“My colleagues study artificial intelligence. I study natural stupidity.”
- Amos Tversky
In early October, Richard Thaler was awarded the 2017 Nobel Memorial Prize in Economic Sciences for his contributions in behavioral economics. The human brain is a marvel, but flawed, and over the last few decades Thaler, Tversky, Daniel Kahneman, and others have detailed a list of mental shortcuts people take instinctively that result in seemingly bizarre decision making.
The implications for asset management are nearly inexhaustible, and the value of a disciplined investment process comes partly from recognizing and containing that which is hard-coded into our DNA. While it is not clear how—or even if—irrational decisions made by individuals combine to make irrational market prices, the impact of the behavioral revolution on investor behavior has been huge, and hugely positive.
A distressingly small percentage of individual investors actually earned the high returns of the last several decades produced by a balanced portfolio of stocks and bonds. The gap stems largely from poor decision-making—buying high and selling low. To the extent index-based investing is a replacement for this behavior, individual investors as a whole benefit at the expense of active managers. Less dumb money in the market means less low hanging fruit left for hedge funds to fight over.