24 Oct Richard Thaler: How this Nobel Prize winner changed investing
I was rather pleased by the news this month, that American Economist Richard Thaler was awarded the Nobel Memorial Prize in Economic Science. Commonly referred to as the Nobel Prize in Economics, this is an award for outstanding contributions to the field of economics and generally regarded as the most prestigious award in that field.
For many years, traditional economists assumed that humans behaved in a perfectly rationally way and always acted in their own best interests.
In his book entitled ‘Nudge,’ Thaler notes that, “People often make poor choices — and look back at them with bafflement! We do this because as human beings, we all are susceptible to a wide array of routine biases that can lead to an equally wide array of embarrassing blunders in education, personal finance, health care, mortgages and credit cards, happiness, and even the planet itself.”
Thaler’s insight has been particularly crucial in the area of investing and retirement planning. For instance, we all know that we need to save more for retirement. But we do much better if we’re ‘nudged’ to do something differently rather than being nagged. So rather than the traditional approach of compelling people to save for retirement on their own, Thaler suggested that employers should automatically enroll workers in pension schemes while allowing us to opt out. Turns out, once people are automatically enrolled into a pension scheme, they rarely opt out!
Thaler and fellow behavioural economist Shlomo Benartzi have proposed a system called ‘Save More Tomorrow,’ in which participants commit themselves to increase their regular savings whenever they get a pay rise.
At Tandem, we use some of the insight gained from Thaler’s work to help develop our investment process. According to Thaler, one reason most investors get into trouble is overconfidence. Most people think they’re above-average investors and as a result they trade too much and diversify too little.
Overconfidence can also lead people to invest during what appears to be a rising market, thinking they will just get out faster than others.
This is one reason why we never attempt to time the market. Instead we work with our clients to invest for the long term based on their goals and risk tolerance.