research shows that the more individuals trade, the lower their returns. Not surprisingly, men suffer from this problem more than women.

This is one of the many reasons why it would be better if we had more women as portfolio managers.

Simply being aware of our biases isn't always enough to combat them. We know we'll suffer tonight for the deep-fried pepperoni pizza we eat today, but we do it anyway. Why?

Most of us know, at some level, that we suffer from self-control problems, but we underestimate their extent. We think we can stop at the bar for just one beer before going to bed but end up having two or three. We think we can save simply by cutting back on unnecessary expenditures, but then we run up credit-card debt.

So how can we combat these self-destructive biases?

The most successful way of dealing with self-control problems is by committing ourselves in advance. Say no to the offer to have just one drink at the bar at the end of the evening. Put the alarm clock on the other side of the room to make sure you don't just hit the snooze button.

In financial matters, the only way most (nonwealthy) people successfully save for retirement is by having money taken out of their paychecks automatically and deposited into a retirement savings plan like a 401(k).

I always recommend that people saving for retirement—especially those who are young enough to have a long horizon over which to invest—should tilt their portfolios heavily toward a globally diversified portfolio of stocks, and then scrupulously avoid reading financial news articles or, even worse, watching financial news networks. Paying attention day-to-day is damaging to one's financial and emotional well-being.

In my parents' generation, another successful way to save was to pay off the mortgage; that was the first financial goal of most families, and a windfall was often used to pay it down. As a result, until about 1980, most people over 60 had little or no mortgage debt.

But the ease of refinancing and the long-term decline in interest rates have eroded this useful social norm. I recommend that anyone over 45 who's getting a mortgage should choose a 15-year term and then just pay it off. Do it today! Interest rates are low.

If we can maintain Spock-like rationality, is it possible for us to profit from the biases that afflict our fellow investors?

I think it is possible to earn superior rates of return by taking advantage of the biases displayed by other investors, but it is not easy to do so. I am a principal in an asset management firm that uses this approach and has been successful, but my advice is, "Don't try this at home."

Notes:

  • All investments are subject to risk, including the possible loss of money you invest.
  • Opinions expressed by Professor Thaler are not necessarily those of Vanguard.
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