You’re only human: An economist explains how it hurts your portfolio
By Barry Ritholtz Columnist June 27
I recently had the privilege of sitting down for a chat with Richard Thaler, professor of the Booth School of Business at the University of Chicago. Thaler is widely recognized as the father of behavioral economics. He is perennially on the short list for a Nobel Prize in economics.
His observations about how people behave in the real world are a welcome change from the basic assumptions of most economists. Thaler breaks down the world into two sorts of people: Econs, the artificial constructs of how people are supposed to behave. They are perfectly rational, have great self-control, calculate like machines and know exactly what is best for themselves.
Then there are Humans, who do all of the things that traditional economic theory suggests they should not. They react emotionally, lack patience, fail to consider consequences and seem to be flummoxed by mathematics. They are filled with all manner of biases and judgment errors. How the Humans get through each day must appear to be a minor miracle to the Econs.
Thaler tells the story of how behavioral economics developed in his new book, “Misbehaving.” Thaler’s great insight — that people do not behave like Econs — is what the title is referencing. This has all sorts of fascinating implications, perhaps none greater than how irrational human behavior is when it comes to investing.
Let’s look at how these behaviors manifest themselves for investors — and what you can do about them.
Endowment effect: In one of Thaler’s early experiments, people were given mugs with a school’s logo — essentially worthless baubles. People turned out to be willing to pay far less to buy them than they were willing to sell them for. In other words, they attached a higher value to an asset they already owned than ones they didn’t.
The impact of this is significant for portfolio management. Investors tend to think more highly of the holdings that are sitting in their accounts than the rest of the investable universe. This is true for stocks, mutual funds, alt investments and exchange-traded funds (ETFs).
Perhaps this explains why so many people have a hard time “cutting their losers.” They believe their own holdings are more valuable than what the market is telling them...
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http://www.washingtonpost.com/business/get-there/richard-thaler-and-econs-vs-humans-doers-vs-planners/2015/06/25/ac09d6fa-1923-11e5-93b7-5eddc056ad8a_story.html