Blog #27 A Toast to Richard Thaler

This month, the Nobel prize for economics was awarded to Richard Thaler, professor of economics at the University of Chicago, for his seminal contributions to behavioral economics. With this prize, Thaler joins Daniel Kahneman (Princeton, Nobel laureate 2002) and Robert Shiller (Yale, Novel laureate 2013) in making the world take notice what we have long suspected – that our brains are prone to making major errors of judgement, often repeatedly, as if we never learn. Such errors are called behavioral biases or cognitive biases. I will simply call them biases.

Nobel

Most of us go through life focusing on immediate needs (or is it wants?) than plan for future goals like saving for retirement. This tendency to overweight the immediate at the expense of the future is aptly called the present bias.

People with the present-bias don’t think much about their future selves, or if they do, they think of their future selves as a stranger. Naturally, you are less inclined to help someone if that person is a stranger. In addition, most people are over-optimistic about their future. While a sunny disposition is healthy, over-optimism, like the present-bias, can cause people to save too little, too late.

One of Richard Thaler’s contribution to behavioral finance is designing corporate retirement savings plans to nudge employees to save more. An interesting “trick” he uses is to have people commit today to saving a fixed percentage of their future pay rise.

This is very clever. By tying saving to future pay increases, the plan mitigates a common bias known as loss-aversion (the psychological pain of having a “pay cut” if you save). Also, by asking people to save a portion of their future pay, this mitigates the present bias. Thaler’s plan goes by the name of Save More Tomorrow, or SMART. It is described in his bestselling book Nudge, co-authored with legal scholar, Carl Sunstein.

A related bias to overoptimism is overconfidence. You are overconfident if you overrate your ability to do a particular task, such as predicting how well you will do in a course.

Overconfidence is a pervasive bias. Here’s a story recounted by Richard Thaler on overconfidence. On the first day of his MBA class, Thaler wanted to know how many students thought they will get an above average grade. As it turned out, every single one of them did. Even a clueless person will know that this statistically impossible.

You can be overconfident as an investor too. This is bad because overconfident investors have the “do’s and don’ts” of investing reversed. Here are three tell-tale signs of investor overconfidence:

  • You don’t believe in diversification
  • You trade very frequently (i.e. you turn over your portfolio rapidly)
  • You think you are able to beat the market through stock picking and market timing

Diversification protects you from picking the wrong asset (e.g., falling in love with a stock that was a success story in the past, but has lost its way). Trading frequently is costly in terms of actual trading cost and mediocre returns because honestly, very few of us can predict the future. Overconfidence can therefore hurt your investments, especially when the stakes are high.

Many investment professionals are also overconfident, probably because they think they are experts. But the problems that experts confront are highly complex, which defy the best efforts of experts.

History is littered with examples of experts goofing up big time on their predictions. You may not remember Long Term Capital Management, a big hedge fund which imploded in 1998. With two economics Nobel prize winners as its partners, LTCM was clearly a brainy outfit. Shortly after its implosion, Charlie Munger, Vice-Chairman of Berkshire Hathaway, has this to say:

“Similarly, the hedge fund known as “Long-Term Capital Management” recently collapsed, through overconfidence in its highly leveraged methods, despite I.Q.’s of its principals that must have averaged 160. Smart, hard-working people aren’t exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods”.

Speaking of “voyages”, I can’t help but think of Elon Musk, founder and chief executive of Tesla Motors, and the eponymous self-driving car that crashed into a tractor-trailer in May 2016, killing driver Joshua Brown (aged 40). As it turned out, Model S, the car that Mr. Brown drove, was available for sale even while in “beta (test) mode”. Yet,  Musk effused supreme confidence of the car’s autopilot feature when he told a news conference just two months before the crash incident, that “The probability of having an accident is 50% lower if you have Autopilot on.”

If high portfolio turnover is a sign of overconfidence, then mutual fund managers are in the overconfidence hall of fame. What has this overconfidence produced in terms of performance? The S&P “active versus passive” investment scorecard shows that in most years, less than half of U.S. mutual fund managers outperform their benchmarks. The verdict is clear. As a group, investors who send money to mutual funds are sending their money to overconfident “experts”.  This cannot be good for your hard earned money.

 

 

 

 

 

 

 

 

 

 

 

 

 

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