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How we can make better financial decisions

John F. Wasik  |  13 Sep 2017Text size  Decrease  Increase  |  

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In a perfect world of economic intelligence, Richard Thaler notes, we would all make decisions like the famous "Star Trek" character Mr Spock, where nearly everything is carefully analysed.

 

"But I don't know anyone like that," says Thaler, who calls these idealised Vulcans "Econs." Instead, we more often make decisions like Homer Simpson.

Thaler, a professor of economics at the University of Chicago's Booth School of Business, is one of the leading minds in the study of behavioural economics.

Along with researchers like his friend Daniel Kahneman, who was awarded the Nobel Memorial Prize in Economic Sciences, he's championed studies over the past 30 years that explore the irrational side of our financial actions. That means, in defiance of the view of classical economics that we are all "rational actors" who consistently act in our own best interest, Thaler maintains we often "misbehave."

Thaler said he first became enamoured of behavioural economics by "stalking" Kahneman and his (late) research partner Amos Tversky, who were visiting professors at Stanford in the mid-1970s.

"My greatest discovery was discovering them," Thaler recalls.

As he has done for the past 30 years or so, Thaler focuses on how people make financial decisions--usually bad ones--which he, Kahneman, Tversky, and others have documented in hundreds of experiments, books, and papers.

One of Thaler's most pragmatic achievements has been the "Save More Tomorrow" program, which automatically enrols employees in 401(k) plans, resulting in dramatically higher savings rates by a factor of four.

Yet most people do little or no analysis when doing things like paying off credit card bills or choosing health plans. In one experiment, Thaler found out that people are often looking at the wrong things. When paying off several credit card bills, for example, most will pay off the biggest balance first, not the one with the highest finance rate, which is going to cost more over time.

"Most of us are on autopilot and have little or no self-control," Thaler notes.

Often the best solution seems counterintuitive. Thaler said that the University of Chicago, for example, recently offered a high-deductible health policy with a health savings plan.

While out-of-pocket costs on the high-deductible plan were higher, participants could save money in separate, tax-deferred health savings accounts--something not available with costlier conventional plans. Then they could keep the money in the health accounts indefinitely and even reap generous tax breaks.

"Unlike dreadful flexible savings accounts, which are 'use it or lose it' plans, it makes sense to max out your HSA. Everyone should have an HSA."

But many people would rather take the higher-premium policy, irrationally thinking that it would be better because of the loftier price tag, flawed thinking that applies to everything from a cup of coffee to luxury cars.

Since our brains are hardwired to our emotional circuits, we don't think logically when it comes to investing and money. The pain of a loss is a much more powerful emotion than experiencing a gain. We're overconfident and sell when we should be buying stocks. We take a "mental accounting" of what we own and make bad decisions. A lot of financial decision-making is topsy-turvy because of our persistent misbehaving.

In his most recent book Misbehaving: The Making of Behavioural Economics, Thaler expands upon how he came to the foundational concepts of why people act so badly when it comes to decisions about money. It builds upon his bestseller, co-written with Cass Sunstein, Nudge: Improving Decisions about Health, Wealth, and Happiness.

Thaler's work and views, though, have put him at odds with many of his colleagues at the University of Chicago over the past two decades, long a bastion for classical and market economics. Thaler opines that the "mathematicisation of economics" is a fairly new development since the field was primarily focused on behaviour from the time of Adam Smith to John Maynard Keynes through World War II, who prosaically called market forces "animal spirits."

One of his closest colleagues and golfing companions is Eugene Fama, who won the Nobel Memorial Prize in Economic Sciences along with Thaler's friend Robert Shiller, a Yale economics professor.

Fama's Efficient Market Hypothesis is a bedrock of financial economics that says that securities prices reflect all available market information. It's a theory rooted in statistical analysis, not social science. Thaler disagrees with Fama, although it apparently hasn't disrupted their friendship.

"I don't want to believe the Efficient Market Hypothesis is true," Thaler says. "It's an idealised world of the Econs."

If there's no rational underpinning of securities prices, then how do we describe what's going on and protect our portfolios from manias and bubbles?

Thaler offers little consolation on this issue, saying it will be "difficult to get beyond the cycles of bubbles and busts." He cites one study of investors who were asked during the pre-2000 tech stock bubble how much they thought tech stocks would gain, despite high valuations.

"They said prices would rise 20 per cent," Thaler says. "That's a bubble. That's when we reach an 'exuberance delta.'"

What about today's stock market, which is trading at historically high valuations based on price to earnings, a time Thaler calls a "risky period."

"We all should be worried about high prices and infinitesimal volatility," he warns. "Given today's news, that's hard to understand. I wake up every morning, read the newspaper and get scared."

Although behavioural economics has gained great currency in the post-2008 environment, it largely comes up short in predicting when bubbles will burst or how debt will ignite the next meltdown.

Unlike physics, his field has yet to develop iron-clad formulas that will predict what markets will do and when they will do it. While behavioural economics is adept at describing the conflicts people have when making financial decisions, it would be supremely useful if it could forecast when the next market crash will occur, which is also a shortcoming of classical economics.

On this score, Thaler says "my crystal ball is broken."

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John F. Wasik is a US-based freelance columnist for Morningstar.com. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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