Behavioural economist Professor Richard Thaler won the 2017 Nobel Prize for economics this month and intends to spend his million-dollar-plus prize money "as irrationally as possible".
It’s not that Professor Thaler, professor of behavioural science and economics at the University of Chicago, is reckless with his money, it’s that he’s realistic about human behaviour.
A central theme of his work over the past 40 years is that people behave in a predictably irrational way, not in the rational way that is often assumed.
In short, our irrational behavioural biases can become significant barriers to making good decisions involving all aspects of our lives including with our finances.
Over the years, Professor Thaler has given numerous colourful examples of our irrational behaviour, including:
- Motorists using the money saved from a cut in petrol prices to buy premium petrol – rather than on things they need.
- A reluctance to buy umbrellas when it’s raining for fear that retailers unfairly put up prices in wet weather. The irrational assumption here is that it makes more sense to buy an umbrella when the sun is out. Thaler argues that while we are often guided by self-interest, we also care about fairness and equity.
- Coffee drinkers rejecting offers to buy their coffee mugs for $6 even though this represents a 100 per cent profit. We tend to place a higher a value on something we already own even if it’s irrational.
An understanding that we are liable to behave irrationally should hopefully encourage us to "nudge" ourselves into better making savings and investment decisions. Thaler is a keen advocate of the behavioural nudge.
For instance, making salary-sacrificed contributions into super acts as a classic behavioural nudge. Fund members agree in advance how much to salary-sacrifice into super over a financial year and have to notify their employer if they want to reduce the size of their regular voluntary contributions part of the way through that year.
Our natural inertia means well are probably unlikely to reduce our contributions during a year even at times when we could do with a little extra cash.
Another way to give ourselves a nudge with salary-sacrificed super is to increase the size of our contributions once a year. Consider making this part of your financial plan.
Once investors recognise that they are vulnerable to making irrational decisions that can take straightforward steps to keep their undesirable behavioural biases in check. These include setting clear, appropriate investment goals and developing (and sticking to) a suitable long-term asset allocation for their portfolios.
And don’t fall into the trap of irrationally deciding that paying higher investment management fees is likely to increase your chances of investment success. High costs handicap returns.
Consider using a skilled financial planner as a behavioural coach to nudge you in the right direction. As Thaler says, investors shouldn’t overlook the fact that they are only human.
NEXT: How our investment past can damage our investment future.