U.S. economist Richard H. Thaler recently snagged the 2017 Nobel Economics Prize for his contributions in the field of behavioral economics. Thaler, a University of Chicago professor, was one of the founders and pioneers of the field, and at age 72, has devoted over four decades to its study.
The theory behind behavioral economics is simply that human emotions influence markets. When we let our weaknesses direct our decisions – like for instance a lack of rationality or self-control – we impact the market in a way that isn’t rational or necessarily predictable from the basis of traditional economic analysis. While his colleagues preferred to view people as rational actors, Thaler devoted his studies to how human bias and temptation affect economics.
Personally, I love Thaler’s work and how it applies to the often-overlooked area of human irrationality’s role in investing.
One of my favorite economic phrases comes from Steven E. Landsburg: “Most of economics can be summarized in four words: ‘People respond to incentives.’” But Thaler proved that, because of our emotions, we do not always respond to economic incentives that are in our best interest.
For instance, Thaler dissected the irrational behavior of why we will splurge on short-term impulse buys, rather than planning for the long term.
So Thaler seems to subscribe to the idea that “people respond to the wrong incentives.”
Consider a recent, global example: Brexit. Thaler has suggested that British voters’ decision to leave the European Union could be an example of behavioral economics in action, arguing that the British people chose an economically irrational route when considering the options put to them by elites and the mainstream media.
Thaler’s 2008 book “Nudge” outlined his “nudge” theory, which suggests that small incentives can move people to make certain decisions. His work was embraced by politicians desperate for ways to shape societies and influence voters during a time of financial crisis.
Both former U.S. President Barack Obama and ex-U.K. Prime Minister David Cameron had teams appointed to investigate whether behavioral economics could help save their governments’ money and drive economies. Today, behavioral policy is making its way across the entire globe.
I am a true believer in the causal relationship between the human element within economic decision-making and the market. I’ve seen it in action professionally. I’ve seen financial decisions not necessarily made by spreadsheet data, but rather by people’s gut feelings. And these gut feelings are extraordinarily powerful, even though they may not make financial, physical or economic sense.
So, despite the math and the numbers being crucially important in financial situations, our own human emotions, behaviors, and intuition often play an even greater role. Take a look on any given day, and you’ll see that this point is evident in how people invest and how they manage their personal finances.
The prize bestowed upon Thaler, officially called the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, garners its name from the Swedish bank and was established in 1968. Today, it is considered one of the highest professional honors a person can receive and comes with a hefty monetary gift. Thaler is taking home a prize of $1.1 million.
I love Thaler’s work. It gives equal importance to the very real concept that human emotions and behavior are easily more important than pure math and pure economics. We are not always rational actors, as other economists chose to believe for so long. We are creatures of feelings, and sometimes those feelings can be irrational. It’s just the way we are wired.
Which leads me to a final point about human nature and feelings. Sure, rationality is a good thing when it comes to investing in the market, but we can’t take all emotion out of our finances. That’s why I believe algorithmic or robo investment advisors will never completely replace their human counterparts. Another person is always the best source of advice for humans, as we as emotional creatures can work together to find the best (and perhaps, most rational) way forward.