The Investment Scientist

What You Can Learn from Richard Thaler

Posted on: October 16, 2017

blog_155_it1_roland_berger_tam_artikel_richard_thaler_image_caption_w768.jpgA few days ago I got the news that Richard Thaler won the 2017 Nobel Prize for Economics. If you don’t know about his work yet, you should. He, Danield Kahneman (2002 Nobel Prize) and the late Amos Tversky are considered the founding fathers of Behavioral Economics. His insights have a great deal of practical application and here I am trying to sum it up in one page for you.

Does The Stock Market Over-react?

This is the title of his paper published in The Journal of Finance in 1985. I read the paper for the first time when I was a PhD student at Carnegie Mellon University. The short answer to the question posed by his title is YES. He found that the market tends to overreact and reverse itself. When you look at five year intervals, stocks that did best in the previous five years tend to underperform over the next five years compared to stocks that did worst in the previous five years. What can you learn from that? Don’t be a hot stock (or fund or sector) chaser.

Myopic Loss Aversion
Richard Thaler coined this term to describe a cognitive bias many investors have which causes them to be afraid of short term loss to the detriment of their long term wealth. As an investment advisor, I encounter this a lot. The question I get the most is, “What do you think the market will do in next few months?” Implicit in the question is their fear that the market might drop and their desire to avoid it. The fear of loss causes many investors to abandon the market prematurely. What can you learn from that? Be oblivious to the market. This sounds counter-intuitive, but it’s the same advice given by another Nobel Prize winner, Daniel Kahneman.

Libertarian Paternalism
Richard Thaler did his research at the University of Chicago, a bastion of Libertarianism. The intellectual foundation of Libertarianism is that individuals are rational, therefore when left to their own devices, they always make the best decisions. Behavioral economists like Richard Thaler and Daniel Kahneman have found that in reality, individuals are not at all rational. That begs the question, “Should a higher authority takes away some individual freedom so that these irrational beings won’t hurt themselves?” This question already borders on philosophy (and politics.) Richard Thaler suggests a middle ground that he calls Libertarian Paternalism, that is, the high authority does not limit individual freedom but makes a good option the default choice. There is no practical application for individual pe se, but you may recognize its influence when you have an auto-enrolled 401k plan or when you go to a school cafeteria and see French fries being placed slightly harder to reach than salad.

There are much much more to Richard Thaler’s insights that one page can sum up and I will write about them in my next newsletter. For now, I highly recommend getting his best-seller – Nudge: Improving Decisions About Health, Wealth, and Happiness.

Schedule a Discovery review with me, or get my white paper for free: The Informed Investor: 5 Key Concepts for Financial Success.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

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