Nobel prize-winning economists do not usually have a lot to say to everyday investors.

This year is different.

Professor Richard Thaler won the Nobel memorial prize for economics for his work in behavioural economics. In short, he won for the understanding he has brought to the way ‘real’ people think and react when making financial decisions.

His work has largely been about challenging classical economic theory about how the world works – in particular he has challenged, and at times ridiculed, the notion that we all act like rational economists all of the time when making big financial decisions.

Where his work broke new ground was in establishing ways of measuring and indeed predicting our supposed “irrationality” in in order to help and inform public policy settings.

Part of the brilliance of Thaler’s work was in capturing the absurdity of pure economic rationalism and expressing it in a simple way that non-rational economic types could relate to.

Like the real-world challenge that comes with deciding what gift to buy a significant other on a birthday or anniversary.

For the rational “econs” as Thaler terms them the answer is elementary – cash.

A gift of cash has the ultimate utility – the recipient can buy whatever they want when they want.

Job done.

Thaler in his book Misbehaving: The Making of Behavioral Economics does not recommend you take this approach with your partner – even if you are married to an economist.

The true value of Thaler – and other behavioral economists like Daniel Kahneman, who broke new ground and also won the Nobel prize in 2002 – is helping us understand our supposedly irrational behavior and put it to work to deliver better outcomes.

For example, in retirement income systems like the US and UK the decision to save for retirement is voluntary so naturally many people don’t. Thaler’s work helped support the idea of auto-enrolment where employees are automatically enrolled in the retirement savings scheme unless they decide to opt out. Most people don’t. With auto-enrolment the human failing of inertia that means most people do not opt in now works in their favor. Auto-escalation uses the same process and means your level of savings rises automatically each year until you say stop or it reaches some defined maximum level.

To getter a better understanding of the practical application of behavioral economics Thaler’s book Nudge – co-written with Harvard Profession Cass Sunstein- provides a terrific insight to our very human ways of responding to situations and the ways we make decisions.

For example why people will refuse to pay more for an umbrella during a storm or why when the price of petrol falls more people buy the more expensive premium fuel for their car.

On many levels when you read Thaler’s work it seems so damn self-evident. His gift to the world of investing is acknowledging our human emotions and foibles which hopefully will help up us be more aware of how emotion can so clearly bypass the strongest rational theory.

 Source: Vanguard 18 October 2017

Written by Robin Bowerman, Head of Market Strategy and Communications at Vanguard.


Reproduced with permission of Vanguard Investments Australia Ltd

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