Behavioural Economics has More to do With Your Investing Success Than You Think
American Economist Richard Thaler was awarded the Nobel prize for economics last week. Mr. Thaler helped demonstrate how human reasoning diverges from rational economic modelling. Mr. Thaler lifted behavioural economics to prominence with his best selling 2009 book “Nudge”, co-authored with Cass Sustein. Setting out to build on the work of Nobel Laureate, Daniel Kahneman’s Prospect Theory, Thaler’s nudge lessons have been adopted by governments across the world. In the US and UK, “nudge units” have been studying how to boost savings and taxpaying, encourage healthy behaviour and reduce energy use. In Canada, you may have noticed that your utility bills now compare how you are doing relative to your neighbors. It gives you helpful hints to make you a more prudent user of electricity.
When it comes to investing decisions, Thaler helped uncover the endowment effect: a tendency to value something more highly just because you own it. He proved that when making choices to buy and sell, reluctance to sell a stock you already own at a higher price versus the current market price can be detrimental. Conversely, buying a stock you do not own, you want to pay a lower than market price. Execution when trading is just as important as what you are buying.
Mental accounting also plays a role when making investment decisions. Presenting the investor with fewer choices, known as “choice architecture” or nudging them in the right direction. One has to be careful too because advertisers are aware of these cognitive flaws too and structure sales material to take advantage.
|ETF||Gross Return||Risk||Cost (MER)|
|ABC||9.1 %||15 %||10bps|
|MNO||10 %||25 %||100bps|
|XYZ||10 %||15 %||100bps|
If you want to learn how to make better investment decisions and how to build portfolios that fit your investor type, come out to the current Berman’s Call tour (The Investor’s Guide to Thriving). You will learn about some of the behavioural biases that might be hurting your investment returns and learn how properly diversify your portfolios. Learn how to identify what type of investor you are and some techniques to improve how to manage your asset allocation so you can preserve and grow your portfolio. The events are free and we ask for a voluntary charitable donation to either Sick Kids Hospital or Baycrest Brain Health research for Alzheimer’s.