Personal Finance: Professor wins Nobel Prize for examining investment mistakes

Personal Finance: Professor wins Nobel Prize for examining investment mistakes

November 1st, 2017 by Christopher Hopkins in Business Diary

The Nobel Prize in Economic Sciences is a relatively late addition to the venerable suite of prestigious awards bestowed by the Royal Swedish Academy of Sciences. First endowed in 1968, the annual prize recognizes outstanding contributions to the field of economics. This year's recipient won deserved acclaim for his contemplation of how investors screw up.

Richard H. Thaler, a professor at the University of Chicago, gained wide recognition for his on-camera explication of the 2008 financial meltdown in the 2015 film "The Big Short." But Professor Thaler was already renowned in the financial world for his work on why individuals make psychological investing mistakes, a field known as "behavioral finance." His work includes suggestions for recognizing and combating the instinctive mental responses that impair our ability to make rational decisions when selecting and managing our investments.

It is now well known that certain "cognitive biases" or psychological traps inform human decision-making. These cognitive biases served an essential primeval function: self-preservation. When faced with mortal threats, early humans could scarcely pause to reflect upon and evaluate sensory inputs to determine potential threats. Rather, instinct took over at the sound of an approaching beast and the brain shouted "run for it!"

Christopher Hopkins

Christopher Hopkins

Photo by Contributed Photo /Times Free Press.

This inherent protective response has proven to be a significant impediment to successful investing.

An earlier Nobel laureate in behavioral economics, Daniel Kahneman, bifurcated our broad thought processes into two categories.

» System 1 thinking, according to Kahneman's taxonomy, is "fast" — an instinctive reaction to potential dangers, or a quick, heuristic assessment of threats when time is of the essence. Think "fight or flight."

» System 2 or "slow" thinking is the more reflective, informed and systematic process of collecting information and rationally formulating a calculated response. While we like to believe that we apply slow thinking to our portfolios, these pioneers have demonstrated that fast or System 1 thinking often impairs our investment performance.

Thaler built upon the work of others in applying these psychological biases in explaining how human aversion to losses distorts our ability to properly value an investment, and how this innate perception affects broader financial markets.

But another important and especially relevant aspect of Professor Thaler's work involves his application of the tools of neuroscientists and psychologists in understanding lack of self-control in financial decision making. Individuals often succumb to short-term temptation to the detriment of longer-term goals (ask any perennial dieter). Few Americans are saving nearly enough for retirement, owing at least in part to our hard-wired preference for immediate gratification.

Thaler's research sheds light on this deficiency and offers some thoughts on how to combat our predispositions and encourage "slower" thinking to increase retirement savings and investments by changing how choices are presented or "framed".

For the retirement under-saving problem, workers are offered a choice between consuming now and saving for later. Drawing on behavioral finance research, Thaler suggests re- framing the choice to favor saving. Specifically, he proposes that the default option for workers should be the maximum allowable salary deferral in their 401(k). Workers could choose to save less or even opt out, but are likely to put more away if they receive what he calls a "nudge" from the manner in which the options are presented.

Advertisers have long been aware of the power of framing in persuading customers to buy their products. This year's Nobel prize award recognized in part the potential value of applying the same principles to improving individuals' financial behavior by nudging them toward better decisions, slowing down fast thinking, and recognizing the psychological traits that helped us outrun a bear but impede our cognitive performance.

Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. Investment Advisors in Chattanooga.

Getting Started/Comments Policy

Getting started

  1. 1. If you frequently comment on news websites then you may already have a Disqus account. If so, click the "Login" button at the top right of the comment widget and choose whether you'd rather log in with Facebook, Twitter, Google, or a Disqus account.
  2. 2. If you've forgotten your password, Disqus will email you a link that will allow you to create a new one. Easy!
  3. 3. If you're not a member yet, Disqus will go ahead and register you. It's seamless and takes about 10 seconds.
  4. 4. To register, either go through the login process or just click in the box that says "join the discussion," type your comment, and either choose a social media platform to log you in or create a Disqus account with your email address.
  5. 5. If you use Twitter, Facebook or Google to log in, you will need to stay logged into that platform in order to comment. If you create a Disqus account instead, you'll need to remember your Disqus password. Either way, you can change your display name if you'd rather not show off your real name.
  6. 6. Don't be a huge jerk or do anything illegal, and you'll be fine.

Chattanooga Times Free Press Comments Policy

The Chattanooga Times Free Press web sites include interactive areas in which users can express opinions and share ideas and information. We cannot and do not monitor all of the material submitted to the website. Additionally, we do not control, and are not responsible for, content submitted by users. By using the web sites, you may be exposed to content that you may find offensive, indecent, inaccurate, misleading, or otherwise objectionable. You agree that you must evaluate, and bear all risks associated with, the use of the Times Free Press web sites and any content on the Times Free Press web sites, including, but not limited to, whether you should rely on such content. Notwithstanding the foregoing, you acknowledge that we shall have the right (but not the obligation) to review any content that you have submitted to the Times Free Press, and to reject, delete, disable, or remove any content that we determine, in our sole discretion, (a) does not comply with the terms and conditions of this agreement; (b) might violate any law, infringe upon the rights of third parties, or subject us to liability for any reason; or (c) might adversely affect our public image, reputation or goodwill. Moreover, we reserve the right to reject, delete, disable, or remove any content at any time, for the reasons set forth above, for any other reason, or for no reason. If you believe that any content on any of the Times Free Press websites infringes upon any copyrights that you own, please contact us pursuant to the procedures outlined in the Digital Millennium Copyright Act (Title 17 U.S.C. § 512) at the following address:

Copyright Agent
The Chattanooga Times Free Press
400 East 11th Street
Chattanooga, TN 37403
Phone: 423-757-6315
Email: webeditor@timesfreepress.com


Loading...