Interview

«Anybody Who's Buying and Selling Stocks Thinks They're Smart»

Richard Thaler, Nobel laureate and Professor of Behavioral Science and Economics at the University of Chicago, talks about the new stock market boom, irrational price movements in stocks like GameStop, and the most common psychological traps in investing. A conversation with the pioneer of behavioral finance.

Christoph Gisiger
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Richard Thaler is one of the rebels of economics. The professor, who teaches at the University of Chicago, has revolutionized economic research with his studies of human behavior. In the fall of 2017, he was awarded the Nobel Memorial Prize in Economic Sciences for his contributions to behavioral economics.

Mr. Thaler focuses on how human characteristics such as social preferences, emotions and, not infrequently, a lack of self-control can lead to irrational decisions. This also applies to investments in the stock market. He thus takes a counter-position to Eugene Fama, with whom he maintains a personal friendship and whose efficient markets hypothesis has had a decisive influence on the evolution of the modern financial industry.

Photo: Bloomberg

«Part of what seems to be going on I call the bored market hypothesis», Mr. Thaler says with a typical touch of irony. In his view, the stock market has changed fundamentally in recent years. Among other things, he sees the main causes for this change in free trading transactions, in the comeback of the small investor, and in a general desire for entertainment.

In this in-depth conversation with The Market/NZZ, which has been edited and condensed for clarity, Mr. Thaler talks about the stunning leaps in meme stocks such as GameStop and AMC, the potential significance of the upcoming IPO of the trading app Robinhood, human weaknesses in investing, and the new edition of his bestseller «Nudge,», which will be released next week.

Professor Thaler, what do you make of current events in the stock markets? As a pioneer in the field of behavioral finance, these must be pretty exciting times.

I sometimes play golf with my colleague Gene Fama, and if we were keeping score by what’s going on in the market rather than strokes made, I think I would be winning. Part of what seems to be going on I call the «bored market hypothesis,» because during the pandemic when people were working at home, especially in the beginning, they just had nothing to do. There weren’t even sports on television because all the games were cancelled. So there was nothing to bet on, and many people started individual investing.

To what extent is this phenomenon surprising from the perspective of behavioral economics?

There was a trend in this direction that preceded the pandemic. At least in the US, it was started by something that in a rational economic world would not matter which is free commissions. Before that, commissions were almost free; $8 or $10 per trade, something like that. That’s basically free. Unless you’re trading any minute or you’re investing very tiny amounts, you’re not going to spend a lot of money on commissions. People like free, so the combination of free commissions and boredom got a lot of them interested in investing, especially at the individual stock level. After all, just buying mutual funds, or even worse, index funds is so boring. There is no entertainment value in buying a global index fund.

There is no lack of action in stocks like GameStop or AMC, for sure. The market value of these meme stocks has become completely detached from the fundamentals.

There has been a reversal of a long-term trend in which individual investors had a decreasing role in the market over time. If you go back, say a hundred years to the big bull market of the Roaring Twenties, there were lots of individual investors. There were no mutual funds. If you wanted to buy stocks, you went out and bought stocks in a railroad company or in a big bank. Gradually, this sort of went away, especially as defined contribution pension plans became prominent. Most people, except the very wealthy, if they had any investments, put their money in their retirement account and in mutual funds. So this comeback of the individual investor is already quite interesting. Then, you combine that with social media, and you get the craziness that we see with these meme stocks.

The last time the general public was so enthusiastic about individual stocks was during the dotcom bubble in the late nineties. Does this suggest that caution is in order?

I have no real opinion about whether the stock market overall is overvalued or undervalued. But when it comes to GameStop, there is no rational world in which that company is worth whatever it’s selling for now. It is quite baffling. What’s more, Robinhood is about to have an IPO, and it seems like they are going to sell themselves to their customers. I don’t see anything wrong with that, but it will certainly be interesting to see whether that becomes a trend. It’s already the case that many people who loved Apple’s product bought Apple’s stock. So this is certainly an interesting time to be a behavioral economist.

