Practical analysis for investment professionals
05 September 2017

Richard Thaler: To Intervene or Not to Intervene

Investing and throwing darts share many similarities.

Most investors and dartists miss. But simple behavioral nudges can help improve our accuracy so that we’re more on target.

Take Richard H. Thaler’s often-cited example of the urinals at an Amsterdam airport: Patrons were making a mess. Their aim was off. Why? Maybe they were distracted, tired, or simply careless. They weren’t irretrievably confused or directionally challenged, but their failures were embarrassing — and easily corrected.

As Thaler recounted, an economist developed a simple fix: etching a small black fly into each urinal. Now that patrons had something to aim at, “spillage” decreased by 80%. Thaler’s book, Nudge, which he co-wrote with Cass Sunstein, discusses these types of behavioral conundrums with insights on how seemingly irrelevant details influence and alter everything we do.

Thaler reviewed many of our behavioral frailties during his lively and engaging presentation at the 70th CFA Institute Annual Conference in Philadelphia. The key takeaway: If only we could learn.

Thaler reminded the audience how counterproductive we can become in everything we do. Our innate irrationality coupled with a lack of adequate expertise lead to subpar, amateurish outcomes. Yet we remain overconfident in our abilities, with often unpleasant results: From choosing the wrong career to failing to save for retirement, our choice pathways remain strewn with predictable errors.

The Fallacy of Intervention

Some of these errors, Thaler noted, like the decision to intervene, are pervasive and stand out for their disappointing outcomes. When things are going badly, we feel an irresistible urge to step in. The logic, on its face, is flawless. Things are not working right, so it’s time for us to make changes.

But we forget how we tend to misconstrue causality, misunderstand our competence, and implement changes that, more often than not, lead to failure.

The illusions of skill, validity and a web of other biases muddle our judgment.

Active fund management offers important insights on interventions. Understandably, active management has faced a difficult time in recent years. Hedge fund attrition is increasing. More than 10% of hedge funds close every year. Investors’ innate bias towards discarding underperformers makes the difficult job of active investing all but impossible.

Thaler’s presentation offered evidence on how ad hoc hiring and firing based on performance lead to poor outcomes. Thaler’s advice? Use processes and well-deliberated algorithms to handle successes and failures.

Behavioral finance makes it clear that human activity, by its nature, is permanently constrained in its ability to optimize decisions. We are not maximizers. We need help, especially with complex choices and in endeavors that require us to exercise control over our biases. Without access to expert thinking, our mistakes will recur. Our record of overcoming behavioral challenges is weak.

So correcting for irrationalities is the wrong approach.

What does Thaler recommend investment decision makers do instead? Generate returns by building a better understanding of the biases and tendencies of everyone involved.

This article originally appeared on the 70th CFA Institute Annual Conference blog. Experience the conference online through the Virtual Link. It’s an insider’s perspective with archived videos of select sessions, exclusive speaker interviews, discussions of current topics, and updates on CFA Institute initiatives.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo courtesy of W. Scott Mitchell


Video


Key Takeaways

  1. Behavioral finance makes it clear that human activity, by its nature, is permanently constrained in its ability to optimize decisions. Our record of overcoming behavioral challenges is weak.
  2. The illusions of skill, validity and a web of other biases muddle our judgment. By misinterpreting causality and misunderstanding our competence, we feel an urge to implement changes that, more often than not, lead to failure.
  3. Instead of correcting for irrationalities, Richard H. Thaler recommends that investment decision-makers build a better understanding of the biases and tendencies of everyone involved.

Transcript

BEHAVIORAL ECONOMICS: PAST, PRESENT, FUTURE, AND FOOTBALL
RICHARD H. THALER

View the full transcript (PDF).


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About the Author(s)
Shreenivas Kunte, CFA

Shreenivas Kunte, CFA, is director of content at CFA Institute, where he contributes financial market insights about India and the developed world. Previously, he taught at and managed SP Jain’s Trade and Applied Research lab, which he helped found. Kunte also served as a country trading strategist at Citigroup’s Tokyo office. He actively contributes to the development sector in India and is an external research scholar at the Indian Institute of Technology Bombay.

Ethics Statement

Beyond the easier to understand, important codes of conduct, “Ethics” for me is awareness; an endeavor for right thought and action.

1 thought on “Richard Thaler: To Intervene or Not to Intervene”

  1. marvin says:

    tells us nothing in way of better investing. solutions . fun but of little practical use

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