At the very heart of what makes us individuals are our idiosyncrasies. They’re the things we do that are often irrational, at best loveable, and at worst, annoying to those we love. We are not robotic; we do not always have a logical explanation; we often make decisions that don’t benefit our happiness, health or wealth. At least, that’s what struck Richard H. Thaler when he was an economics PhD student.
Thaler recognised that people’s behaviour in day-to-day life wasn’t always predictable. In fact, many of us do things that make no analytical sense at all. It seems we are very biased. Thaler hypothesised that this must have some impact on our finances. A decade of research later, his ideas lead to a new area of study, Behavioural Economics.
In his book, cheekily titled ‘Misbehaving’, Thaler recounts a story about challenging a professor who also happened to be a wine collector. Are there choices we make outside the model of constrained optimisation? This was the popular economic theory at the time, based on the premise that people choose the best from a limited budget and that prices always fluctuate based on supply and demand.
Investors often deviate from logic and reason. We each experience and react to things differently, and this can have a profound effect on how we manage our finances.
“One case came from Richard Rosett, the chairman of the economics department and a long-time wine collector. He told me that he had bottles in his cellar that he had purchased long ago for $10 that were now worth over $100. In fact, a local wine merchant named Woody was willing to buy some of Rosett’s older bottles at current prices. Rosett said he occasionally drank one of those bottles on a special occasion, but would never dream of paying $100 to acquire one. He also did not sell any of his bottles to Woody. This is illogical. If he is willing to drink a bottle that he could sell for $100, then drinking it has to be worth more than $100. But then, why wouldn’t he also be willing to buy such a bottle? In fact, why did he refuse to buy any bottle that cost anything close to $100? As an economist, Rosett knew such behaviour was not rational, but he couldn’t help himself.”1
If you can relate to this, then you might be interested in your own answer to the following question that Thaler later used in a survey among subscribers to an annual newsletter on wine auction pricing called Liquid Assets. He asked:
“Suppose you bought a case of good Bordeaux in the future market for $20 a bottle. The wine now sells at auction for about $75. You have decided to drink a bottle. Which of the following best captures your feeling of the cost to you of drinking the bottle? (Ignoring exchange rates, of course.) [The percentage of people choosing each option is shown in brackets.]
- $0. I already paid for it. [30%]
- $20, what I paid for it. [18%]
- $20 plus interest. [7%]
- $75, what I could get if I sold the bottle. [20%]
- -$55. I get to drink a bottle that is worth $75 that I only paid $20 for so I save money by drinking this bottle. [25%]
“When we included option 5, which we found greatly amusing, we were not sure anyone would select it. We wondered whether there were really people who are so sophisticated in their use of mental accounting that they can consider the drinking of an expensive bottle of wine as an act that saves them money. But many people took that option seriously, and over half of the respondents said that drinking the bottle was either free or saved them money. Of course, the correct answer according to economic theory is $75, since the opportunity cost of drinking the wine is selling it at that price.”2
Interestingly, Thaler asked the question again but with a small modification. He posed it like this: “We asked subjects how it would feel if they had dropped and broken the bottle. A majority said they felt that dropping the bottle costs them, $75, what they could get for selling it.”
Most of us agree that a loss is felt more strongly than a gain. Insurance companies understand this all too well. We tend to attach greater value to the things that we have lost. This is one example of how we are all prone to ‘misbehaving’. My previous post, Homo -Economicus : 8 Common Investor Biases That May Be Affecting Your Portfolio Performance, references some of the behavioural biases that investors might face.
Investors often deviate from logic and reason. We each experience and react to things differently, and this can have a profound effect on how we manage our finances.
Understanding our own biases and how to overcome them in investing has the power to positively influence portfolio performance.
It’s important to note that Thaler also said: ‘The good news is that we do not need to throw out everything we know about how economics and markets work.’3 What we can apply from Behavioural Economics is how to avoid ‘misbehaving’. Understanding our own biases and how to overcome them in investing has the power to positively influence portfolio performance.
At Quadrant Group, we work closely with clients to understand their tolerance to risk and to recognise their individual biases and predispositions. It’s our primary aim to provide you with financial peace of mind, by implementing a long-term investment plan that gives you confidence in your returns.
—
1 Misbehaving – The Making of Behavioural Economics, Richard Thaler pg. 17
2 Misbehaving – The Making of Behavioural Economics, Richard Thaler pg. 68
3 Misbehaving – The Making of Behavioural Economics, Richard Thaler pg. 7
—
This article does not constitute financial advice. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner to take into account your particular investment objectives, financial situation and individual needs. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections.
