Yesterday I mentioned that behavioural economist Richard Thaler had won the Nobel Prize in economics. He was awarded the prize for applying psychology to economics.
It comes 15 years after psychologist Daniel Kahneman won the Nobel prize in economics for basically the same thing. Although Kahneman was a psychologist, not an ‘economist’.
To be honest, I don’t know how economists can be anything but ‘behavioural’. But as Thaler has made a career of pointing out, most economists assume people are not human. They assume they are rational decision making machines.
Clearly, that is not the case. And if you’re an investor who has ever made a dumb mistake before, you know what I mean.
Although we operate with the most sophisticated hardware and software ever devised in our brains, we tend to make the same silly mistakes over and over again.
This insight was behind Thaler being awarded the Nobel Prize. He not only pointed out the obvious fact that we humans tend to act irrationally, but that we do so in predictable ways.
A number of policies, in both the public and private sectors, have been implemented with great success using his work on human psychology and decision making.
I’m a big fan of Thaler’s work. I believe you can gain great insights by assessing the ‘psychological lay of the land’ when evaluating investment opportunities. If you get on the right side of the psychology of the market, you can make good, consistent gains.
That’s because, as Thaler points out, humans behave irrationally in consistent ways. For example, when a stock goes up for fundamental reasons, it attracts the attention of more investors. You then imagine it will continue to go up and make you rich, so you buy based on hope, rather than rational analysis.
What’s happening is that the older part of your brain (what Thaler calls the ‘automatic’ system) is telling you to buy impulsively because it’s a survival shortcut. That is, why put in hard work to pick a stock when you can just jump on board an idea that everyone else seems to think is a good one?
Your rational decision making process (what Thaler calls your ‘reflective’ system) doesn’t get a look in. Not until much later, most likely when the damage has been done.
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Similarly, your automatic system kicks in when a stock price falls. Rather than calmly assess the situation and rationally decide if the stock is fairly priced, you panic and get out. And you often panic because you see other people panicking.
This constant engaging of the automatic system causes price anomalies to arise all the time. Good investors employ their reflective systems to make decisions that take advantage of these anomalies.
Coincidentally, I have Thaler’s most recent book, Misbehaving, on my desk ready to read. Thaler is considered a pioneer in the field of behavioural economics, but at the start of the book he gives a nod to those who came before him:
‘The foundation of political economy and, in general, of every social science, is evidently psychology. A day may come when we shall be able to deduce the laws of social science from the principles of psychology.’
Vilfredo Pareto, 1906
For something written 111 years ago, that’s a pretty good call.
The message for you, if you want to be a better investor, is to understand your own psychology first. Forget about understanding everything about a stock, or bitcoin, or the economy, or Donald Trump. Get your head around your own psychology and you’ll be miles in front of just about everyone else.
The reason why most people don’t do this is that — initially at least — it is hard. Introspection doesn’t come easily. Examining what your biases and weaknesses are is a difficult task.
Some people have such ingrained biases they don’t even realise they are biased. It’s simply the truth they are living. And where is the bias in truth?
Truth, like beauty, is in the eye of the beholder. But it’s more than that. It’s also in the mind of the beholder. That’s why, when you’re listening to two opposing sides argue about a point, you can bet the ‘truth’ lies somewhere in between.
Similarly, the ‘truth’ you have concocted about a stock, or a market, is simply the product of your bias. And it’s more than likely wrong.
This is why understanding your own psychology is so important. If you’re not sure how to start on the journey, you could do worse than pick up a few of Thaler’s books.
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Editor, Crisis & Opportunity