While economic models assume humans make rational choices, University of Chicago economist Richard Thaler isn’t having any of it.
Early in his career, Thaler penned a list of things people do that fly in the face of this assumption. Dubbed “The Dumb Stuff People Do,” Thaler’s list became the backbone of his career, earning him a Nobel Prize in Economics last year.
At its core, Thaler’s pioneering work in behavioral economics examines the flaws and biases that influence our actions. As we’ve shared here, these biases can wreak havoc on investor wealth.
But they don’t have to.
Wild swings in the market this month have given investors the opportunity to stay disciplined and think long term. Keeping some of Thaler’s key behavioral biases in mind can also bolster resolve:
- Loss Aversion—People experience negative feelings associated with loss about twice as much as they derive pleasure from gains. Gains seem temporary, and losses feel permanent. Take a properly diversified portfolio consisting of numerous asset classes. Combining asset classes can result in a portfolio with higher returns and less risk than a concentrated portfolio. The diversified portfolio is also expected to have a return differential between asset classes, some of which can actually lose money. This wide disparity in results can inflict feelings of pain and regret. Prudent investors look past this short-term pain toward long-term gain.
- Recency Bias—We tend to remember recent events more vividly and overweight the value of recent information over historical information. The Dow’s recent 2,300-point loss may look and feel like a big deal. The percentage change, however, is minor, and it certainly does not discount the astonishing run investors have experienced since March 2009. Smart investors remember that what’s happened recently is not more likely to occur—it’s important to keep a broad perspective.
- Hindsight Bias—We tend to overestimate our ability to predict an outcome that could not possibly have been predicted. Some investors claim to have known the market would crash in 2008. Memory distortion can lead investors to find casual connections when none exist, affecting interpretations of both past and future events. Disciplined investors know that picking winners is a losing game. No one – not even leading active managers – can confidently predict which asset class will outperform in the future.
To negate the tendency to misbehave, investors must get comfortable with being uncomfortable. Realize it’s never the market that’s being tested—it’s you. Loss aversion, recency bias, and hindsight bias are just the “dumb things” that cloud the long view needed for building wealth.