Behavioral economist Dr. Richard Thaler was Monday’s closing keynote at IMCA’s annual conference in National Harbor, Md. Thaler, whose groundbreaking work on behavioral issues is well-known in the advisor industry, was interviewed by IMCA vice chairman John Nersesian. Nersesian began by asking Thaler about claims by many advisors that “they saw 2008 coming.” If so many had, he asked, why hadn’t more investors avoided the aftermath?
Thaler, the Ralph and Dorothy Keller Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business, responded that hindsight bias—the tendency to remember that our forecasts were better than they really are—is a powerful psychological phenomenon.
“In 2004, who would have predicted that four years later we would have the first black president?” he said by way of example. “Most thought at the time, ‘no way.’ But today everyone is saying they absolutely would have predicted it.”
Clients have selective memories, he added before launching into a story about baseball that he uses in his class. He said he shows his students a clip from an old baseball game between the New York Yankees and Kansas City Royals. The third-base coach for the Yankees had to make a split-second decision as to whether or not to send a runner home. He did, and the runner was thrown out. Following the game, Yankee owner George Steinbrenner fired the base coach.
“Steinbrenner had the benefit of knowing the outcome,” Thaler said. “He hired Don Zimmmer to replace the coach. Zimmer was very conservative. If you fire someone for a poor outcome even though the decision was sound, you will never take risks.”
Continuing with the sports theme, Nersesian noted the extensive work Thaler has done with NFL franchises, and specifically with how teams choose players from the draft.
Thaler said he began with a hunch that teams overvalued early picks; the picks they made were too pricey and they traded away others.
“Is it a smart strategy to trade up in the draft for an earlier pick? No, and they should actually trade down,” Thaler said. “We actually found that that a sixth-round pick is more valuable than a second-round pick.”
Football team owners are billionaires, he added, so they are obviously smart, but they “fall in love” with certain players, and it clouds their better judgment. Much to the chagrin of the audience members, Thaler said the New England Patriots ranked the highest in his study for the quality of the picks they’ve made.
Nersesian then asked Thaler about how investors could profit from the behavioral mistakes of others.
“My golf partner is Gene Fama, the father of the efficient market hypothesis,” Thaler, who has a money management firm, responded. “We don’t talk finance when we play. The thesis holds that market prices can’t be predicted in order to beat the market. It also holds that prices are always ‘right,’ the NASDAQ never went to 5,000 and the real estate bubble in Las Vegas was all a dream. But mistakes in the market do happen. We classify them as either severe underreactions or severe overreactions. We then add our secret sauce and make lots of money for our clients.”
One of the biggest laugh lines came when Nersesian asked Thaler about the value of risk tolerance questionnaires.
“Ah …I wish you hadn’t asked me that question,” Thaler said. “It is very difficult to predict risk by using a piece of paper. We have clients that skydive, but then invest only in T-bills. Is that person aggressive or conservative with risk? The problem is that no one knows what their risk tolerance is because risk tolerance is situational. Danny Kahneman and I worked for years on developing a better questionnaire to accurately assess risk. I don’t know that it can be done …yeah, next question.”
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