Behavioral Finance and Your Portfolio. Michael M. Pompian
While this is clearly not an exhaustive list, the names of the people we will review are: Professor Robert Shiller, Professor Richard Thaler, Professor Meir Statman, Professor Daniel Kahnemann, and Professor Daniel Ariely.
The first prominent figure we will discuss is Yale University Professor Robert Shiller (Figure 1.3). He famously predicted two of the biggest bubbles of all time: the dot-com bubble and the housing bubble. Both times he published an edition of his book Irrational Exuberance, which described and predicted each respective bubble. Perhaps most impressive is the fact that Professor Shiller was one of three people to win the 2013 Nobel Prize in Economics. The theme of the 2013 award was “Trendspotting in Asset Markets,” and the Nobel Committee pointed to Shiller's work in forecasting intermediate-term moves in asset prices. The Nobel Committee was impressed with his work identifying that stock prices fluctuate much more than corporate dividends, and that the ratio of prices to dividends tends to fall when it is high, and to increase when it is low. More recently, Professor Shiller wrote Narrative Economics: How Stories Go Viral and Drive Major Economic Events.2 In the book he gives a groundbreaking account of how stories help drive economic events—and why financial panics can spread like epidemic viruses.
Figure 1.3 Robert Shiller, Sterling Professor of Economics Yale University and 2013 Recipient of the Nobel Memorial Prize in Economic Sciences
Source: Bengt Nyman/Flickr
Another high-profile behavioral finance researcher, Professor Richard Thaler, PhD (Figure 1.4), is the 2017 recipient of the Nobel Memorial Prize in Economic Sciences for his contributions to behavioral economics. Thaler studies behavioral economics and finance as well as the psychology of decision-making which lies in the gap between economics and psychology. At the University of Chicago Graduate School of Business, he investigates the implications of relaxing the standard economic assumption that everyone in the economy is rational and selfish; instead he entertains the possibility that some of the agents in the economy are human. He penned a classic commentary with Owen Lamont entitled “Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs,”3 on the general topic of irrational investor behavior set amid the tech bubble. The work relates to 3Com Company's 1999 spin-off of Palm, Inc. and argues that if investor behavior were indeed rational, then 3Com would have maintained a positive market value for a few months after the Palm Pilot spin-off. In actuality, after 3Com distributed shares of Palm Pilot to shareholders in March 2000, Palm Pilot traded at levels exceeding the underlying value of the shares of the original company. “This would not happen in a rational world,” Thaler notes. Professor Thaler is also the author of the book Advances in Behavioral Finance, which was published in 1993.
More recently, Professor Thaler, is the co-author (with Cass R. Sunstein) of the global best seller Nudge (2008) in which the concepts of behavioral economics are used to tackle many of society's major problems. In 2015 he published Misbehaving: The Making of Behavioral Economics. He has authored or edited four other books: Quasi-Rational Economics, The Winner's Curse: Paradoxes and Anomalies of Economic Life, and Advances in Behavioral Finance (editor) Volumes I and II. He has published numerous articles in prominent journals such as the American Economics Review, the Journal of Finance and the Journal of Political Economy.
Figure 1.4 Richard Thaler, PhD, 2017 Recipient of the Nobel Memorial Prize in Economic Sciences
Source: Anne Ryan/Chicago Booth
The following is an interesting and insightful excerpt from an interview Amazon.com conducted with Thaler and Sunstein.4 I particularly like the reference to choice architecture.
Amazon.com: What do you mean by “nudge” and why do people sometimes need to be nudged?
Thaler and Sunstein: By a nudge we mean anything that influences our choices. A school cafeteria might try to nudge kids toward good diets by putting the healthiest foods at front. We think that it's time for institutions, including government, to become much more user-friendly by enlisting the science of choice to make life easier for people and by gentling nudging them in directions that will make their lives better.
Amazon.com: Can you describe a nudge that is now being used successfully?
Thaler and Sunstein: One example is the Save More Tomorrow program. Firms offer employees who are not saving very much the option of joining a program in which their saving rates are automatically increased whenever the employee gets a raise. This plan has more than tripled saving rates in some firms and is now offered by thousands of employers.
Amazon.com: What is “choice architecture” and how does it affect the average person's daily life?
Thaler and Sunstein: Choice architecture is the context in which you make your choice. Suppose you go into a cafeteria. What do you see first, the salad bar or the burger and fries stand? Where's the chocolate cake? Where's the fruit? These features influence what you will choose to eat, so the person who decides how to display the food is the choice architect of the cafeteria. All of our choices are similarly influenced by choice architects. The architecture includes rules deciding what happens if you do nothing; what's said and what isn't said; what you see and what you don't. Doctors, employers, credit card companies, banks, and even parents are choice architects.
We show that by carefully designing the choice architecture, we can make dramatic improvements in the decisions people make, without forcing anyone to do anything. For example, we can help people save more and invest better in their retirement plans, make better choices when picking a mortgage, save on their utility bills, and improve the environment simultaneously. Good choice architecture can even improve the process of getting a divorce—or (a happier thought) getting married in the first place!
Amazon.com: You point out that most people spend more time picking out a new TV or audio device than they do choosing their health plan or retirement investment strategy. Why do most people go into what you describe as “auto-pilot mode” even when it comes to making important long-term decisions?
Thaler and Sunstein: There are three factors at work. First, people procrastinate, especially when a decision is hard. And having too many choices can create an information overload. Research shows that in many situations people will just delay making a choice altogether if they can (say by not joining their 401(k) plan), or will just take the easy way out by selecting the default option, or the one that is being suggested by a pushy salesman.
Second, our world has gotten a lot more complicated. Thirty years ago most mortgages were of the 30-year fixed-rate variety, making them easy to compare. Now mortgages come in dozens of varieties, and even finance professors can have trouble figuring out which one is best. Since the cost of figuring out which one is best is so hard, an unscrupulous mortgage broker can easily push unsophisticated borrowers into taking a bad deal.
Third, although one might think that high stakes would make people pay more attention, instead it can just make people tense. In such situations some people react by curling into a ball and thinking, well, err, I'll do something else instead, like stare at the television or think about baseball. So, much of our lives is lived on auto-pilot, because weighing complicated decisions is not so easy, and sometimes not so fun. Nudges can help ensure that even when we're on auto-pilot,