Readings Digest 13.10.17: Behavioural Finance

Weekly Chart: The value function  below was pioneered by Daniel Kahneman and Amos Tversky in their paper Prospect Theory: An Analysis of Decision under Risk. The paper provided the base for Richard Thaler to begin ´​misbehaving`.  Prospect theory states that people hate losses much more than they love gains even though the losses and gains are equal in magnitude.

Screen Shot 2017-10-13 at 17.54.32
Source: Misbehaving: The Making of Behavioral Economics

One of the highlights this week is that

Richard Thaler, the renowned behavioural economist, won The Sveriges Riksbank Prize in Economic Sciences (The Nobel Prize in Economics) for what the The Royal Swedish Academy of Sciences stated are “his contributions to behavioural economics”. He is considered the father of behavioural economics that field that leverages psychological insights to influence economic thinking or in anutshell tries to make economics more human. A flurry of content appeared online this week concerning him and most carried the underlying message that this was a deserved award that was long overdue.

He recounts in his autobiography Misbehaving: The Making of Behavioural Economics the assessment of him given by fellow Nobel Laureate, Daniel Kahneman. He said: “Oh, the best thing about Thaler, what really makes him special, is that he is lazy.” Well, the certifiably lazy person won the Nobel prize this week. 

For a summary of Thaler´s works and influence read the article titled The Rise of Behavioral Economics: Richard Thaler’s ‘Misbehaving’  by his Nudge Co-author: Cass Sunstein. Here are a few quotes on him and by him from around the web: 

Masters in Business:  Richard Thaler on the Human Side of Economics

Barry Ritholtz interviews Richard thaler.

Noah Smith: A Nobel for Humility in Economics

“Thaler is intent on making econ about what works, instead of what we think ought to work. As such, it has the potential to have reach and power far beyond the specific topics Thaler has spent his storied career investigating.”

Barry Ritholz: An Economics Heathen Wins the Economics Nobel

“Thaler’s approach as an academic was to find specific errors, taking them apart slowly and methodically. Once he demonstrated the errors were not mere anomalies, he came up with simple unobtrusive ways to overcome many critics of those modelling errors. Being both a critic of the traditional economic model and a practitioner who could help repair its fundamental flaws is a highly unusual combination.”

Richard Thaler: University of Chicago Graduate School of Business Convocation Address June 15, 2003

“Now, you might ask, what is rational about choosing a career based on fun? I say that nothing could be more rational. I think of fun as the ultimate hedge. If you enjoy what you are doing, you establish a pretty good floor on how life turns out. In contrast, if you suffer through every stage of the process, can becoming rich or famous really be worth it?”

Cass R Sunstein: Thaler Changed My Life (and Everybody Else’s)

From Cass, we learn of the programs that have been influenced by Thaler´s thinking:

  • The Save more for tomorrow: People mind more if present income is taken away but do not mind if future increases in income is taken away to savings. Therefore, the program a percentage of future income increases to be saved. The result is an increase in retirement program enrollement.
  • Automatic enrolment: To increase enrolment in retirement programs, make it a default that people are automatically enrolled. Inertia plays a role in making people stay even if they did not want to in the first place.
  • Thaler advised him to “Make your research about the world, not the literature.”
  • “Each one of these ideas …did not mean that people are “irrational,” but they did show that we aren’t nearly as rational as economic theories assume, in ways both concrete and predictable.”

 Alfred Nobel’s story for creating the Nobel Prize:

“When his brother Ludvig died, in 1888, one newspaper mistook him for the more famous Alfred, and published an obituary under the headline: “The merchant of death is dead.” Mortified, Alfred, without telling his family, left his fortune to found the Nobel Prizes, which were and remain among the richest awards in the world. Perhaps he thought this would do something to atone for the massive carnage and destruction that his inventions had already caused by the time of his death in 1896.”

Ted Talk: Why we should all stop saying “I know exactly how you feel”

  • The shift response vs the support response: ” The first shifts attention back to yourself, and the second supports the other person’s comment”
  • The challenge of using our feelings to determine how the other person feels: “instead of helping us better understand someone else’s experience, our own experiences can distort our perceptions of what the other person is saying or experiencing”
  • Beware of the natural instinct to share your stories instead of listening. Make an effort to listen more and talk less.

The Economist: Manias, panics and Initial Coin Offerings 

  • “Markets are not perfectly efficient. But they are usually efficient enough to punish those who mistake a bet on one version of the future for a sure thing.”
  • “As Charles Kindleberger explained in his book “Manias, Panics and Crashes”, enthusiasm for new markets or technologies frequently results in excessive optimism, which ultimately collides with reality in a spectacular crash.”

Dan Bortolotti: It’s time to stop bashing index funds

  • Index funds have allowed “even the smallest investors to build diversified, tax-efficient portfolios at rock-bottom cost” and “liberated investors from the corrosive costs of traditional funds and made it possible to invest on your own without having to research companies and buy individual stocks.”
  • The possibility of paying a bit more for goods because of the increase in mutual fund ownership is a small price to pay for the benefits accruing to investors as a result of owning index funds
  • “If saving 90 per cent on investing costs over a lifetime means paying a little more for an airline ticket once or twice a year, that’s a good trade-off”

New York Times:  The story of Wesley R. Gray of Alpha Architect

  • Is promoting ETFs based on factors to replace human stock selection. Worked as a professor at Drexel University where he wrote articles assessing the ability of hedge funds to pick stocks. His writings led a billionaire’s son to contact him and give him capital of $20 m to start a fund. Fund is now at $700m and growing
  • He still works out of his garage. Remind me of Warren Buffet. He still writes and reads. Zero marketing except through what they write.

The Rock Test: A Hack for Men Who Don’t Want To Be Accused of Sexual Harassment

“Simply offer them the same respect, admiration, and healthy dose of fear you’d offer anyone who could completely destroy you should you deserve it.”

Harvard Business Review: Starting a Business Can Increase Older Workers’ Quality of Life

  • Late-career entrepreneurship i.e. starting small companies when you get older reduces the level of income, increases the quality of life. “entrepreneurship allows late-career workers to achieve a higher quality of life even if it comes at a significant cost in income.”
  • Sample of 2851 individuals aged 50–67 years resident in England and employed full time at the beginning of each survey. 115 switched to entrepreneurship, 464 switched to another job, and 2272 remained in the same job.

We end with a Quote of the week:

“The worst thing in life that you can have is a job that you hate, that you have no energy in, that you’re not creative with and you’re not thinking of the future. To me, might as well be dead.” – Robert Greene-

 

 

Author: Mokaya Erick

I am a learning investor who writes to make my thoughts clearer. I am interested in investment research and analysis, financial modelling and portfolio management.

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