It's been 10 years since Daniel Kahneman, a Princeton psychologist, won the Nobel Prize for Economics for his research on decision-making. He won for "having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty." Those 18 words from the Nobel Foundation ushered behavioral economics into the mainstream from its previous home in academia. (Kahneman shared the prize that year with economist Vernon Smith from George Mason University.)
Behavioral economics shuns one of the primary assumptions of classical economics—that people and companies make completely rational decisions. Consequently, it draws very different conclusions.
Six years later, the markets went into meltdown mode. That's when Alan Greenspan (another academic who knew a thing or two about real-world decisions) acknowledged to Congress that his long-held convictions on the ability of the markets to self-correct were wrong. The New York Times' David Brooks predicted at the time that the crisis would be a "coming-out party" for behavioral economists who had never believed in an efficient market.
And indeed, a number of economists moved swiftly to become the face of a new discipline, explaining its usefulness, penning books and articles, and appearing on news programs. I've read a number of their books, and talked to several of them. I have to admit, I grew intrigued by their insights, which made economics seem more pragmatic, not to mention more interesting.
As a joke, I once described behavioral economics as a fun parlor game. While I believe the scrutiny it brings to classical economics really does make it relevant, there is still a lingering question: So what? Have the concepts behind behavioral economics and behavioral finance substantially helped investors or consumers?
Indeed, it has been criticized publicly as being little more than a hodgepodge of interesting ideas and critiques with no overarching theory of its own.
As for its usefulness, I believe there are two things to bear in mind, at least for non-psychologists—a group that includes me, most advisors and most of their clients. One is the degree of necessity of this new discipline. The other is the confusion that can occur when incentives are misunderstood.
First, the necessity. Any new discipline should be based not on interesting books and dynamic lectures, but on whether the previous framework failed.
The prevailing economic theory before the crisis had been based on rational decisions and efficiency. Did it fail? Greenspan said it did, at least as far as the stock market was concerned. But with the advantage of hindsight, I wonder if he was right. He made his comments on Oct. 24, 2008, just five weeks after the bottom fell out in mid-September. The market kept falling until the following March. But then, surprise, it came back. In fact, it soared. The S&P 500 returned 19% in 2009.
So, yes, the market failed. But I would argue that it did self-correct. Not immediately, nor within a week or a month. But within six months it was starting its recovery. Four years on, that doesn't seem so bad. By comparison, after the crash of 1929, it took 25 years for the markets to recover fully.
To be sure, late 2008 and early 2009 was a gut-wrenching time. Almost all asset classes were falling simultaneously, which wasn't supposed to happen. There was wailing and gnashing of teeth, and a lot of ink was spilled describing a whole new world. But how new is it? Are the winning investment strategies today radically different from those five years ago? You could make a strong argument that they aren't.
What does all that mean? It means that while I happen to think the markets are pretty efficient in the long term, they obviously can be wildly inefficient in the short term. And this is when clients need help and a steady hand. I also think the efficiency stage kicks in sooner than it used to, but there is no telling with certainty just when short-term ends and long-term begins in this context. (Keynes put a somber spin on that issue when he said, "The markets can remain irrational longer than you can remain solvent.")
The second thing to keep in mind is one of the most basic tenets of economics: People respond to incentives. (That comes from economist Steven Landsburg.) They may not respond the way you expect, or in a way you can understand. But that often means they were responding to an incentive you didn't consider.
From a 30,000-foot level, you can make a strong argument that people were rationally responding to incentives throughout the crisis. Politicians leaned on banks to extend more mortgages so voters could become homeowners; bankers figured out a way to do so while earning a profit; people eagerly took the available loans and bought the biggest houses they could. And on it went, everyone responding to incentives.
So when your clients appear to be acting irrationally, they may simply be responding to forces you haven't considered.
Instead of focusing on why clients make the decisions they do, advisors would be better served focusing on how.
Richard Thaler and Cass Sunstein describe two systems of the brain in their book Nudge. The "automatic system" uses intuition and shoots from the hip (and usually does a good job). The "reflective system" is more measured and contemplative. Which may be part of the reason why the market is better in the longer term. Once everyone stops shooting from the hip and starts using the reflective parts of their brains, things seem to operate more efficiently.
Which part of the brain do your clients use when talking to you? Have they relegated their investments to the reactionary mode? That was certainly the case in the late 1990s when investors would buy a stock if it had a dot-com in its name.
You need to get clients using their reflective system for their investments. First, listen and try to determine the incentives they are truly responding to—even if it's inertia. You need to explain in ways they can understand the need for a plan and how you can help. And they need to understand the future ramifications of the decisions they make today.
See if you can help them make their short-term inefficient period even shorter.
