You’d Make Better Investments and More Money if You Understood the Psychology Impacting Your Decision-Making (Nobel Prize Winner)
You should make the best financial choices your default option.
Photo By Bengt Nyman on Wikimedia
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Richard Thaler is an American economist with a fantastic blend of intelligence and humour.
He doesn’t follow the herd.
And his approach to money and investing focuses on human behaviour instead of relying on boring numbers and spreadsheets.
It’s kinda refreshing.
His father owned a grocery store in New Jersey, where he worked as a teenager. His experiences working in the store taught him the importance of pricing, salesmanship, and customer psychology.
Richard Thaler
“I learned a lot about pricing working in my dad’s store. We sold tuna fish at the same price as our competitor, but my dad’s tuna fish had a money-back guarantee on the can.
I said, ‘Dad, how can you afford to do that?’
And he said, ‘Because I know they won’t bring it back. They’re not going to go through the hassle for 49 cents.’ That’s an early lesson in psychology.”
I always find these origin stories intriguing, and there’s one common thread — these high achievers always seem to start young.
Thaler’s interest in behavioural finance led him to win the Nobel Prize in Economics. This fascination was triggered when he noticed how golfers made decisions about their shots on the golf course.
He noticed golfers often made irrational choices, like taking risky shots to avoid a penalty, even if it would be better to take the penalty and play it safe.
Golfers were more focused on avoiding losses than gaining points. It caused them to take risky shots to prevent losing a stroke, even if it would be better to play it safe and take the penalty.
You may relate if you’ve ever been on a golf course with a substandard swing and a lot of pride.
Thaler applied these insights to the world of finance and noticed that many investors and financial professionals also made decisions based on avoiding losses and irrational behaviour.
It’s the type of thinking that could lead you to bad financial choices and inefficiencies in the market.
Emotions, overconfidence, and social pressures affect people’s decision-making. They were all of the same things that influenced people’s financial decisions, such as how they save or invest their money.
Thaler is a proponent of using “nudges” to assist you in making better decisions without the need for conscious thought.
Small changes in your environment or design of choice can nudge you in the right direction, making it easier to make consistently good decisions.
Richard Thaler’s idea is to make the right choice the default option so you’re more likely to make good decisions without having to exert a lot of mental effort. By doing so, you can avoid making irrational or impulsive choices and make better progress towards your financial goals.
Let’s roll up our sleeves and dive in.
The Less Attention You Pay, the More Money You’ll Have.
Thaler uses an old tale of a man named Rip Van Winkle to make his point about investing.
In the story, Rip walks in the mountains and encounters a group of strange men playing ninepins. They offer him a drink, and after drinking it, he falls asleep. When he wakes up, he finds that 20 years have passed, and everything and everyone he knows has changed.
It’s how Thaler says you should think about investing.
Pay less attention.
Not focusing on short-term market fluctuations makes you less likely to make irrational decisions and be better off financially.
Instead, taking a long-term perspective and holding onto investments with a 20-year outlook could lead to positive returns even if short-term volatility exists.
Richard Thaler — Source
“Suppose Rip Van Winkle is an economist with rational expectations. He knows he’s about to sleep for 20 years and calls his broker and says, ‘Put it all in equities.’ How is he going to sleep?
Fine.
There’s never been a 20-year period when equities didn’t go up or didn’t outperform bonds, so he’s going to sleep very well.
Compare that to somebody watching one of those financial news stations all the time, and the market has a week like it did recently.
They’re going to say, ‘Equities? Oh my god, 5% today? Volatility is just too risky. Don’t touch it.’
The less attention people pay, the better they’re going to sleep, and ironically, the more money they’ll have.”
Psychological Biases Can Impact Your Decisions. The More You Automate, the Better.
Richard Thaler’s research has questioned the old-fashioned belief that people make logical decisions based on objective economic information.
You know how sometimes you make choices that aren’t so great, even when you think you’re being rational? His study has shown that our emotions and biases often steer us wrong with money.
He’s found things like social pressure, default settings, and how you think about your money can all impact your financial decisions.
Sometimes, investors can get a little carried away with the ups and downs of the market and start to see certain stocks as always good or bad, even when that’s not really the case.
Richard Thaler — Source
“It illustrates the idea of investor overreaction.
Over a period, investments can almost become like stereotypes. After trailing the market for a few years, a company gets a bad reputation.
We can all remember when Apple was a bad company, and nobody would think of buying stock in that company that was about to go under.
Now, you’d buy (Apple) at any price. And people see it as just the opposite.
It’s a company that can’t possibly do anything wrong. And obviously, neither of those views is correct.”
You’ll Have a Better Outcome if You Apply the “Nudging Theory” to Your Finances.
Nudging is a concept that helps you make better choices without forcing them or overthinking them.
The idea is small and subtle environmental changes can encourage you to make positive decisions.
For example, putting healthy snacks at eye level in a vending machine could nudge you towards choosing a healthier option. Or lines painted on the road to encourage sticking to one side and safer driving.
You create an environment where you don’t have to think these things through and rely on mental shortcuts or “heuristics” to make decisions. In other words, you create a way of simplifying the decision-making process.
Thaler says you can do this with your finances, and “nudging” can be applied in several ways to help you grow your investments and make more money.
Automate yourself in the right direction.
Give yourself a framework that takes any irrational emotional decisions out of play.
Here are some examples.
Automatic savings: Thaler says you can be “nudged” into saving more money by using automatic enrolment in retirement savings plans, such as 401(k)s. Similarly, you can set up automatic savings plans that deduct money from your paycheck or bank account each month and deposit it into a savings or investment account.
Choice architecture: You can use the principles of choice architecture to design your financial choices in a way that encourages better decision-making. For example, you can use mental accounting to separate your savings goals into “buckets,” such as a down payment for a house, vacation, or emergency fund. Doing so may make you more likely to achieve each goal than spending the money on something else.
Framing effects: How you frame financial decisions can also influence your choices. For example, instead of asking yourself whether you can afford to buy something, ask yourself how much the purchase will cost you regarding your overall financial goals. It can help you make more rational decisions and avoid overspending.
Setting default options: You can select default options for your financial choices to encourage better decision-making. For example, you can set up automatic bill payments to avoid late fees or opt-in to a retirement savings plan at work. Doing so makes you more likely to be more consistent and make sound financial decisions without thinking too hard.
Using social norms: You can also use social norms to nudge yourself into making better financial decisions. For example, you can make yourself accountable to others by sharing your savings goals with friends and family to create social pressure to stick to your goals.
Final Thoughts
Some theories about investing are nothing burgers.
I believe this one isn’t, especially with the consistent access to information, fear-mongering in the media and financial tools at our fingertips.
It can be a recipe for disaster.
The message here is clear.
If you’re looking for a way to improve your financial decision-making, don’t watch investment news every 5 minutes and look for a framework that works for you.
Automate it so it takes out your irrational decisions.
Everyone makes impulsive purchases and finds it difficult to save money or invest consistently.
We don’t have the mental arithmetic to stick at it. Heck, we, the majority, barely maintain a consistent gym routine.
The ones who are more consistent have a better system in place than others.
Their system nudges them in the right direction without having to overthink.