How to apply the lessons of behavioural economics to your own investing

Richard Thaler won the Nobel prize for economics this week.

Thaler won it for his work on behavioural economics. This is the science of trying to convince other economists that human beings are not perfectly rational, profit-maximising, decision-making units. Instead, we're well human.

"Man wins a million dollars for doggedly banging head off brick wall for decades" was the alternative title for this Money Morning...

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The slow and stubborn demise of homo economicus

Richard Thaler's big contribution to economics is to have been a leading light in the battle to encourage the economics profession to squeeze human beings back into the science somewhere.

It's not news to anyone who isn't an economist that human beings don't act the way they do in economic theories. And as Thaler himself points out, the economists most of us think about Adam Smith, John Maynard Keynes, Friedrich Hayek all viewed human action and motivation as integral to their theories. They wouldn't even have considered taking them out of the picture.

But human behaviour is tricky to model with maths. If you simplify it all away, you can get a much more scientific-looking model. And with financial markets being particularly keen to find ways to predict the future, models and maths is what they want.

Thus we ended up with the "efficient markets hypothesis". This is the idea that individuals can be represented by homo economicus. Homo economicus is great at processing data. He or she doesn't make basic arithmetical errors; processes information in exactly the same way, regardless of how it is presented; is born with a deep understanding of probability etched into their genome; and values the far future as much as the near present. Think Spock without the sense of humour.

In a market crowded with specimens of homo economicus, you can accept the efficient market hypothesis that is, the idea that markets are always right. Prices perfectly reflect all available, relevant information. As a result, they can only change when new information comes into the market. As this new information is by its very nature unpredictable, it's therefore impossible to beat the market (this is the "random walk" theory).

Of course, even the most rational person you know does not come up to the standards of homo economicus. As a result, the efficient markets hypothesis is very easy to criticise. And to be fair, no one takes it seriously in its "hardest" form any more.

However, behavioural economics has still had quite a hill to climb to get to the point where the likes of Thaler (whose books are well worth reading my colleague Merryn Somerset Webb interviewed him in 2015, watch it here) could win a Nobel prize.

This is partly because economists are as stubborn as the rest of us (if not more so, because they have a lot of faith in their own expertise). No one likes to have their worldview challenged, for lots of reasons. We cling to our belief system because it's cognitively demanding to replace it and the brain takes an "if it ain't broke, don't fix it" attitude to these things.

It's also because behavioural economics is not as "neat" as the efficient markets hypothesis. People want to be able to make forecasts, and behavioural economics doesn't have as much of the "maths-iness" of the old theory.

But at the end of the day, it's also because, while behavioural economics can move the science on somewhat, its ultimate conclusions are still not radically different in practice for most investors. For example, Professor Andrew Lo has tried to make a better model with his adaptive markets hypothesis the idea that markets effectively evolve as new strategies go into competition with one another, and the better ones win out (here's our review of his book, Adaptive Markets).

Michael Mauboussin, another great thinker about markets, has described the market as a complex adaptive system. In effect, the individuals within the system may not be thinking rationally, but when you aggregate their views, prices usually roughly end up being right. However, you can still get pockets of inefficiency, and you can also end up with bubbles and busts when there's insufficient diversity of thought among the individuals in the market. (Mauboussin has written a number of good books on investing I can recommend his Think Twice, for example).

This is all fascinating stuff and very enjoyable to read, particularly if you enjoy market psychology. But the basic conclusion of these theories is that markets are "kinda, sorta, efficient". Homo economicus might not exist. And bubbles and busts are possible (whereas under efficient markets, they are rationalised away with very suspect arguments). But at the end of the day, prices usually broadly end up being right most of the time, even if the individual participants aren't rational.

What behavioural economics means for your investing

So what does any of this stuff actually mean for you as an individual investor? After all, you already presumably know that you're not perfect.

For me, the main thing investors need to understand about behavioural economics is that being aware of your flaws is almost no help at all in dealing with them. We could run through a big list of cognitive biases, but having an encyclopaedic knowledge of them won't help you in the thick of it.

If you want to be a better investor, you have to take specific actions to prevent your instinctive self from rushing in and ruining everything. That means planning. It means carefully considering what you are going to do before you do it.

It means not sitting in front of your computer during trading hours, with your stockbroker account open on the screen, while Twitter is pouring out headlines in one corner, and in another corner the financial news is blaring at you to "BUY!" or "SELL!".

In truth, it means aspiring to be something close to homo economicus, even if that's an impossible aspiration.

This is all possible. It's my firm belief that the best way to slow yourself down is to write down a formal entry in an investment journal before you take action. That way you're forced to consider what you're actually doing, and the sorts of risks you are taking. It's much harder to get carried away.

And always focus hard on the downside (that's what Warren Buffett means when he gives that unhelpful comment about "Don't lose money"), because your instinctive desire at the start of an investment, when you feel optimistic is to dream about the upside.

All of this is another reason why a bias towards passive investing isn't a terrible idea for most people. You sit down and work out the asset allocation you want. Then you drip-feed money into a small range of tracker funds that reflect that allocation. You check your portfolio and rebalance it maybe once or twice a year. But otherwise, you do your best to ignore it, which stops you from doing anything impulsive. And best of all, your investing doesn't take up much of your time then.

But if you're going to be a more active investor, the insights from Thaler and behavioural economic in general tell us that these three things are key.

Slow down. Plan ahead. Focus on the downside.