In the new edition of «Nudge: The Final Edition» you and your co-author Cass Sunstein describe how movies or music songs can become popular by mere chance through herd dynamics. Are similar factors at play with these meme stocks?

In a wonderful experiment, Duncan Watts, a sociologist and a professor at the University of Pennsylvania, and his colleagues showed that for a song to become popular it really depended on the whims of the first few people who listened to it in an environment where everybody is communicating with everybody else. But if anybody has a theory for why those particular stocks became popular is beyond me. I think it’s different from Tesla which certainly seems to have too high of a stock price. But it’s a great company and a great product. In contrast, with these meme stocks there is no real story to tell.

At its essence, «nudging» is about choice architecture, the context that can gently nudge us toward a certain behavior when making decisions. Is a company like Robinhood deliberately exploiting these insights to entice its customers into excessive speculation?

Look, I can’t be against good choice architecture. Amazon, Google and Apple are three of the biggest companies in the world, and on merit. Much of their success is based on good choice architecture. Search is now called «googling». Or think about a bookstore that has every book. You just get a big headache. But Amazon takes my mantra of «make it easy» and no one has ever had trouble finding a book they wanted to buy on Amazon. And you can pay with one click. That’s just good customer service.

And what about a trading app like Roobinhood that makes trading stocks and options as easy and exciting as a video game?

That’s an interesting point: Is Robinhood, by having great choice architecture, facilitating too much trading? Certainly, you can think of the analogy to a casino, and casinos are designed to encourage gambling. I know, that’s the most obvious thing anybody could ever say. And of course, all casinos have an ATM machine close to their tables. So good choice architecture certainly can lead to excesses, but I don’t think I can blame Robinhood for that. They delivered a product that people wanted. They could try to rein people in, but that would obviously be against their own self-interest. It’s like asking a beer company to help people drink less beer.

Behavioral economics also shows that we tend to do mental accounting: We spend money that we win in the casino much more loosely than money that we have to work hard for. Is this factor also at play in the stock market right now?

Absolutely. If you add in the «house money» effect to the «bored market hypothesis» this is a perfect storm for all kinds of craziness. Last year, the market went crashing down for two months and then has been going up pretty steadily ever since. That can easily convince people to believe that they know something because no one is really computing their returns on a benchmark adjusted basis. It’s too hard.

What do you mean by that?

I’m a principal in a money management firm called Fuller & Thaler Asset Management. We have around a dozen different products, and we get a spreadsheet every morning of what each fund did and how that compares to its benchmark. No individual investor gets that. Also, the more often you are trading the harder it is to keep track. There is this famous story about the Beardstown Ladies. It was a group of elderly women who had an investment club. They seemed to have a very good track record, so they wrote a book on their investment strategy. But later, it turned out that they just had made a mistake in how they were computing their rates of return. So it’s really hard, and if the market is going up like this market which has nearly doubled in the last year or so, anybody who's buying and selling stocks thinks they're smart.

In addition, humans also like to overestimate themselves. In your book, for example, you point out that when students are surveyed, typically less than 5% of a class say their academic performance puts them in the bottom half.

That’s right, and there is a nuance to this. Most people are overconfident about most things, but they’re most overconfident about easy things. If you ask somebody how they think they would rate their ability to juggle or ride a unicycle, they’ll think that they are below average. It’s not because they would be, but because it looks hard. It’s different for most things that are vaguely defined. For example, everybody thinks they have a great sense of humor because they know what’s funny. But they never try to be a standup comedian. They’re not as funny as Jerry Seinfeld, but they’re not benchmarking themselves against a comedian. So again: It comes back to benchmarking. We can get these biases because we’re not getting good feedback.

So are there ways to nudge ourselves toward certain behaviors to achieve better long-term investing results?

