Investors are not rational beings

We aren’t rational. We like to think we are, but it just isn’t so. Instead, we treasure things we have already to the extent that we’ll demand people pay us more for our own goods than we would pay for them in the first place (the endowment effect). We experience the pain of financial loss more strongly than the joy of financial gain (loss aversion). We rate new information more highly than old and don’t notice how much that skews our judgement (recency bias) and we just hate change (status quo bias).

That you aren’t 100% clear-minded, analytical and rational might come as no surprise to most of you. But to many economists it is a bizarrely new thought – and one for which Richard Thaler has just been awarded the 79th Nobel Prize in Economic Sciences. This is shocking in one sense: how can the economics profession have got itself into such a formulaic rut that having the common sense to point out that people react to more than one influence at a time became an insight so radical that it is worthy of a Nobel prize? But the fact that behavioural science is gaining ground in economics is also encouraging.

When I interviewed Thaler a couple of years ago we agreed that there is a long way still to go. Governments have embraced behavioural economics on one level, trying to use Thaler’s findings to manipulate us into doing what they want. For example, pensions auto-enrolment relies on the idea that once we are enrolled we are unlikely to opt out. Yet the message has not yet made its way into macro economic models.

When our central banks look at interest rates they assume that cutting them is stimulative by boosting asset prices and bank lending. But if people are interested in income (not capital returns), low rates on deposits could terrify older populations into cutting spending. And low bond yields could terrify the firms supporting those older populations via their pension funds into pulling back on capital investment.

And what of employment rates? How can a macroeconomic model take into account the rise of social media and virtual reality gaming that may make working age people drop out of employment regardless of the financial incentives of staying in – or perhaps make them want to work only part time?

These “are exactly the kind of questions” that the next generation of behavioural economists must start asking with a view to changing the way that policymakers think, says Thaler. We hope his prize encourages them to do so. In the meantime, our congratulations to him on his well-deserved success.

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