In October Richard Thaler was awarded the 2017 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for his contributions to behavioural economics.
Thaler’s Nobel Prize citation noted the importance of his work on self-control and mental accounting, but what isn’t widely appreciated is that the insights of Thaler and his collaborators have been instrumental in the creation of goals-based advice and investment.
While the “rational” investor knows that a dollar is a dollar, what normal people tend to do is keep assets in different pockets. Many people assign some of their money into a "safe" account which is invested conservatively while at the same time treating other money differently, even speculatively.
Goals-based advice adopts Thaler’s mental accounts framework and starts by identifying each major goal separately.
The retirement income goal, the desire to support the education of grandchildren and the goal of leaving money for charity are all different and are addressed separately. Contrast that with the standard approach to advice which doesn’t seek to understand the purpose of the money but focusses on the volatility of the invested value of the money.
Away from the goals-based advice concept, behavioural economists generally seek to understand and predict outcomes based on observations of how normal people make decisions rather than tell us what we should do if everyone were to act completely rationally and had access to deep analytical tools.
I was first to introduced to behavioural finance – that is, the application of behavioural economics to decision-making in finance – over twenty years ago. It was a time when active managers were increasingly being asked to justify why they believed they could add value on a repeatable basis (plus that the more things change the more they stay the same!).
At that time standard models in finance were based on rational investors operating in efficient markets. Behavioural finance offered hope to active managers - a plausible academic explanation of market “anomalies” based on systematic behavioural “errors” of investors. I think the jury is still out on whether it provides an effective rationale for the wide-spread use of active management.
To be sure, in the early 2000s I did visit an equity fund manager, Fuller & Thaler Asset Management, in San Mateo, California who shunned traditional fundamental analysis and sought to capitalize on Thaler’s academic insights on behavioural biases. These are biases that may cause investors to over-react to old, negative news or under-react to new, favourable information. While we didn’t invest with them, they do appear to have generated quite an attractive track record.
However I do think that the most important and lasting benefit of the research is that it has shown how frameworks informed by insights from behavioural economics can help individuals make better decisions.
Linking to goals
Within goals-based advice, risk isn’t the same as volatility. Hersh Shefrin and Meir Statman, long-standing collaborators of Thaler, developed a behavioural portfolio theory in which risk refers to the likelihood of failing to attain a stated goal.
Rather than focussing on an investor’s tolerance for asset volatility, their attention is on investors’ capacity to take investment risk to attain a goal. For example, there is limited scope to take risk to achieve high priority goals (ie: low capacity for failure) while it might even make sense to gamble on an outside chance to try to attain a low priority goal.
The other thing investment managers and advisers can learn from Thaler and his colleagues is the importance of communicating economic and investment concepts through simple narratives and story-telling.
Nudge, a book Thaler authored with Cass Sunstein, provides many easily understood examples of how to actively engineer “good” choices such as saving through automatic “round-ups” from every day purchases. And of course, who could forget Thaler’s cameo appearance with Selena Gomez in the movie “The Big Short” where they explained the role of synthetic CDOs in the global financial crisis while they played blackjack?
The award of a Nobel Prize not only recognises personal achievement but can sometimes provide belated endorsement of areas of research historically considered to be outside the mainstream. I think it is wonderful to see the recognition of the theoretical underpinning of a framework for goals-based advice and its implementation.
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