In his January 2018 retrospective “Richard Thaler and the Rise of Behavioral Economics”, Nicholas Barberis reviews the development of behavioral (less than fully rational) models of economics and finance, with focus on Richard Thaler’s contributions. This retrospective summarizes key models that make psychology-based assumptions about: individual preferences; individual beliefs; and, the process by which individuals make decisions. He further segments work on individual preferences into: preferences over riskless choices; preferences over risky choices; time preferences; and, social preferences. From the body of behavioral finance ideas and research since the 1970s, he highlights:
- Riskless choice – Investors tend to offer less to buy an asset than they require to sell it (endowment effect). More academically, asset utility derives not only from consumption level but also from gains and losses for components of consumption, and losses have more impact than gains.
- Risky choice – The equity risk premium derives from investor reference dependence (gains and losses) and loss aversion (more sensitivity to a loss than a gain). These behaviors make the stock market somewhat unappealing to them (suppressing prices), and they therefore require a high average return to hold stocks.
- Time preferences – each investor has “planner” (plans to save) and “doer” (can’t help spending) selves with overlapping periods of control. The longer the delay in consumption, the lower the discount rate for investments, and discount rates are lower for losses than for gains.
- Social preferences – Investors tend to offer less for assets (such as sin stocks) offered by those they think have behaved unfairly toward others.
- Beliefs – Investor beliefs are are not fully rational, such that (for example) they have excessive pessimism about stocks with prior losses.
- Decision-making process – Investors engage in mental accounting, such that they tend to think and act at the asset level rather than the portfolio level.
- Auto-enrollment in retirement plans and auto-escalation of contributions with income help mitigate the bad effects of investor irrationality.
In summary, considerable research supports belief that investors exhibit irrationalities that predictably affect asset pricing and returns.
Cautions regarding highlighted models include:
- The retrospective is conceptual and does not obviously translate to successful investment strategies or strategy features.
- Irrationality may not be so irrational as portrayed in behavioral finance via mathematically tractable simplifications of complex real world social systems. Much evidence indicates that such systems are largely unpredictable, making judgments about investor expectations (and therefore their rationality) problematic. See “Persistence of Diversity in Investor/Trader Beliefs”.
