When someone titles their memoir Misbehaving, you know it’s going to be interesting. And, as it turns out, it can also help you win a Nobel Prize. Such was the case this week when Richard Thaler, an economist at the University of Chicago, won the prize in economics.
As you may know, Thaler helped to pioneer a relatively new field in economics known as behavioral finance. What this means is that he was one of the first to bring principles from psychology into the study of economics. And, in so doing, he turned traditional economics on its head. Where previously economists had always assumed that people act rationally when making financial decisions, Thaler argued that this was hardly the case. His view was that people very often are not rational in their decision-making and actually are quite emotional.
Thaler’s research provides two important lessons for anyone invested in the stock market:
Lesson #1: Put away the crystal ball
Thaler published his first study of the stock market in the mid-1980s, at a time when the prevailing view was that “the market knows best” — that is, that stock prices are always “correct” because they reflect investors’ collective, rational assessment of each company. Thaler’s conclusion, however, was that this was very often wrong. In his studies, he was able to prove that investors regularly over-react to market news, pushing stocks too high when they get excited and too low when they get scared or depressed.
While many economists rejected Thaler’s findings (and still do), my view is that history has proven him right. In fact, as if on cue, in October 1987, shortly after he published his first work, the stock market saw an inexplicable, out-of-the-blue twenty-percent drop in one day. Subsequently, as Thaler points out, there was a tech bubble and crash and then a housing bubble and crash, the latter of which ended up dragging the stock market down fifty percent. We have also seen a few intra-day “flash” crashes. In short, investors very often lose their heads. As a result, it can be virtually impossible to predict what will happen next.
This finding — that it is impossible to predict what will happen next — provides Thaler’s first important lesson for investors. While many investment professionals spend their days trying to predict the future, I’m in agreement with Thaler that this is an impossible task. Instead of trying to make predictions, I believe investors are much better served by preparing their portfolios to handle whatever the market brings. That way, there is no need to spend time looking into a crystal ball, which can’t possibly provide useful answers.
Lesson #2: Popular does not mean profitable
Thaler’s second observation was built on the first. This time, he compared the market’s most popular, high-flying stocks to another group made up of the market’s most out-of-favor, beaten-down stocks. Before Thaler’s research, the accepted view was that one should expect the high-fliers to do better than the unpopular stocks. What Thaler found, however, was the exact opposite. It turns out that unpopular, unloved stocks are, in aggregate, the ones that do best over time, and with less risk. Popular, high-flying stocks may deliver great results for a while, but as a group, they actually end up being laggards.
This finding provides Thaler’s second important lesson for investors: It is important to own more “value” stocks (industry jargon for the unpopular stocks) than “growth” stocks (high-fliers). In other words, value stocks may be more boring, but they are also more profitable.
Taken together, Thaler provided the investment world with a deceptively simple formula: Don’t try to profit by guessing what’s going to happen next. Instead, profit by simply positioning yourself to do well over time by owning the types of stocks that have historically done better than average.
With such a simple formula you might ask why everyone doesn’t do the same thing. The answer is, again, deceptively simple: investors are human, and they’re irrational. Despite all the evidence that it’s an unproductive strategy, people enjoy making guesses about the future, and people enjoy chasing high-flying stocks. Fortunately for you, though, it is precisely because so many people don’t want to follow Thaler’s formula that it is still possible for you to make money by doing just that.