Nobel Prize-Winner’s Theory Describes “The Rest of Us”

Most economic models of market strategy are predicated on a flawed premise: that investors behave rationally. In most market models, the assumption is that all the factors impacting investment decisions are known, that all prices are a fair assessment of actual value, and that buyers and sellers are making their decisions based on logic and mathematics.

Do you know anyone who behaves according to these principles, especially in a market that is either overheated on the upside or falling through the floor on the downside? Neither do I.

That’s why many in the world of economics and professional investing sent up a cheer when the Royal Swedish Academy of Sciences announced the winner of the 2017 Nobel Prize for Economics. Richard Thaler, an economist at the University of Chicago, spent his entire career exploring and trying to understand the differences between the idealized assumptions of many academicians and the actual decision-making behavior of human investors.

Thaler studied and formulated a theoretical basis for understanding the mental shortcuts that people take when they make financial decisions. These mental processes, sometimes called “heuristics,” lead us to believe that we are making decisions rationally, despite the fact that we are often merely following well-worn emotional paths to the same illogical destination.

For example, one of Thaler’s most famous experiments involves what we now call the “sunk cost fallacy.” Suppose someone bought a ticket to the theater that cost $100. On the way to the show, they realize that the ticket is lost. Most people will sadly return home, believing that $200 is too much to pay to see the show. However, Thaler demonstrated that this is a logical fallacy; if it was worth $100 to see the show in the first place, it would still be worth that. The purchaser already decided that the show was worth $100, and it presumably still is, so based strictly on mathematical logic, she should simply go and purchase another $100 ticket in order to experience the original value. However, most people illogically view the cost of the ticket as “sunk,” and fail to make the purely logical choice.

Another of Thaler’s concepts involves what economists call “recency bias,” which means that we tend to expect more of what we have experienced most recently. So, if the market is going up, we expect it to continue. If it is dropping, we expect it to keep heading for the basement. Neither expectation is based on logic, but our heuristic behavior makes us believe they are.

All of Thaler’s work involves a concept called “behavioral investing,” which encompasses the way that emotions influence our financial decisions. Behavioral investing accounts for the ways in which our fear (loss aversion) and our greed (desire to gain) can both cause us to make irrational investing decisions that often undermine our ability to achieve our long-term goals.

The work of Richard Thaler and other economic theorists forms an important foundation for the evidence-based investing principles that our firm, along with many professional advisors, uses to guide portfolio strategy. As Thaler realized, most of us allow our emotions to guide us more than we realize. A qualified professional advisor can help you put logic–and science–to work for you and your portfolio.

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