Human beings are complicated. We seek to simplify decisions to their lowest common, logical denominator based on our experiences with the goal of making choices that will benefit us the most. Economic theory assumes that every feasible alternative would be considered relative to its long-term consequences. Unless you live under a rock with a theoretical economist, this is not how humans roll. Ask a Registered Investment Advisor (RIA). Many investors spend more time planning their vacation than they do their long-term economic viability.The video, It’s Not About The Nail, is very funny and very telling. Sometimes we just don’t know what’s good for us even when it is as abundantly obvious as a nail in your frontal lobe. Although humorous, this obvious distortion of empirical evidence is provided in support of Richard Thaler’s Nobel Prize-Winning research in behavioral economics. In what Thaler has coined as “Limited Rationality,” his theories help the financial advisor see and understand why investors do what they do.
Bounded or Limited Rationality is a descriptor explaining how people’s cognitive limitations and decision making bias toward immediate gratification is often at the expense of their long-term benefit. The “Mental Accounting” of how people approach financial decisions often renders inappropriate conclusions like using high rate credit cards to finance a vacation, the enjoyment of which has long since diminished by the time the bill arrives…plus interest.
Another example of how economic theory is debunked by human behavior can be seen in the chart represented by the Herzfeld Caribbean Basin Fund also known as the CUBA Fund. Unlike Open-End mutual funds that price based on Net Asset Value (NAV), the CUBA Fund was a Closed-End mutual fund, the prices of which fluctuate based on investor sentiment and the resultant buying and selling behavior.
The CUBA Fund held no assets in Cuba. No US company has been able to do business with Cuba since 1960. Yet notice the spike in the CUBA Fund’s Price indicated in the chart below.
Can you take a guess why this phenomenon occurred? Of course, sanctions were eased by the US government against Cuba. Prices rose by over 70% and remained elevated for nearly a year thereafter. Behavioral Economics at work.
No one tells you as an RIA that you might want to keep a claw hammer in your top desk drawer. It’s not always easy to save people from themselves.
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Sources:
It’s Not About the Nail
Richard Thaler on Behavioral Economics: Past, Present and Future
Thaler, the BUVA fund and the efficient markets hypothesis | FT Alphaville