It depends what you’re trying to nudge yourself to do. It’s pretty easy to nudge yourself to save more for retirement. We know the formula: You just take money out of your paycheck before you get a chance to spend it and invest it in a diversified portfolio. And if you can’t afford to save a very large percentage now, you increase it gradually over time. That’s what we call «save more tomorrow». That recipe has been proven to work because you do just one thing, and the problem is solved. But compare that with, say, diet. That’s much harder, because I can’t just flip a switch and turn on a healthy diet. Every time I have an opportunity to eat, I could get off the path. So in terms of investing, we can solve the how much and how to invest if it’s in our own separate mental account, like the retirement account. And by the way, I think having a relatively small amount of a portfolio that you’re investing on a site like Robinhood is pretty much harmless. It’s certainly no worse than betting on football games. But it’s dangerous when people take all their money out of the equity of their house and use it to buy meme stocks on leverage.

What should investors generally keep in mind when navigating the markets?

The harder question is how we could de-bias individual investors. As we were talking before, the best way would be to get them to benchmark returns, so they can really keep track. But it’s not surprising at all that I don’t know of any individual brokerage house that offers such a service. Just imagine if a broker like Charles Schwab or Robinhood would offer to rate you the way Morning Star rates mutual funds - and then they say you only get 2 out of 5 stars.

What do you think of passive instruments like ETFs in this context? Warren Buffett, for example, recommends that small investors simply invest in an index fund on the S&P 500.

Keep in mind that I’m a principal in a firm that engages in active management. And, I have money invested in our funds. Nevertheless, the facts are pretty clear: Even professional money managers don’t beat the index on average, and individual investors do worse. So it’s certainly the case that what Buffett is saying is sound advice. Then again, we actually know what we’re doing at Fuller & Thaler. We’ve been in business for over twenty years. Of course, Gene Fama would say, it would take a hundred years to convince him that you actually can take advantage of investor misbehavior. But he’s 80 years old, so it’s not going to happen.

What is your investment approach based on?

Obviously, I’m not going into detail of all the things we do. Some of them are proprietary. But the general philosophy of our firm is that we think we can use behavioral finance to predict other people’s mistakes. We classify mistakes as two types: overreaction and underreaction. We’re mostly in small caps. That’s not because we believe that small stocks perform better than large stocks in general. It’s because we think active management has a better chance of working in small caps.

How come?

In some ways it’s simple economics because there is less competition. Every money manager in the world has an opinion about Apple or Google. But if we look at some small boring company that manufactures ball bearings in Iowa, and there are two analysts following it, it’s much more likely that the market has the stock price of that company wrong.

Today, the vast majority of stock trading is conducted by emotionless computer programs. What does this mean from the perspective of behavioral economics?

Surprisingly, we’re not a quant firm. The problem with a purely quantitative strategy is everybody has the same data. I’m going to exaggerate, but to some extent everybody even has the same models. There have been periods when quantitative managers have found they’re all doing well or all doing badly at the same time. For instance, in August 2007 there were three days in a row that hedge funds that had like 100 long stocks and 100 shorts saw 70 of their longs go down. At the same time, 70 of their shorts lost value too. The chances that this would happen three days in a row were like one in ten billion. But it was happening to everybody they know, and they didn’t know why this was happening.

What are the implications of this?

There is a lot of co-movement in asset management, and it’s especially true for quantitative models. That’s not to say that those models don’t work, or that some of them don’t work better than others. Lots of people have gotten very rich using those kinds of models. But one of the factors in those models is momentum. And, if you have momentum in your model, then the more something goes up, the more you’re going to buy it. The same is true of index funds. When Tesla joined the S&P 500, every index fund had to buy it, and a lot of it. I’m not making forecasts about any individual stocks. But if Tesla is overvalued as many think, that means lots of its shares are being held in these passive investments. It’s just mechanical. That’s the way it works.

