Rational fools and the Nobel Prize
03 November 2017 | Topical insights
Commentary by Garrett Harbron, investment analyst with Vanguard Investment Strategy Group in London.
"The purely economic man is indeed close to being a social moron. Economic theory has been much preoccupied with this rational fool."
– Richard H. Thaler
Misbehaving: The Making of Behavioural Economics
Richard Thaler, a professor at the University of Chicago, was recently awarded the Nobel Prize for Economics for his groundbreaking work in behavioural economics. For centuries, economic models were based on the idea of the "rational man," a theoretical person who unfailingly makes the best long-term decision in any given situation. Professor Thaler had the revolutionary idea that … get ready … people aren't always rational!
Shocking, I know.
But for some economists, this was like Copernicus declaring that the Earth orbits the sun, instead of the other way around. No one knew how to model the behaviour of an actual human, and so a whole new field of study was born.
Arguably, one of behavioural economics' most enlightening subjects is that of behavioural biases. Three of the most common behavioural biases investors exhibit are:
Status quo: The tendency for people to just let what is, be. A close cousin to laziness, it's sometimes also referred to as the "Eh, whatever" bias, as in, "It's raining; if you don't go back and get an umbrella, you're going to get wet." "Eh, whatever." It's often easier for us to just keep doing what we're doing than it is for us to change things, even if the result is less than ideal.
Overconfidence: Being more confident in our abilities than is justified. Also called the "Lake Wobegon Effect," for US author Garrison Keillor's fictional town in Minnesota, where "all the women are strong, all the men are good looking and all the children are above average." This is why 80% of people believe they're better-than-average drivers (if that's true, the other 20% must all live in my neighbourhood). In investing, this can show up as a client who trades excessively in their portfolio, sure that they can successfully time the market.
Anchoring: Using the first piece of information we encounter to influence future decisions, even if the information is irrelevant. Think of this as the "on offer" effect. If I tell you the price of an item is £1,000 but you can have it for the bargain price of £400, you'll feel like you're getting a good deal, even if the item isn't worth £400. You've anchored on the £1,000 price. Investors display anchoring when they refuse to sell an investment that's lost money "until it comes back."
The good news is, understanding these biases and how they impact decision making is a force that can be used for good. Auto-enrolment in pension schemes, for instance, uses the status quo bias to get employees to save for retirement who otherwise probably wouldn't. Advisers who understand these biases can also use them to be more effective behavioural coaches and help their clients make better investment decisions.
At Vanguard, we're big believers in the power of behavioural economics and behavioural coaching to improve outcomes for investors. Keep an eye out in the coming months, because we're going to have more to say on these topics.
In the meantime, congratulations to Professor Thaler on winning the Nobel Prize! Thanks to him, we can feel better about sometimes making bad decisions, knowing it means we're not social morons or rational fools.
Special thanks to Vanguard Investment Strategy Group's Giulio Renzi-Ricci for providing the inspiration for this post.
Investment analyst, Vanguard Investment Strategy Group
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