Richard Thaler, the winner of the 2017 Nobel Prize in economics, is considered the father of behavioral economics, which advanced the notion that people generally do dumb things that are against their own self-interest.
Applying psychology to economics isn’t new. However, the behavioral analytical movement sought not only to study people but also to learn to manipulate or “nudge” behavior to mitigate or to avoid dumb decisions when people are left to their own devices.
The rub is that people are moved by short-term satisfaction even if it harms long-term outcomes.
The madness of crowds has always moved markets from the infamous Tulip Bubble to the Technology Bubble. When it reaches a fevered pitch, few can resist the excitement of short-term financial gains. Even Sir Isaac Newton considered the fourth smartest man that ever lived chased an infamous bubble and lost all his money.
Ironically, after making money in the South Sea Bubble early on, Sir Isaac Newton warned his friends and anyone else that would listen that it was a scam and was doomed to fail. It didn’t collapse right away; however, he watched his friends get rich. Racked with regret, Newton got back into the bubble.
There was room for Newton to make a profit, but he didn’t. When the decline began, his regret turned into pride along with his ego, and a long ride lower. Keep in mind, the stock market contained a few South Sea stocks. Bubbles are known to burst and vanish into the history books.
Moreover, as underlying fundamentals improve, so does the justification for higher market value. I think it’s been irrational for so many people to sit and wait for a 10% pullback or a 20% correction. Even a good old-fashioned crash probably would only erase a year or two of gains – I have a database of folks from March 2009 that are still waiting for a second leg down lower.
These types of horror stories become lore and are used by those that choose risk-aversion as excuses for not investing or doing things that could materially improve their lives.
When I say the word “irrational,” most people would think the next word would be “exuberance.” The opposite of that phrase is “reasonable apathy.” That is not how America or any great fortune was created. Risk aversion isn’t an American characteristic, even if it’s misplaced from time to time.
During President Bush’s term in office, the phrase “ownership society” was used a lot but never got the full-throated support from the administration that President Obama put behind things like solar energy. Later, the Wall Street bailout came along and the idea of capping individual risk and rewards took off along with disdain for ownership.
Now, we are cheering the “sharing economy,” but there is an ownership component beneath the surface.
Even Wall Street which lives and dies on gains from investments prefers to call good days in the market “risk on” versus “risk off” for down days. This seems antithetical to the reality that unvested cash loses value to inflation over time.
Mr. Thaler’s “nudging” methods have been adopted by governments to influence a variety of issues including:
Nudges from governments and businesses with automatic enrollment in 401Ks have resulted in millions of people having some savings. Currently 58% of all 401K participation comes from automatic enrollment, up from 8% in 2000. We should be concerned when it curbs choices that we want to make.
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