Some mechanisms are also deliberately designed to make our lives difficult. In the new edition of «Nudge», these are referred to as «Sludge». Basically, it means a choice architecture that is designed to prevent us from taking desirable actions, such as voting, by means of barriers.

As we discussed with the Robinhood App, you have to be careful what you wish for. But some kinds of sludge would be very good to get rid of. One of my pet peeves is that for some things it’s very easy to join and very hard to quit. This is true of many news publication subscriptions and gym memberships. It’s not a consumer-friendly practice, but it’s very common, and I just find this to be predatory. So I hope our book gets people to check how easy it is to quit before they join. Another possibility is legislation: If you’re living in California, and that’s the address of your credit card, then by law you can quit with one click. I would like to see a federal law passed about this, and if we have to do it state by state, that’s fine too. It’s also something the EU or Switzerland could look into.

Are there other approaches in the financial sector that go in a similar direction?

Another thing we talk about in the new edition of «Nudge» is what we call «smart disclosure». The idea is that we should consider the «radical» thought of moving at least into the 20th century in the way important information is disclosed. For instance, if you go to some website and you look at the terms, they ask you: Do you agree to take cookies, or would you like to read our terms? No one ever reads those terms because they’re too long. So there are also lots of financial products that should come with smart disclosure.

What would be an example of this?

One example would be a mortgage. A long time ago in the US, there was something called the Truth in Lending Act. It required lenders to report interest rates using a certain formula, and everybody had to use the same formula. That’s helpful because it makes the interest rate a sufficient statistic, meaning it’s the only number you need to know. It’s like when you fill up your car. The only number you need to know is the price per gallon. In contrast, when you buy a mortgage, the interest rate is not the only number you need to know. If it’s a variable rate mortgage you need to know what it’s pegged to and how quickly it can move. You also need to know how much it will cost you if you pay it off quickly. But that’s all going to be buried in the fine print. So it’s hard to know what will happen if you miss a payment, what the penalty will be.

How would Smart Disclosure change that?

If we had smart disclosure, every aspect of the mortgage would be in the equivalent of a spreadsheet that is machine readable. It’s not that any individual would look at that. But what we call «choice engines» could use it. The best example of a choice engine are travel websites: Today, if you want to fly from Los Angeles to Zurich, you don’t need a travel agent any more. You can find the best fare in five minutes online. So we shouldn't need mortgage brokers, just a website that makes finding the best mortgage as easy as finding the best flight. Of course, sometimes travel websites aren’t as good as we want because they don’t include things like checking bag fees. So you would want everything disclosed. There has been some progress in financial markets in that way. For example, quarterly reports companies publish are now in an electronic format. But we can go much further.

Richard Thaler

Richard H. Thaler is the 2017 recipient of the Nobel Memorial Prize in Economic Sciences for his contributions to behavioral economics. He studies behavioral economics and finance as well as the psychology of decision-making which lies in the gap between economics and psychology. He investigates the implications of relaxing the standard economic assumption that everyone in the economy is rational and selfish, instead entertaining the possibility that some of the agents in the economy are sometimes human. Mr. Thaler is the former faculty director of the Center for Decision Research (CDR), a Governing Board member of the CDR, and the co-director (with Robert Shiller) of the Behavioral Economics Project at the National Bureau of Economic Research. «Nudge: The Final Edition» will be available on August 3.
Richard H. Thaler is the 2017 recipient of the Nobel Memorial Prize in Economic Sciences for his contributions to behavioral economics. He studies behavioral economics and finance as well as the psychology of decision-making which lies in the gap between economics and psychology. He investigates the implications of relaxing the standard economic assumption that everyone in the economy is rational and selfish, instead entertaining the possibility that some of the agents in the economy are sometimes human. Mr. Thaler is the former faculty director of the Center for Decision Research (CDR), a Governing Board member of the CDR, and the co-director (with Robert Shiller) of the Behavioral Economics Project at the National Bureau of Economic Research. «Nudge: The Final Edition» will be available on August 3.