A Dozen Things I’ve Learned from Richard Thaler about Investing

Richard Thaler is not only a famous economist and author, but is also part of a very successful fund said Bloomberg in an article published just today:

The 70-year-old University of Chicago professor, whose stock-picking theories drive the Undiscovered Managers Behavioral Value Fund, is getting discovered in more ways than one. The small-cap mutual fund, which beat 99 percent of its Bloomberg peers over the past three and five years, has almost doubled in size to $3.7 billion during the past 12 months as investor deposits surged. “What we try to do is put academic research to use,” Thaler said in an interview this month in Los Angeles. “We’re interested in the dogs that are going to look better….“We’re an active manager, so we think we can beat the market by a little most of the time,” he said. “Our methods are kind of a hybrid. We don’t fit neatly into a single quant versus judgmental box. We use judgment based on academic-style rigorous testing.”

1. “Behavioral economics [is] a field that only exists because regular economics is based on an idealized economic agent, sometimes called Homo Economicus. In the book we refer to such creatures as Econs. Econs are creatures that can calculate like a super computer, never get tempted by fatty or sweet foods, never get distracted, and probably aren’t a whole lot of fun to be around. In contrast, real people, who in the book we call humans, don’t make any appearance in standard economics. Behavioral economics is economics about humans. Humans are busy, can’t solve every problem instantaneously, and get tempted by luscious desserts. Sometimes they need some help.” Some economists believe that introducing ideas from psychology into economics is an admission that ideas from economics might be less valuable. In actual fact introducing a greater degree of realism into the profession causes the credibility of economics to rise rather than fall, especially among people who are not economists. In other words, people like Thaler who work to bring psychology into economics increase the credibility of the profession and as a side effect make jokes about economists “assuming a can opener” less funny. It would certainly make life easier if humans and an economy were as predictable as the systems in a physics experiment. But even a small child knows that assumptions such as one that assumes humans are perfectly informed rational agents do not tie in any reasonable way to reality. The joke that economists have predicted nine of the past five recession is humorous for a reason since the core of humor is truth. The more the economics profession becomes reality-based by adopting the ideas of people like Thaler, the better it will be perceived.

2. “Models of Econs may provide a good approximations of what happens in the real world…. but those situations are the exception rather than the rule.” I like this phrasing in a recent blog post by Allison Schrager: “Economics offers a series of parables to help us understand how the economy works. The parables are abstractions that make many simplifying assumptions because the world is too complicated to capture in a simple model.” The value of economics that Schrager talks about is a very good thing for society. Charlie Munger has written an essay on the strengths and weakness of economics, that includes this text about strengths:

“Economics was always more multidisciplinary than the rest of soft science. It just reached out and grabbed things as it needed to. And that tendency to just grab whatever you need from the rest of knowledge if you’re an economist reached a fairly high point in Mankiw’s textbook (Principles of Economics). I checked out that textbook. I must have been one of the few businessmen in America that bought it immediately when it came out because it had gotten such a big advance. And there I found laid out as principles of economics: opportunity cost is a superpower, to be used by all people who have any hope of getting the right answer. Also, incentives are superpowers. And lastly, the tragedy of the commons model, popularized by UCSB’s Garrett Hardin.”

The ideas from economics like Munger mentions above are essential mental models that must be part of any investor’s worldly wisdom. Others include comparative advantage, competitive advantage and creating destruction just to mention three that starts with the letter “c”. That economics reaches out and grabs ideas from other disciplines is a good is a very good thing argues Munger, but assuming that an economy can be modeled using the same assumptions and formulas that would be applied to physical systems is, in Munger’s view, folly. What Thaler calls “a good approximation” should not only be the goal, but a critical idea to apply so as to avoid mistakes caused by hubris. It is far better to be approximately right than precisely wrong.

3. “The combination of free entry, unfettered competition, and free choice seems hard to quarrel with.… However, if participants are not well-informed or highly motivated, then maximizing choice may not lead to the best possible outcome.” “If people starting new businesses on average believe that their chance of succeeding is 75% then that should be a good estimate of the actual number that do succeed. Econs are not overconfident.” “Economists assume people are unboundedly unscrupulous—or I’ll say self-interested, a more polite term. But there have been lots of experiments where you leave a wallet out and depending on the place—I don’t remember the exact data—but a large percentage get returned.” “There’s no reason to think that markets always drive people to what’s good for them.” “Most economists recognize that some of the people are not fully rational some of the time, and some of the time that matters.” Charlie Munger again says it better than I can:

“How could economics not be behavioral? If it isn’t behavioral, what the hell is it? And I think it’s fairly clear that all reality has to respect all other reality. If you come to inconsistencies, they have to be resolved, and so if there’s anything valid in psychology, economics has to recognize it, and vice versa. So I think the people that are working on this fringe between economics and psychology are absolutely right to be there…”

4. “Most of economic theory is not derived from empirical observation. Instead it is deduced from axioms of rational choice, whether or not those axioms bear any relation to what we observe in our lives every day. A theory of the behavior of Econs cannot be empirically based, because Econs do not exist.” Empirical data can be based on the idea that humans are, well, human. The contributions of people like Kahneman and Thaler on this point are enormous. Economics becoming more empirical is only helpful if it is reality-based. I recommend Thaler’s books on this point and other sources which I link to in the notes.

