Publications

- December 1, 2017: Vol. 4, Number 12

Markets Are Efficient but Investors Are Human: U.S. economist Richard Thaler and his well-deserved Nobel Prize

by Gregg Fisher

Whenever I think about Richard Thaler, who was awarded the 2017 Nobel Prize in economics Oct. 9 for his contributions in the field of behavioral economics, my mind flits to the Giant Blue Whale in New York’s American Museum of Natural History. In November 2008, amid financial panic and cratering stock markets (the S&P 500 Index was already down 45 percent from its October 2007 high), this pioneer in behavioral finance spoke to our clients at an event we held beneath the blue leviathan. Drawing from research for the just-published bestseller he had co-
authored, Nudge: Improving Decisions About Health, Wealth and Happiness, the University of Chicago economist discussed how the principle of “choice architecture” can be used to nudge individuals to make decisions that are in their own best interests. Our goal for this memorable event (entitled Managing the Fight or Flight Reflex: Keys to Staying Rational in an Irrational Market) was to explore some of the common behavioral traps into which investors can fall — and to equip clients with the information they need, particularly during times of crisis, to make more informed and rational decisions.

I’ve been a huge fan of Thaler’s work for many years, devouring all of his research papers and incorporating elements of his findings into our investment strategies and financial advice for clients. As money managers for real people since 1993, so much of his research — which demonstrated that investors aren’t always rational and do not behave as assumed in modern portfolio or efficient market theory — rhymes with what we have observed in the real world. One of our guiding investment beliefs is: “Markets are efficient, but investors are human,” which means that, while investment markets are mostly efficient, they are not perfectly efficient, due in large part to emotions and judgmental biases of human participants in those markets.

Beliefs such as this seem almost like common sense today, but in his lively, saucy 2015 book Misbehaving: The Making of Behavioral Economics, Thaler recounts his long, often caustic struggle with a rather dogmatic economics establishment (including in his University of Chicago economics department), whose economic models (wrongly) assumed that investors were “cold-blooded optimizers,” utility-maximizing machines who made decisions (wrongly) assumed to be unbiased. He writes: “Financial markets were thought to be a place where foolish behavior would not move market prices an iota.” The title Misbehaving relates to his description of human (and investor) behavior that is “inconsistent with the idealized model of behavior that is at the heart of what we call economic theory.” In fact, due to human frailties such as overconfidence, impulsiveness, shortage of knowledge or attention span, excessive envy and lack of self-control, we make biased, suboptimal choices — and commit errors that are quite predictable all the time.

Congratulations to Richard Thaler for a well-earned Nobel Prize.

 

Gregg Fisher is founder and head of quantitative research and portfolio strategy at Gerstein Fisher.

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