How Richard Thaler's theories can help investors

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University of Chicago professor Richard Thaler won the Nobel Prize in economics (Source: Getty)

The thinking of professor Richard Thaler, an expert in behavioural finance, can help you become a better investor, so we were delighted to see him awarded a Nobel Prize in economic sciences.

Firstly, his views should matter to you as a citizen.

He developed the theory of “nudge”, where rules, structures or incentives are subtly tweaked to achieve a better outcome for those being nudged. It led to “auto-enrolled” pensions in the UK, for example. Millions more people have a pension as a result.

But his views should also matter to you as an investor.

His books – Nudge (2008) was but one – have established the notion that humans often make irrational decisions. Once you accept this, you can become a better investor. Instead of listening to a “story” about a company, you pay more heed to the facts, and to the numbers.

This is also value investing –a discipline our team patiently follows.

To be a successful value investor, you buy stocks substantially below their intrinsic value and avoid those that exceed it. In doing so, you inevitably exploit the irrationality and emotions of others.

Prof Thaler also helped to kill the notion that stock markets are efficient. Economists for decades had clung to the notion that investors decisions were rational, based on all the facts.

In this respect Prof Thaler’s work echoes that of another pioneer from half a century earlier. Benjamin Graham, the father of value investing, wrote in 1949 of how stocks could be ignored due to “neglect or prejudice”.

Stocks today in that camp include unloved companies such as banks, mining stocks or retailers.

We explain the full reasons for each of these decisions on our blog. But just consider retailers for now. One investor might say this is a dying industry being buffeted by online shopping. Another might argue that bricks and mortar chains are reinventing themselves as shopping experiences and have a glowing future.

The disciplined value investor ignores these “stories” and focuses on the facts, on the numbers.

Plenty of evidence has shown this approach to work over long spells, so surely investors would all do it this way? They don’t. Investors, after all, are only human, and Professor Thaler’s work proves humans’ irrationality.

Please remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

  • Kevin Murphy is an author on The Value Perspective, a blog about value investing. It is a long-term investing approach which focuses on exploiting swings in stock market sentiment, targeting companies which are valued at less than their true worth and waiting for a correction.

 

 

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