Imagine you’re throwing a dinner party.
Guests are seated at the table, but the food isn’t quite ready yet. So you put a bowl of cashews on the table to give your guests something to nibble on.
Soon enough, they start to devour the bowl and you worry they might lose their appetite before they’ve even had a single bite of the nice meal you’re preparing.
So, you take the bowl away again. Your guests thank you for it. They are now no longer tempted to fill up on the nuts right in front of them.
Looking from a purely economic point of view, this makes no sense.
A first principle of economics is more choices are better than fewer choices. By taking away the bowl, you’ve effectively limited the choices of your guests, yet they seem to be happier because of it.
It’s one of the many reasons why economist Richard Thaler started a new discipline: behavioural economics.
He realised that economic models often assume completely rational behaviour from humans to base their models on. And that’s exactly why they tend to be off from time to time.
To illustrate the point, Thaler writes this imaginary conversation between a human and an Econ (the theoretical human that only exists in economic models):
Econ: Why did you remove the cashews?
Human: Because I did not want to eat any more of them.
Econ: If you did not want to eat any more nuts, then why go to the trouble of removing them? You could have simply acted on your preferences and stopped eating.
Human: I removed the bowl because if the nuts were still available, I would have eaten more.
Econ: In that case, you prefer to eat more cashews, so removing them was stupid.
I really enjoyed reading Thaler’s book Misbehaving. It’s an interesting and humorous account of a professor explaining how our collective idiosyncrasies mess up the carefully constructed economic models.
People misbehave, as Thaler calls it. They don’t always act the way they’re expected to act and that makes it hard for economists to build models that accurately predicts certain outcomes.
Over the past decades, behavioural economics has been gaining in importance. Daniel Kahneman and Robert Shiller have received Nobel Prizes for their contributions to the field.
New Labour started applying behavioural economics to government policies and this development was continued by the coalition government.
David Cameron even appointed Thaler, one of the discipline’s founding fathers, to head a unit to ‘nudge’ people towards making better choices.
Now that might sound a bit ominous but the idea isn’t to perform Pavlovian experiments on humans. It’s more about showing them ways to behave more in their own and society’s interest.
For example, if people live more healthily, it’s better for their own personal health and it’s better for society since it could ease pressure on public services like hospitals.
It’s also led to some innovative ways to get people to pay into their pensions and limit unnecessarily excessive consumption.
In other words, getting people to think more about the long-term than the short-term when it comes to their money management.
Behavioural finance challenges the idea that humans always behave in a rational fashion. In this sense, it’s just as applicable to investing as it is to economics.
Back in 1985, Thaler already concluded that most people overreact to unexpected and dramatic news in a paper called ‘Does the stock market overreact?’
This clearly has an impact on the markets.
Investors overtrade. They tend to be impatient and overreact to market noise and it costs them dearly. It may be why Thaler advices stock market investors to “scrupulously avoid reading anything in the newspaper aside from the sports section.”
There are plenty more examples of irrational stock market behaviour.
Investors have a habit of selling their ‘winners’ too soon and holding on to their ‘losers’ too long because they’re reluctant to accept the loss.
There’s also the ‘bandwagon effect’, which is people following the herd thinking ‘if so many people believe it, it must be right’.
It’s the stuff bubbles are made of. Market caps reach levels where they no longer reflect the intrinsic value of companies.
Interestingly, penny share expert Sean Keyes gave a few examples of his own in a speech he recently gave at the Master Investor Show.
“Investors lack patience and call their broker too often,” says Sean.
“They learn about a stock, get excited, but then they lose patience with it, get bored and they want to move on. That doesn’t really make them better investors. It means they’re giving more money to their broker.”
Sean goes on to share some more examples of typically irrational behaviour that costs investors a lot of money.
“People tend to buy in when the market is at its top, when your friends or your brother-in-law are making money in the stock market and talk to you about it. That’s when people get excited. That’s when they put their money in and it’s why they tend to buy at the top.
“Equally, when the markets are at their worst and the Daily Mail has a worried-looking trader guy on the front cover, that’s when people tend to sell.
“So the effect is that people are buying high and selling low. Over time that badly eats into your returns.”
The average equity investor makes about 2.5% per year, whereas FTSE stocks have returned on average 5-10% annually over the past 10-20 years.
It just goes to show how much money investors throw away by acting not altogether rationally in the markets.
Sean reckons the average investor can reasonably hope to make 13.5% on a yearly basis. At the Master Investor show, he went into more detail about how they might go about achieving it.