Taking stock of the human side of the investment game

Richard Thaler’s book ‘Misbehaving’ is a must-read for investors and non-investors

In a world populated by Spock-like econs, all of us would conduct our financial affairs in a rational, self-interested manner. However, the world is populated by humans, not econs; as a result, investing can sometimes be a very messy and painful business.

So says Richard Thaler in his latest work, Misbehaving, which reflects on "how economics became behavioural" over the last four decades. The investment game is not the primary focus of Misbehaving, but Thaler's work has enormous implications for investors everywhere.

Loss aversion

Anyone with an investment portfolio, for example, would be well advised to check its value as rarely as possible, says Thaler. Why? He tells the story of an attractive coin-flipping bet – heads you win $200, tails you lose $100 – offered by Nobel economist

Paul Samuelson

to an academic colleague. As Samuelson had guessed, the bet was declined, his colleague saying he would “feel the $100 loss more than the $200 gain”.

This loss aversion is a very human thing, with countless studies confirming people are more motivated by avoiding losses than by acquiring gains. Accordingly, says Thaler, people who check their portfolio frequently are more likely to experience the pain of losses.

After all, if you check your portfolio on a daily basis, you can expect to see a loss almost half of the time. Checking your portfolio on a monthly basis reduces the incidence of losses, although they are still common; historically, stocks have declined in roughly two in every five months. If you check your portfolio on a quarterly basis, you are likely to see a decline in value in a third of cases. A once-a-year glance improves the win-loss ratio further, with stocks registering declines a quarter of the time. Over a five-year period, the odds of an investment loss fall to just 14 per cent and to a mere 5 per cent over a 10-year period.

“The more often people look at their portfolios, the less willing they will be to take on risk, because if you look at it more often, you will experience more losses,” writes Thaler.

His own research confirms this thesis, with one experiment finding participants who saw their results eight times a year only put 41 per cent of their money into stocks, compared to 70 per cent for those who saw their results just once a year.

Endowment effect

Loss aversion can overlap with other


eccentricities such as the endowment effect, the tendency for us to value things much more when we own them compared with before we owned them. In one Thaler experiment, students given coffee mugs were reluctant to sell them, demanding a median selling price of $5.25 – roughly twice as high as the median price offered by would-be buyers.

Numerous other versions of the experiment were conducted, but the results never varied: owners always asked for twice as much as what buyers were willing to pay.

“The endowment effect experiments show that people have a tendency to stick with what they have, at least in part because of loss aversion,” Thaler says. “Once I have that mug, I think of it as mine. Giving it up would be a loss.”

For the same reasons, investors can hold onto a losing stock for too long; rather than sell at a loss, they hold on and curse the market for undervaluing “their” stock. (To see the endowment effect in action, check out any online investment forum, where furious arguments are wont to break out if someone dares to criticise a stock held by another poster.)

Pensions nudge

Thaler is famous for proposing that policymakers devise nudges to guide sensible behaviour. His most well-known nudge relates to auto-enrolment into workplace pensions. Auto-enrolment means a portion of one’s pay is automatically directed into a pension fund; employees are free to opt out, but inertia means many will simply stick with the default option. Thaler also proposes a policy of auto-escalation, with the percentage of one’s pay being siphoned off gradually increasing over time.

Auto-enrolment is now common in the UK, US and other countries, with Ireland expected to follow suit in the coming years. A recent Danish study suggests the policy is even more successful than Thaler might have imagined. It found tax subsidies had next to no effect on how much people saved for their pensions, with 99 per cent of new savings attributed to auto-enrolment.

Irrational markets

Clearly, investors can be a funny bunch. Can their sometimes irrational behaviour move markets? Yes, says former US treasury secretary

Larry Summers

, who once wrote an unpublished paper that began: “THERE ARE IDIOTS. Look around.”

Thaler agrees. One of his own papers, Can the Market Add and Subtract?, relates the story of handheld computer-maker Palm, which saw its shares soar after its initial public offering (IPO) in 2000. Almost all of Palm was owned by its parent company 3Com; despite this, Palm's valuation was almost twice as high as 3Com's. Widely reported in the press, the discrepancy nevertheless persisted for months.

The Palm/3Com debacle was not an isolated one, says Thaler, who argues market mispricings are inevitable due to inherent behavioural biases. He rejects the idea put forward by efficient market theorists such as Eugene Fama, who argue that value stocks have historically outperformed due to the outsized risk attached to holding out-of-favour firms. Value stocks are generally not riskier than other stocks, says Thaler; rather, their unfashionable status causes them to be underpriced, setting the scene for future outperformance.

Still, while Thaler scoffs at the idea that the price is always right, he accepts that it is extremely difficult to beat the market.

“Even when investors can know for sure prices are wrong, these prices can still stay wrong, or even get more wrong,” he writes. “This should rightly scare investors who think they are smart and want to exploit apparent mispricing. It’s possible to make money, but it’s not easy.” Investors who accept the efficient market “gospel” and invest in low-cost index funds, he says, “cannot be faulted for that choice”.



, like Daniel Kahneman’s

Thinking, Fast and Slow

, is one of those books that should be read by investors and non-investors alike. Readers will find next to no discussion about price-earnings ratios, asset allocation models or fundamental valuation methods, but they will learn an altogether more important lesson: all of us are prone to costly behavioural biases and cannot be trusted to plan our financial futures in a consistent, unemotional manner. We are homo sapiens, not homo economicus, humans, not econs. Little wonder, then, that even the best investors are prone to a little misbehaving.

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