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What I learned from Richard H. Thaler

"We tend to regard events as obvious in hindsight. By fostering the illusion that the world is more predictable than it really is, overconfidence tends to be promoted."



There’s no better time to be reminded of the limited rationality and the lack of self-control individuals are prone to in the grips of a bull and bear market than right now.

So Richard H. Thaler, the University of Chicago professor, who is recognised as one of the founders of behavioural economics and finance, winning the Nobel Prize for Economics this week came like a gift – or perhaps a message – from the gods.

With global financial markets reaching new highs again, spurred on by years of liquidity pumped into the system by the US Federal Reserve’s Quantitative Easing program – now in its final throes – Thaler’s insights relating to crowd behaviour are worth revisiting.

Sometimes, being at one with a crowd can be nice, like at rock concerts, because it adds to the ambience and safety in numbers can provide comfort, Dr Shane Oliver, Head of Investment strategy, Chief economist and sometimes concert goer, remarks.

However, when crowds turn, they can be dangerous, Oliver says, reflecting on learnings he’s taken from Thaler and other behavioural economists over the years.

Thaler – along with others including 2002 Nobel economics prize winner Daniel Kahneman – has been a major contributor to economics and finance through his work showing that people are not always rational when making decisions, Oliver points out.

“Rationality, or lack thereof, goes a long way to explaining why asset prices can deviate far away from fundamentally justified levels and has had huge impact on my career as an economist and investor which started with my PhD thesis which was built on such insights,” Oliver says.

“As Thaler pointed out after winning the prize ‘in order to do good economics, you have to keep in mind that people are human’,” he notes.

Following are takeaways Oliver notes investors could benefit from familiarising (or refamiliarising) themselves with which Thaler and other thinkers in behavioural economics have helped bring to the fore over the years.

The danger of crowds


Crowds tend to down-play uncertainty and project the current state of the world into the future resulting in a tendency to assume recent investment returns will continue, Oliver notes.

People within crowds tend to give more weight to recent spectacular or personal experiences in assessing the probability of events, he says. This results in an emotional involvement with an investment – if it has been winning an investor is more likely to expect that it will continue to do so, he adds.

Individuals tend to focus on occurrences that draw attention to themselves, such as stocks or asset classes that have risen sharply or fallen sharply in value.
 
“We tend to regard events as obvious in hindsight. By fostering the illusion that the world is more predictable than it really is, overconfidence tends to be promoted,” Oliver says.

“We tend to be overly conservative in adjusting their expectations to new information and do so slowly over time – explaining why bubbles and crashes normally unfold over long periods and we tend to ignore information conflicting with past decisions,” Oliver adds.

How contagion spreads


The means by which individual lapses of logic morph into collective views on markets include the general media, both traditional and on-line and pressure for conformity via such mechanisms as industry standards, interaction with friends at dinner parties, BBQs, as well as monthly fund managers’ performance charts & benchmarking which ultimately discourage “risk” taking and deviation from the crowd, Oliver notes
“The combination of lapses of logic by individuals in making investment decisions being magnified by crowd psychology go a long way to explaining why speculative surges in asset prices develop.

“Usually after some good news valuations will stretch and then will stretch further when they feed on themselves, as individuals project recent price gains into the future, exercise “wishful thinking” and receive positive feedback via the media, their friends,” Oliver highlights. 

Controlling your emotions


During a bull market “optimism” progressively gives way to “excitement”, then “thrill” and eventually “euphoria” as the actions of the thousands of investors push the asset class – be it shares, property, bonds or a currency  - ever higher in value, Oliver says.

“It is at this point that investors are most bullish. Unfortunately it’s usually at this point that the market has become overvalued and with the crowd fully on board everyone who wants to buy has and so it only takes a bit of bad news to tip the market down,” he says.

When a bear market begins investors initially see it as a short term setback but as “anxiety” gives way to “fear”, investors eventually capitulate and become despondent, selling their investments, Oliver notes.
It’s actually at the point of maximum crowd pessimism, when the crowd has sold and the asset class is cheap and unloved, that the best buying opportunity emerges, Oliver outlines It then usually only takes a bit of good news to start tipping the market higher. 

“So while it’s impossible to drill into the minds of thousands of investors, the behaviour of the crowd gives a great guide to investment market opportunities both at tops and bottoms. Tops are usually associated with some form of crowd euphoria and market bottoms are associated with mass despondency. So being a contrarian and doing the opposite to the crowd at extremes makes sense,” Oliver notes.
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