Sunday, May 25, 2008

Economists take advantage of people's weaknesses

Washington Post
The world of the behavioral economics, which melds psychology, finance and emotion, seeks to explain and sometimes exploit why we do what we do when it comes to investing. It is a field that has become more accepted lately, particularly since 2002, when Princeton University psychologist Daniel Kahneman was awarded the Nobel Prize in Economics for, as the Swedes put it, integrating "insights from psychology into economics, thereby laying the foundation for a new field of research."

Kahneman is a director at Fuller & Thaler, a firm whose other namesake is Richard Thaler, a prominent University of Chicago behavioral economist and a frequent collaborator with Kahneman. Two of the funds the firm manages that use behavioral methods have beaten Russell benchmarks from their inception through the first quarter of this year. Not surprisingly, Fuller & Thaler is not the only firm using such techniques. Firms ranging from J.P. Morgan to AllianceBernstein say they seek to capitalize on the faulty investor mind.

For instance, Fuller & Thaler likes to pay close attention to analysts who may be anchored on a stock, not raising their earnings-per-share estimates enough even though positive information has come out about the company. Fuller & Thaler's investment team pounces before the analysts realize they were wrong. As Kahneman said in an interview, "I think that betting on mistakes of people is a pretty safe bet."

Good for them. My interest in talking to the likes of Kahneman, Thaler and other behavioral economists and personal finance advisers -- besides confirming that I am not dumb -- was to understand these mistakes and what there is to do about them. "I don't think you can fix what's in your head," Thaler said. "What you can do is train yourself to say, 'This is a risky situation, and this is the kind of situation where I get fooled.' "

I asked Kahneman what fools us most frequently. That was simple, he said: overconfidence. "It's the idea that you know better than the market, which is a very strange idea," he said. "Individual investors have no business at all thinking they can do better."

Why do we? "It's because we have no way of thinking properly about what we don't know," Kahneman said. "What we do is we give weight to what we know and then we add a margin of uncertainty. You act on what you think will happen." That's what I did by buying Citigroup. But Kahneman added, "In fact, in most situations what you don't know is so overwhelmingly more important than what you do know that you have no business acting on what you know." Oops.

Barbara Warner, a financial planner with Warner Financial in Bethesda, said she sees a lot of overconfidence among two groups of people: relatively new investors to the market (me), particularly recent business school graduates (not me), and retirees (never, with my investment sense). The latter group can be exceptionally frustrating. "Now they have entirely too much time on their hands to devote to CNBC and Money magazine," she said. "People suddenly think they are smarter than they used to be because they have more time to pay attention to it."

That's a disastrous situation, Kahneman said: "The more closely you pay attention, the more you do things. And the more you do things, the worse off you will be." For proof, he pointed to groundbreaking research done by one of his former students, Terrance Odean, now a professor at the University of California at Berkeley.
...
Odean said he saw two options: Be dumb and let others make money off you, or just buy a no-load index mutual fund and stop focusing on beating the market.
Don't think about it, it will only cost you.

Here's how the American Economic Association allocates its portfolio.

1 Comments:

Anonymous Anonymous said...

Interesting read, Im a psychology student and have just recently become interested in economics.

If you have any books to recommend you should post them up on your blog.

1:54 PM  

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