Richard Thaler and Your Investments

Richard Thaler's Nobel Prize is yet another sign of the growth of behavioral economics as a dominant part of the field of economics. Others behavioral economists that have won the Nobel Prize was Daniel Kahaneman (2002)Kahneman was actually a Psychologist and Thaler's mentor,, and Robert Schiller(2013). The fact that both Schiller and Thaler have been heads of the American Economists Association says much about the "mainstreaming" of behavioral economics.

Thaler put his findings susinctly "the only people that think humans are rational are economists" Or as I like to say "it ain't physics"Thaler's latestbook Misbehaving gives his intellectual biography and thus a history of the field. His previous book(written with Cass Sunstein Nudge showed how public policy and other decisions can influence behavior and was used in both the UK and US as an input to policy decisions. In my view it was the only case in which policies based on an academic economist were implemented and led to results which virtually everyone views as positive,

I would put the findings of Thaler into two categories of relevance to investors:

Forced savings: the most practical implementation of Thaler's theory was his success in getting 401k plans to incorporate automatic enrollment thus implementing automatic payroll deductions to go into a retirement account (of course people are free to opt out..but the overwhelming number do not do so). Based on a "rational economic man" expectation there would be no difference in the number of employees enrolling in such plans if there was a choice available or if the enrollment was the automatic/default selection. Of course if that wasn't the case and there was no open enrollment the theory would be proven wrong in 401k plans increased tremendously when the automatice deductions was implemented. Regulations regarding 401k plans were altered in 2006 to allow plans to have automatic enrollment and participation by employees has increased as a consequence.T

The implications for individual investors is clear the more one sets up an automatic transfer from checking/savings accounts into an individual investment account the better for building a retirement portfolio (rather than making decisions about each transaction. Also it makes sense to opt for the maximum possible 401k contribution (which is not the default option in automatic enrollment plans)

Investor behavior. 

Loss Aversion. In a 'rational world" an investor would always choose the possibility of a coin flip (investment) in which there was a 51% chance of a gain of $101 and a 49% chance of a loss of $100 (higher expect return for the former) but in fact the number at which investors would demand a gain far larger than the loss to make the rational (higher expected return) choice tolerate a potential loss in  is far far higher.  Investors feel more pain about a loss than pleasure at a gain, Not surprisingly one of the consequences for this that  the more often an investor checks his account value (more likely to find short term losses) the more often he will sell his investments.

What is the consequence of the above ? Investors systematically under allocate to stocks relative to bonds given the risk return characteristics of stocks and bonds. This is particularly the case if investors are presented with short term data as to past behavior of stocks and bonds (which of course show more down periods than long term data). This behavior could also explain "busts": sharp down moves in assets as investor show loss aversion. In my personal experience working with clients I have at least two take aways: when presenting allocation proposals to clients stress long term data and the commitment to have discipline and 2. the academic measure of rik "standard deviation over a one year period is and should be irrelevant to most investors. Since the investor should have a long term focus why should the one year fluctuations of an investment be an important input to their discussion (also long term investments dont fit a bell curve distribution...but that is another more academic discussion.

Loss Aversion does have another nuance: past outcomes influence current decisions.

House money effect: Investors tend to take more risks when playing with "house money" i.e. gambling with profits. Rationally the decision to invest aggressively/take more risk simply because there are already profits in the account is irrational there should be no difference where the new investment money comes from. But investors don't behave that way. That likely explains bubbles and momentum in markets.

By the way it  could explain why Thaler has stated that he is concerned about current market levels its continual rise  with low volatility yet markets go higher and it seems investors continue adding to their stock allocation.

Break Even effect: Investors are prone to take more risks when presented with the possibility to make back the money lost.

All of the above factors should not influence investor behavior if they were rational decision makers the "homer economicus" of classical economics...but they do.

Furthermore all of the above factors work against the investor making the proper allocation policy: rebalancing by selling some of their winning positions and buying more of the losers. Everything described above moves investors to buy high and sell low.

Smart Beta, Thaler, and Your Portfolio:

"Smart Beta" is a hot term in finance although many of these factors have been known for quite awhile and have been available to investors through passive vehicles

The value factor:

 Data shows that over the long run value and particularly small cap value stocks outperform the overall market. The explanation for this is likely at least in part behavioral investors: overreact to losses and bad news which causes price declines and are drawn to stocks with recent high performance. and investors are drawn to "hot  stocks" that are in the news and have had recent large price gains --the exact opposite of  vale and small cap value stocksThis leaves "value" stocks based on measures like low price/book or p/e, particularly small cap value stocks   to have good long term performance...but likely periods of shorter term underperformance. Dimensionsal Fund Advisors was the first to offer passive/index vehicles weighted towards these factors. They are now available at very low cost through a number of value ETFs large cap and small cap using a variety of methodologies.

Momentum

Another factor that has been clear in market data has been momentum:,the tendency of markets and asset classes to perform in trends. This factor has long been used in "technical analysis" which academics have dismissed as voodoo for many years. More systematic research has indeed shown a momentum effect leading even the most  stubborn of "efficient markets" advocates Nobel Prize winner Eugene Fama to admit he couldn't find a rational(risk/reward based) explanation for this behavior. It would seem that the house money effect is at least one of the factors at work here. The behavioral explanation is clear investors extrapolate expectations of future performance from recent short term performance..which in turns adds to the "herd effect" in markets. As the market rises and the investors have gains in their portfolios they are more willing to take risks and purchase additional stocks..even riskier ones.

Momentum ETFs which purchase individual stocks based on their short term momentum and sell them when the momentum ends attempt to take advantage of this anomaly. Momentum factor ETFs are a more recent phenomenon and can be accessed with an ETF like MTUM which carries a management fee of .15% Momentum shows its best performance in strong up markets thus it is not surprising that momentum has not only outperformed a market cap weighting but also the other smart beta factors..over the past 3 years by a significant margin (total return of 66.5% vs. 44.5% for the cap weighted index).

Low/Minimum Volatility This strategy tilts towards stocks with low volatility. Because these stocks offer the prospect of smaller gains and smaller losses they are ignored by investors who are attracted to "lottery tickets": stocks with a low prospect of very high returns despite the fact they also have a much higher likelihood of losses. This the effect caused by investors trying to "make back" their losses.
 In other words the higher expected return of the low volatility portfolio (high likelihood of small losses and small gains) is rejected in favor of the higher risk portfolio with a lower expected return but a perceived higher potential of a "big gain" to make back losses. This low/minimum volatility strategy can also be incorporated through low cost ETFs. This strategy has shown long term outperformance by showing smaller losses relative to a market cap weighted index during market downturns while underperforming in strong up markets. It represents a "free lunch" that efficient markets theorists say cannot exist: higher returns without an increase in risk.

If in the past the work of Nobel Prize winners seemed esoteric with little relationship to real world decisions we all make this is clearly not the case with regards to Thaler's work. This time around with academic work that doesnt include books full of equations the Nobel Prize winning work is accessible to all. Reading Thaler' very readable accessible and entertaining book Misbehaving is highy recommended...a rational choice of reading material.

One last anecdote: when asked how he would spend his Nobel prize money Thaler replied "as irrationally as possible".