This month, University of Chicago economist Richard Thaler was awarded the 2017 Nobel Prize in Economics by the Royal Swedish Academy of Sciences. This was a controversial decision, for a number of reasons.
Thaler is a proponent of behavioral finance, which is the study of economics and finance from a psychological perspective. Up until recently, mainstream economic theory was based on the assumption that people behave rationally. Professor Thaler’s theories, on the other hand, pioneered the view that people, especially when it comes to personal finance, often behave in ways that contradict traditional economic rules and reason.
The traditional economic approach was to view human financial choices like particles in physics. The outcome could be predicted by a few established rules. All of us—and especially professional financial planners—know that these assumptions are far from what we have observed in the real world. After receiving the award, Professor Thaler commented, “In order to do good economics, you have to keep in mind that people are human.”
Thaler spent his entire career exploring the differences between these unrealistically idealized economic assumptions and actual human behavior. He demonstrated that people take mental short-cuts—called “heuristics”—when they make what they believe to be logical decisions. He showed that in the real world, human decisions are often impulsive, and self-control is more often an aspiration than a reality. Although investment selection and globally-diversified asset allocation are important investing tools, it is often behavior that ultimately determines whether a portfolio will help an investor achieve fulfillment and satisfaction in life.
Thaler also developed a theory of “mental accounting,” which explained how people make financial decisions by creating separate accounts in their minds—one for college funding, say, and another for retirement, and still another for vacations or a new car. He explored those mental short-cuts and found that people tend to expect more in the future of what they’ve recently experienced (short-term bias), and often believe they have more knowledge about their decisions than they actually do.
Although his views have been regarded by radical by some traditionalists, they have already had broad impact in the real world. In his 2008 book, “Nudge,” Thaler and his co-author Cass Sunstein discussed ways to help people make better financial decisions, and argued for public policy changes that would help average people by “nudging” their behavior in a positive direction. For example, there was a pervasive problem that most people were not saving enough for retirement. It was difficult for many people to control their impulses. If they had money in their hands, the tendency was to spend it, rather than put it away for the future.
Thaler suggested “opt-out” retirement savings plans. Previously, employees had to take individual action to enroll in their company’s 401(k) retirement plan. Even though the money they contributed to the 401(k) would grow tax-deferred, would reduce their taxable income, and in many cases would be supplemented by an employer’s matching contribution, many employees failed to enroll. Thaler’s studies sparked a sweeping shift towards automatic enrollment into employer-sponsored retirement plans. In other words, participation is now the default option, and you have to take individual action if you choose not to enroll. This shifted inertia to the side of the preferred decision.
Thaler’s thinking is especially relevant today. In a perfectly rational world, all-knowing investors and consumers would never have market bubbles or market crashes, since every market price is right and fair at any particular moment. We have had 8 years of fairly-sustained growth in the market, but we know that every 8 to 10 years on the average, we have a market correction of 10% or more. This is normal and healthy for the market, and is a way for stocks to find their true value. If we were perfectly rational people, we would recognize that the market has always recovered from these corrections, and will likely proceed to hit new highs. However, the emotional, irrational side of us could take over, and cause us to sell all our holdings at the bottom on the market. Not only would we be locking in the losses, but losing the long-term growth could prevent us from accomplishing important, long-term goals. As financial advisors, we do our most important and valuable work when markets are down, guiding our clients through those difficult periods and helping them manage their behavior.
Thaler’s prize suggests that the world of economics is starting to catch on to the messy decision-making that actually goes on in the real world.
* Washington Post, 10/9/2017
* The Guardian, 10/11/2017
* New York Times, 10/9/2017
* The Economist, 10/23/2017