A Nobel Prize winner’s take on investing

Humans are complicated.

We’re irrational, we don’t follow rules and we’re constantly exchanging ideas and opinions. (Here’s us doing exactly the latter!)

It’s one of the reasons why several recent winners of The Nobel Prize in Economics – Daniel Kahneman and Robert Shiller being two of them – could be better described as psychologists. Their research into behavioural economics has been fascinating.

This week Richard Thaler was awarded the famous gong.

His life’s work has been summarised as “[building] a bridge between the economic and psychological analyses of individual decision-making”.

His work challenges traditional economic theory, which assumes that:

– people have good access to information
– they process and act on it rationally
– they’re only interested in personal gain.

In his research, Thaler demonstrates how simplistic these assumptions are. In fact, consumers are irrational human beings and very often we don’t act in a logical way.

Two aspects of his work are worth a mention, especially because they back up our investment approach:

1. Behavioural biases

Investors are prone to a whole range of emotional biases which impact (mostly negatively) on their outcomes.

Thaler hypothesized that we assign more value to things merely because we own them. It’s why we experience the negative feeling of a loss more strongly than the positive sense of the same level of gain. And explains why so many investors panic during a market crash.

Another of his hypotheses is the house money effect. In other words, if you’ve won big on the markets or at a casino, you’ll be more relaxed about to taking risk than someone who suffered a loss.

2. Self-control

We’re all vulnerable to short-term temptations that threaten our long-term well-being; for example, we’d rather spend money on things we don’t need rather than invest it for our retirement.

He described an internal tension between our ‘planning self’ who makes decisions with the aim of long-term happiness, and our ‘doing self’ who’s just focused on short-term goals.

We all have an irresistible urge to do something; especially when things go wrong. As investors, we know that we should avoid the temptation to sell underperforming funds and buy recent winners. But it can be tough; even when we know the evidence tells us this behaviour leads to poor performance.

So, here’s to Richard Thaler – just another Nobel Prize winner backing up our investment theory!

The value of investments and the income from them can go down as well as up and you may get back less than you originally invested. Past performance should not be regarded as a guide to the future.

The value of investments and the income from them can go down as well as up and you may get back less than you originally invested. Past performance should not be regarded as a guide to the future.