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28 October
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Misbehaving (The Total Investment & Insurance
Solutions)
Richard Thaler is the world’s foremost
theorist on behavioural finance, a field that was developed by Daniel Kahneman
(Nobel Prize-winner in 2002) and Amos Tversky from the 1970s. Most of them, and
another top researcher, Cass Sunstein, have worked together at some stage or
another to generate fabulous insights into how irrational out behaviour is.
Behavioural economics, and its subset behavioural finance, of course, is
designed to show that human beings are not rational while making decisions. The Total Investment & Insurance
Solutions
His recent book Misbehaving:
The Making of Behavioural Economics is a fascinating history of how this
new discipline developed into such a major force over the past four decades and
has come to dominate the mainstream economic thinking. The Total Investment & Insurance Solutions
After all, Thaler is now the president
of the American Economic Association, a position held by luminaries from
conventional economic stream, such as Milton Friedman, JK Galbraith and Amartya
Sen. The Total Investment &
Insurance Solutions
The book starts with a fascinating
example of how irrational we are. For a mid-term exam, Thaler had set up a test
that was designed to distinguish between three broad groups of students: those
who really mastered the concepts taught; those who grasped the basic concepts;
and those who just did not understand. For this, the exam had to have some
questions that only the top students would get right, which meant that the test
was tougher than usual. Thaler writes that “the exam succeeded in my goal—there
was a wide dispersion of scores—but when the students got their results, they
was an uproar among them. Their principal complaint was that the average score
was only 72 points out of a possible 100.” As happens, this reaction was
irrational. The average numerical score had absolutely no effect on the grades
since the average grade was a B or B+, and only a few got grades below C. The Total Investment & Insurance
Solutions
Thaler writes that “I had anticipated
the possibility that a low average numerical score might cause some confusion
on this front, so I had reported how the numerical scores would be translated
into actual grades in the class. Anything over 80 would get an A or A-, scores
above 65 would get some kind of B, and only scores below 50 were in danger of
getting a grade below C. The resulting distribution of grades was not different
from normal, but this announcement had no apparent effect on the students’
mood. They still hated my exam, and they were none too happy with me either. As
a young professor worried about keeping my job, I was determined to do
something about his, but I did not want to make my exams any easier. What to
do?” The Total Investment &
Insurance Solutions
For the next exam, Thaler, the
behavioural expert, made the total number of points available 137 instead of
100! This exam was harder than the first, with students getting only 70% of the
answers right (as opposed to 72% in the first); but the average numerical score
was a cheery 96 points.
He says, “The students were delighted!
No one’s actual grade was affected by this change but everyone was happy. From
that point on, whenever I was teaching this course, I always gave exams a point
total of 137, a number I chose for two reasons. First, it produced an average
score well into the 90s, with some students even getting scores above 100,
generating a reaction approaching ecstasy. Second, because dividing one’s score
by 137 was not easy to do in one’s head, most students did not seem to bother to
convert their scores into percentages. Lest you think I was somehow deceiving
the students, in subsequent years, I included this statement, printed in bold
type, in my course of syllabus: ‘Exams will have a total of 137 points rather
than the usual 100. This scoring system has no effect on the grade you get in
the course, but it seems to make you happier.’ And indeed, after I made that
change, I never got a complaint that my exams were too hard.” This book is full
of stories like these. The Total
Investment & Insurance Solutions
Behaviourial
Finance Meets Quants
One of the more interesting applications
of behaviourial finance is, surprisingly, in clarifying a knotty investment
conundrum which is the domain of quants. For instance, academics have intensely
debated an anomaly called the ‘equity premium puzzle’, first announced by Raj
Mehra and Edward Prescott in a 1985 paper. The Total Investment & Insurance Solutions
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Misbehaving 2(The Total Investment & Insurance
Solutions)
Now ‘equity risk premium’ is the
difference in returns between equities (stocks) and some risk-free assets such
as government bonds. The premise is that investors demand a premium for buying
equities over risk-free securities because equities are risky. The question is:
How big is this premium? We can look at history but the answer depends on the
period used and various definitions. Mehra and Prescott studied the period
1889-1978 and concluded that the equity premium was about 6% per year. The Total Investment & Insurance
Solutions
“In many economics articles, the
analysis would stop at that point,” writes Thaler. “The theory predicts that
one asset will earn higher returns than another because it is riskier, the
authors find evidence confirming this prediction, and the result is scored as
another win for economic theory. What makes the analysis by Mehra and Prescott
special is that they went beyond asking whether economic theory can explain the
existence of an equity premium, and asked if economic theory can explain how
large the premium actually is.” The
Total Investment & Insurance Solutions
Mehra and Prescott went ahead and
developed a model to predict equity risk premium. The largest value they could
predict from their model was 0.35%, far lower than the actual historical figure
of 6%! This made no sense. Stocks are highly risky. Why would investors take
the risk of buying stocks when all they get is 0.35% over risk-free returns? The Total Investment & Insurance
Solutions
The model and its conclusions were
controversial. Mehra and Prescott took six years to get the paper published.
Once it was published, many economists came forward to offer their
explanations. Thaler and his associate Shlomo Benartzi offered theirs: people
behave differently over short term and long term. While Mehta and Prescott
arrived at a 6% figure reward figure for the risk one took to buy stocks, it is
worth asking why don’t more people go for that reward? Why do investors hold
more bonds than stocks? The answer: they were taking too short-term a view of
their investments. Humans are not rational.
To test this, Thaler and Shlomo ran an
experiment using employees at the University of Southern California which had a
defined contribution retirement plan. Under the plan, employees have to decide
how to invest their retirement funds. They told each employee to imagine that
there were only two investment options in this retirement plan, a riskier one
with higher expected returns and a safer one with lower expected returns.
They were shown charts showing the
distribution of 68-year returns. They were not told of the asset classes, to
avoid any preconceptions they might have about stocks and bonds. The trick was
in what the charts revealed. In one version, the subjects were shown the
distribution of annual rates of return; in another, they were shown the
distribution of simulated average annual rates of return for a 30-year horizon. The Total Investment & Insurance
Solutions
“The first version captures the returns
people see if they look at their retirement statements once a year, while the
other represents the experience they might expect from a thirty-year
invest-and-forget-it strategy. Employees who were shown the annual rates of
return chose to put 40% of their hypothetical portfolio in stocks, while those
who looked at the long-term averages elected to put 90% of their money into
stocks,” writes Thaler.
The more often people look at their
portfolios, the less willing they will be to take on risk, because if you look
more often, you will see more losses. Thaler later explored this idea in a
paper with Kahneman and Tversky, the only paper that these three stalwarts
published together and that too after Taversky passed away. This is a book full
of interesting stories from the world of behavioural finance that will keep you
engrossed if you are interested in this discipline, as every investor should
be. The casual reader, too, will find these fascinating.The Total Investment & Insurance Solutions
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