- Today, we’ll look into Richard Thaler’s work to find out how to take advantage of behavioral finance.
- Taking advantage goes hand-in-hand with not making behavioral mistakes.
- A few examples and 7 questions will give you plenty of food for thought.
The recent Nobel prize in economics was awarded to Richard Thaler from the Chicago Booth School of Business for exploring the biases and cognitive shortcuts that impact how people absorb and process information.
As the stock market is all about information and how prices absorb that information, this Nobel prize award gives us excellent motivation to dig into professor Thaler’s work in order to find the best ways to profit from the predictable irrational behavior stock market participants show, or to just simply limit our own costly behavioral mistakes.
On top of everything, Thaler isn’t just a university professor, he also runs a small cap fund that focuses on taking advantage of behavioral activities.
Let’s dig into Thaler’s work, fund, and look at contemporary examples to better explain his theories.
Richard Thaler’s Work
Thaler focuses on behavioral economics and finance, as well as the psychology of decision-making which lies in the gap between economics and psychology. His primary position is that market participants aren’t always rational like the predominant economic theory assumes where all market participants have the capacity to properly apply new information to prices and make rational decisions in order to maximize their profit.
Thaler simply states that we are human, and thus irrational, and that such behavior is often reflected in market prices. He has developed the following concepts:
The Endowment Effect
We tend to value items more because we own them. Thus, when related to stocks, you probably value your stocks higher than the rest of the market does and that is why you stick to them. If not, then you might be tempted to sell and buy a market fund.
Additionally, an out of pocket loss is weighted much more heavily than an opportunity cost, even if the impact on our financials is the same.
Do you hold onto something that you think is much more valuable than it actually is?
I usually see people holding on to remote pieces of real estate that have practically no value to them, have no yield, but, regardless, they think any kind of real estate has exceptional value. In the long term, it’s completely illogical and leads to huge opportunity costs. Nevertheless, they don’t weigh as a cost disposing of a low value asset or thinking about what to do with it. Many prefer not to fuss, but that isn’t the way to invest.
We always try to simplify our environment in order to make the decision process easier, this is only natural. Just think of the weather, it’s either cold or warm, you don’t nitpick too much about degrees.
Similarly, we have different budgets, for food, rent, entertainment, etc., where we apply different rules. The problem is that when you apply such a system to stocks, it isn’t usually the best strategy, especially in a bear market when all the risks suddenly come out and the stocks you considered safe fall sharply.
The most obvious example is owning a safe dividend yielder that gets crushed. This leads to another irrational approach to our portfolio, which is portfolio segmentation. A rational person wouldn’t have a part of their portfolio called “speculative,” or “growth,” or “value.” All parts would carry equal risk, reward weights no matter the type of investment.
Do you have different parts of your portfolio assigned to different goals?
Mental accounting is further present in buying and selling stocks. For example, when a financial asset is bought, a new account is opened in our mind with a reference point set to its acquisition value. Since it’s painful to close the account (sell the asset) at a loss, this leads to us holding on to portfolio losers while we easily sell the winners. Selling implies closing the account and experiencing the loss which is the most painful investing activity, and is 10 times more painful than a trade with an equal gain brings joy.
I must say, I’m a victim of mental accounting. It’s very easy for me to sell a winner and difficult for me to sell a loser. This is my biggest flaw to work on.
Are you a victim of mental accounting and do you hold on to your losers in hope that they will recover?
In contradiction of the standard model of exponential discounting, more discounting occurs between the present and the near future than between periods in the more distant future.
This is something long term investors should really take advantage of. If there is a long-term project that will happen in the distant future, then those future cash flows and occurrences are usually heavily discounted by market participants.
An example is Cheniere Energy (NYSE: LNG), which has a huge pipeline of projects coming up in the next decad,e but the discount on the value of those projects is much greater than what the current expected returns are (my estimation is 12% to 15% discount for Cheniere versus 4% for the market). It isn’t a coincidence that LNG is one of Seth Klarman’s largest positions.
Do you prefer immediate gratification in the form of a dividend, or do you equally discount present dividends and long-term investment opportunities?
The Impact The Irrational Have On Financial Markets, i.e. Behavioral Finance
Thaler’s work on the impact of behavioral finance on financial markets focuses on two fields: asset pricing implications of investor psychology, and documenting violations of the law of one price in financial markets, implying the importance of limits to arbitrage.
Asset Pricing Implications Of Investor Psychology
According to Thaler, individuals systematically deviate from the assumption that rational traders hold “correct” beliefs that are revised according to when new information arrives. De Bondt and Thaler compared returns of loser stocks (stocks that recently dropped in value), and winner stocks. They found that loser stocks outperform winning stocks which leads to the conclusion that the market overreacts to negative news.
When bad news comes out from a company you own, do you rush to sell or buy more?
Mis-Pricing & Limits To Arbitrage
Thaler has done extensive research on mis-pricing showing how closed equity funds usually trade at a discount to the assets they own. Spin-offs are also usually discounted in comparison to the previous value as part of the big company. These and many other mis-pricing examples show how there are various prices for the same asset depending on the market’s perception on it.
Do you prefer buying at a discount, or to follow the market even if something is too pricy?
Applying Thaler’s Concepts To Current Examples
According to Thaler, the biggest fear we investors have is the fear of loss and if we buy a stock that falls, our behavior isn’t rational as it might have been when buying. Buying a stock is rational, you estimate your returns based on future projections on what will happen. But losing money quickly becomes emotional.
Another interesting behavioral aspect of investing is anchoring on where we usually stick to past numbers. For example, current year EPS or revenue have an anchoring effect on analysts that simply adjust their information to the previous data point instead of modeling off new information.
The perfect example is the recent stock price movement in Amazon (NASDAQ: AMZN), which recently beat analysts’ expectations both on revenue and earnings. Current business models are far too volatile and disruptive to apply stable and fixed economic models onto them.
Another implication of behavioral finance is anchoring to something or someone you like. Evan Spiegel is always described as a very likable person, and once said about himself:
“I am a young, white, educated male, I got really, really lucky. And life isn’t fair.”
Many investors followed and immediately invested in SNAP while he was selling stock at the IPO to de-risk his investment and set himself up for life, alongside the $800 million bonus for taking the company public.
Will SNAP recover as Facebook did? No one knows, but it’s a clear example of anchoring to something that isn’t rational.
Another example? Thinking that if a Victoria Secret model choses to wed the CEO of a company like SNAP, then the company must be good. It’s amazing what we anchor our investment decisions on.
Anchoring expectations on what has happened with Facebook’s stock, or to the glamor of SNAP’s owners, hasn’t really worked our so far. Hopefully, this will change in the future for those who are invested
Further, Thaler is against setting stock price targets because that’s a perfect example of anchoring. For example, many things can happen between now and the point in time when you expect the stock to hit your price target, thus setting a price target is the first sign of anchoring and irrational behavior.
I’ll finish today’s article with a final question:
Do you have price targets and how much are you influenced by them?
These questions give a lot of food for thought, but there is more from Thaler involving how we approach investing and saving. We’ll discuss that more tomorrow.