In recognition of just how very unscientific personal money management is, University of Chicago Economist Richard Thaler has been named this year’s Nobel laureate in economics.
Thaler is considered one of the founders of behavioral economics. Whereas the traditional definition of economics assumes people make rational financial decisions that are in their best interests, behavioral economics recognizes the many emotional factors that influence people’s financial choices, often to their detriment.
One of Thaler’s contributions was finding that people do not just behave irrationally sometimes; they are consistently irrational. That gave rise to his best-known solution: Nudge people into doing the right thing. Popularized in a best-selling book by the same name that Thaler co-authored in 2008, a nudge is a rule or procedure that gives people a gentle push toward better decisions.
Perhaps the most sweeping example of this type of "nudge" is the now widely adopted process whereby companies automatically enroll new hires in 401(k) plans. That seemingly simple change — from an opt-in process where people had to choose to participate, to an opt-out process where they have to choose not to participate — has driven the overall plan participation rate up significantly.
We’ve mentioned Thaler’s work numerous times over the years, most recently in an article entitled, The SMarT Way to Boost Your Saving and Investing. It explains how people who do not have access to an automated 401(k) plan can implement Thaler’s ideas for increasing the amount they save or invest over time.
Thaler also coined the term The Endowment Effect to describe the behavioral bias in which people tend to value something they own more than they would value the same item if they did not own it. For example, in one study, researchers found that people who own NCAA Final Four tickets tend to demand far higher prices for those tickets that they would be willing to pay for them.
From an investing perspective, the endowment effect is what’s at work when investors resist selling a position — especially one that has gone down in value recently — even if selling would be in their best interest.
How to overcome it? Follow an investment strategy that delivers trustworthy nudges — objective, rules-based recommendations (ahem), telling you exactly what investments should be bought or sold and when.
Asked what he plans to do with the $1.1 million that comes with the Nobel Prize, Thaler was ready with the best possible answer: “I will try to spend it as irrationally as possible.”