The Prophet of the Irrational

article appeared on “New Model Adviser-CityWire”

Multi-asset: Prophet of the irrational

Multi-asset: Prophet of the irrational

Richard Thaler has won the Nobel prize for his work in behavioural finance. His insights can also teach us much about investment

History is full of examples of irrational human investment behaviour. Yet most economics and finance models assume humans are rational and always make the right decision based on the available information.

Earlier this month, Richard Thaler, who built his career by questioning this premise, won the 2017 Nobel prize for his work on behavioural economics. A professor at the University of Chicago, he is also one of the founders of behavioural finance, which studies how cognitive limitations influence financial markets.

Thaler suggests that, in inefficient markets, there can be no free lunches. As a corollary of this, the fact professional money managers cannot beat the market is not necessarily evidence of market efficiency.

Ups and downs

One focus of his work is on how the psychology of investors influences asset prices. With Werner De Bondt, he tested the overreaction hypothesis (exploring excessive investor optimism and pessimism) with two papers, published in 1985 and 1987. They found portfolios of the most poorly performing stocks, in share price terms, went on to outperform portfolios comprising the best performing stocks. At first, the results presented in those papers were thought a ‘programming error’ from the financial community.

Another example is his work on prospect theory, used to explain the so-called equity premium puzzle (Benartzi and Thaler, 1995). This states that, even though stocks appear to be an attractive assets, investors seem generally unwilling to hold them and demand a very high premium to hold the market supply. According to the study, the combination of loss aversion and frequent portfolio performance evaluations keeps the equity risk premium high.

Option to opt in or out

Finally, he is famous for ‘The Nudge’. He prompted employers to upend the default choice of not joining a defined contribution retirement plan, therefore ‘nudging’ employees to save more.

Research has shown that, when people must opt in to participate in an employer-sponsored pension savings plan, many choose not to sign up. But when they are opted in by default and must choose to opt out, more people tend to contribute.

Similarly, a default option that increases the amount contributed as the employee’s salary increases leads to higher contribution rates. This is a practical consequence of his work on bounded rationality and self-control (Thaler and Benartzi, 2004). It also fits with his mantra: ‘If you want people to do something, make it easy.’

Human irrationality

He studied the impact of limits to arbitrage on mispricings, contributing to the body of evidence demonstrating violations of market efficiency. For example, one of his early critiques of the efficient market hypothesis is found in his explanation of why closed-ended funds, such as investment trusts, can sell at premiums and discounts to their net asset values (Lee, Shleifer and Thaler, 1991).

Here, he argues some investors in these funds are ‘noise traders’ who have irrational expectations about future fund returns. Sometimes they are too optimistic and other times too pessimistic.

This affects fund share prices and causes deviations from net asset values. Rational owners of closed-ended funds have to deal with this additional source of risk. Hence they demand compensation for it. The discount on closed-ended funds is a frequently used measure of investor sentiment.

A later paper, presenting evidence on violations of the ‘law of one price’, is a study on equity carve-outs (Lamont and Thaler, 2003). In this case, evidence of limits to arbitrage are presented and attributed to the difficulty of short-selling overpriced carve-out shares.

The debate on whether markets are efficient is far from over.