Two and a half years ago, University of Chicago economist Richard Thaler won the Nobel Prize for his foundational work in creating the discipline now known as behavioral economics, from which we have gotten the field of behavioral finance.
We described one of Thaler’s main discoveries:
“Humans are not immune to ignorance or stupidity, and their economic actions prove it. In more polite terms, humans have the problem of ‘bounded rationality’ or ‘cognitive limitations.’ They may be rational, but that’s not all they are. For example, Thaler observed that individuals are more averse to losses than they are enthusiastic about gains. (This means, among other things, that they weigh out-of-pocket costs more heavily than opportunity costs.) He coined the phrase ‘endowment effect,’ which means that individuals assign greater value to things they possess than to similar things they don’t own. (In one experiment, people given a mug and then offered the chance to sell it valued the mug on average four times more highly than they did when they were bidding on other people’s mugs.) And he developed a theory of ‘mental accounting,’ where individuals fail to consider their economic life as a whole, and compartmentalize it in a way that prevents them from maximizing the value of their resources. All of these distort ‘fully rational’ behavior in a variety of ways, and help explain systematic deviations from the value-maximizing behavior that mainstream economic theory predicted.”
Thaler’s insights are well-known by the best gamblers, particularly poker players, and investors who are tempted to ignore their human frailty in these areas could do well to learn from them.
A corollary of the “endowment effect” is the “disposition effect” — which causes traders to be more eager to sell assets in which they have a gain, and to be more eager to hold on to assets in which they have a loss, than pure rational decision-making would suggest. In short, traders (and basically, most humans) have an innate disposition to dislike losing more than they like winning. They want to avoid taking losses… so they take quick gains, and let their losses run, in the semi-conscious hope that it will “work out in the end.”
Sometimes, that hoped-for “end” is a long, long time away, if indeed it ever comes — and by holding out for that eventual recovery, an investor will suffer a lot in lost opportunities. By falling prey to this common, deep-seated, evolutionarily implanted tendency, they have allowed their aversion to loss to trump their long-term well-being.
That behavior is a recipe for underperformance, and possibly disaster, when it comes to trading — and even long-term investment, under some circumstances (such as deep, prolonged market drawdowns driven by negative large-scale macroeconomic and financial trends).
Efficient Markets? Not So Fast
In 2017, we noted that because this kind of irrational tendency characterizes individual market participants, Thaler’s work shows us that it also characterizes markets as a whole. Economic orthodoxy, in some circles, still maintains that markets are “efficient” — that is, that they very quickly price in all available data. Thaler’s work suggests that we take the efficient markets hypothesis with several grains of salt.
If You Trade, Trade Like a Good Poker Player
Given all of the above, we believe that one of the best ways for individual investors to avoid these pitfalls is to maintain an emotionless loss-cutting discipline. However this discipline is set up — whether targeted at a certain level below the purchase price, or in some other way — investors should stick to it, even when it feels wrong (which it probably will, given the basics of human psychology identified by Richard Thaler, unless you happen to be a champion poker player). The most fundamental defense against irrationality is rules — strictly followed.
Investment implications: We believe that individual investors with any tactical component to their portfolio management should keep a tight and disciplined loss-cutting mechanism in place. That way, they will be more likely to avoid common psychological and behavioral pitfalls that would otherwise lead them to cut their winners, and let their losers run.