5. “You can [beat the market] but it is difficult.” Warren Buffett once said: “I’d be a bum on the street with a tin cup if the markets were always efficient.” His partner Charlie Munger adds: “There’s no way to make investing easy. Anyone who finds it easy, you’re living in an illusion.” “I think it is roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don’t think it’s totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It’s efficient enough, so it’s hard to have a great investment record. But it’s by no means impossible. Nor is it something that only a very few people can do. The top three or four percent of the investment management world will do fine.”

6. “In some ways the, the venerable Ben Graham has been given a Fama-French seal of approval, since they also endorse value and profitability.” Fama-French endorses value as a statistical factor which is sort of an endorsement of value as an analytical style (Ben Graham). But the two approaches are very different. A portfolio composed of hundreds of stocks in the form of an index is very different from a portfolio selected on a bottoms up fundamental basis that may only have 10 stocks in it. I have written about this point on my blog before and I link to it in the notes below. Thaler is correct in making the statement the quotation but one must be careful to not conflate value as a statistical factor and value as an analytical style.

7. “Rational models are one hundred percent flexible. If you allow time-varying discount rates, there is no discipline whatsoever. If you look at what happened to tech stocks and then to real estate, and you say maybe there wasn’t a bubble—where is the discipline in that?” Those of us who lived through the Internet crash in 2001 know that bubbles exist. One particular example of silliness is often cited, in this case by Burton Malkiel: “in one celebrated case during the Internet bubble, the market price of Palm Pilot stock (which was 95 percent owned by the company 3Com) implied a total capitalization considerably greater than that of its parent, suggesting that the rest of 3Com’s business had a negative value. But the arbitrage (sell Palm stock short and buy 3Com stock) could not be achieved because it was impossible to borrow Palm Pilot stock to accomplish the short sale.” The Internet bubble was a time when people went bonkers due to fear of missing out. People like Thaler who explain and remind us why people are often not rational are helpful to civilization.

8. Diversification Bias: “When an employee is offered n funds to choose from in her retirement plan, she divides the money evenly among the funds offered. Use of this heuristic, or others only slightly more sophisticated, implies that the asset allocation an investor chooses will depend strongly on the array of funds offered in the retirement plan. Thus, in a plan that offered one stock fund and one bond fund, the average allocation would be 50% stocks, but if another stock fund were added, the allocation to stocks would jump to two thirds.” This quotation and its implications raises the question of whether ordinary people should be making their own investment decisions. Can nudges be enough? I tend to think not. Soft paternalism isn’t enough in my view since the negative spillovers for society are simply too big to let people do so poorly investing their retirement money since they end up living in poverty as elderly adults. I understand that some people believe my view is too paternalistic. But a year does not pass that I don’t get more convinced that most people are incapable of investing wisely when left to their own devices. I agree with Charlie Munger that efforts some time ago to privatize social security were a deeply flawed idea. I link below in the notes to a recent New York Times article entitled “Nudges Aren’t Enough for Problems like Retirement Savings.” The article notes: “Automatic enrollment in retirement accounts counts as the most successful nudge yet tested on a large scale [But] only 40 percent of American families in the bottom half of the income distribution have any form of retirement savings plan. And even among those who have one, their savings total, on average, is just $40,000.” Nudges are great but sometimes are not enough.

9. Loss Aversion: “When they have to give something up, they are hurt more than they are pleased if they acquire the very same thing.” You can see loss aversion in human behavior in many settings if you know where and how to look for it. It is almost always combined with other biases so loss aversion (also called Prospect theory) varies in the way it presents itself. New findings and support for the existence and impact of loss aversion bias are still appearing in the literature. For example,

“according to a new study, occur when people are so desperate to avoid them that they blunder into them. It’s like a child worried about missing a fly ball or dropping a pass, or a newlywed husband fearful he will drop his new bride as he carries her across the threshold; once it’s in the mind — and the person starts to adjust thinking drastically to avoid it — that’s when the trouble starts. The new research from Dr. Rui Yao, an associate professor of personal finance at the University of Missouri, identified risk factors for people who are “more likely to make investment mistakes during a down market,” and found that aversion to losses was the key character trait.”

