What a Nobel Prize Winner tells us about Investor Behavior

University of Chicago’s  Richard H. Thaler, one of the founders of behavioral finance, was awarded the 2017 Nobel Prize in Economics for shedding light on how human weaknesses such as a lack of rationality and self-control can ultimately affect markets.

People who are not financial experts frequently turn to investment advisors to manage their portfolios.     But many smart people use advisors to overcome very common psychological obstacles to financial success.

The 72-year-old “has incorporated psychologically realistic assumptions into analyses of economic decision-making,” the Royal Swedish Academy of Sciences said in a statement on Monday.

“By exploring the consequences of limited rationality, social preferences, and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes,” it said.

Thaler developed the theory of “mental accounting,” explaining how people make financial decisions by creating separate accounts in their minds, focusing on the narrow impact rather than the overall effect.

….

He shed light on how people succumb to short-term temptations, which is why many people fail to plan and save for old age.

 

It does not take a Nobel Prize to understand that people often make decisions based on emotion.  We do it all the time.  We judge people based on first impressions.  We buy things not because we need them but because of how they make us feel.  We go along with the crowd because we seek the approval of the people around us.  When markets rise we persuade ourselves to take risks we should not take.  When markets decline and our investments go down we allow fear to overcome our judgment and we sell out, afraid that we’ll lose all of our money.

Professional investment managers have systems in place that allow them to overcome the emotional barriers to successful investing.  It begins by creating portfolios that are appropriate for their clients.  Then, in times of stress, they use their discipline and stick to their models, often selling what others are buying or buying what others are selling.  This is the secret to the old Wall Street adage that the way to make money is to “buy low and sell high.”  By taking emotion out of investment decisions professional managers take a lot of the risk out of investing.

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