10. The House Money Effect: “The money that has recently been won is called ‘house money’ because in gambling parlance the casino is referred to as the house. Betting some of the money that you have just won is referred to as ‘gambling with the house’s money,’ as if it were, somehow, different from some other kind of money. Experimental evidence reveals that people are more willing to gamble with money that they consider house money.” Prior gain can increase a person’s willingness to accept bets involving greater risk and uncertainty. In other words, the potential for gains or losses is considered by humans relative to a reference point, rather than calculated on the basis of the absolute level of wealth. Thaler and Johnson have called this phenomenon: “prospect theory, with memory.”

11. Status Quo Bias: “Hundreds of studies confirm that human forecasts are flawed and biased. Human decision making is not so great either. Again to take just one example, consider what is called the ‘status quo bias,’ a fancy name for inertia. For a host of reasons, which we shall explore, people have a strong tendency to go along with the status quo or default option.” Sales and marketing departments love status quo bias. For example, magazines often offer free trials or issues at a reduced price if the customer agrees that the business can continue to send them issues until they actively end the subscription. When making decisions people tend to follow the adage: “when in doubt, do nothing.” For this reason, getting a customer’s credit card information is a holy grail for marketers, who hate it when credit cards expire. Customers know this to some degree, which means they are reticent to hand out their credit card data even for a free trial. The incentives must be significant to obtain customer credit card data as a result.

12. Optimism Bias: “The ‘above average’ effect is pervasive. Ninety percent of all drivers think they are above average behind the wheel.” “People are unrealistically optimistic even when the stakes are high.” “I think the people who’ve been the most overconfident in our business in the last decade have been the people that called themselves risk managers. And the reason is they failed to learned the primary lesson we should have learned from when Long Term Capital Management went belly up ten years ago. That is, investments that seem uncorrelated can be correlated simply because we’re interested in it. …the world is much more correlated than we give credit to. And so we see more of what Nassim Taleb calls ‘black swan events’– rare events happen more often than they should because the world is more correlated. I think one lesson we have to learn is that there’s a lot more risk than we’re giving credit to, a lot more what economist calls systematic risk. I think we also have learned the lesson that we have to have better incentive structures.” I have met Thaler and find him not only to be a delightful and insightful, person but also an to be an optimist. Optimism is good quality to have as long as it does not become a dysfunctional bias. When people talk about optimism bias it always reminds me of a story:

A family had twin boys, whose only resemblance to each other was their looks. If one felt the temperature was too hot, the other thought it was too cold. If one said the television was too loud, the other claimed the volume needed to be turned up. Opposite in every way, one boy was an eternal optimist, the other boy a total pessimist. On the twins’ birthday their psychologist father loaded the pessimist’s room with every imaginable toy and game. The optimist’s room was loaded with a huge pile of horse manure. That night the father passed by the pessimist’s room and found him sitting next to his many gifts crying bitterly.

“Why are you crying?” the father asked.

“Because my friends will be envious, I’ll have to read all these instructions before I can do anything with these toys and games, I will constantly need new batteries, and they will eventually get broken.” answered the pessimist twin.

Passing the optimist twin’s room, the father found him dancing for joy in the middle of the pile of manure. “What are you so happy about?” he asked.

The optimist twin boy replied, “There just must be a pony in here somewhere!”

Notes:

My post on Fama-French: https://25iq.com/2014/03/16/ben-grahams-value-investing-%e2%89%a0-famafrenchs-factor-investing/

My post on Kahneman https://25iq.com/2013/07/18/a-dozen-things-ive-learned-about-investing-from-daniel-kahneman/

Nudges Aren’t Enough for Problems like Retirement Savings. http://www.nytimes.com/2016/02/24/business/economy/nudges-arent-enough-to-solve-societys-problems.html?_r=0

Thaler article in Bloomberg: http://www.bloomberg.com/news/articles/2016-02-26/-big-short-professor-s-fund-swells-as-theory-works-in-reality

Charlie Munger on economics: https://www.farnamstreetblog.com/2015/03/charlie-munger-academic-economics/

Allison Schrager: http://qz.com/611394/economics-education-is-awesome/

Burton Malkiel https://www.princeton.edu/ceps/workingpapers/200malkiel.pdf

Dr. Rui Yao research: http://www.seattletimes.com/business/for-investors-fear-of-loss-can-be-costly/

Interview with John Cassidy http://www.newyorker.com/news/john-cassidy/interview-with-richard-thaler