Richard Thaler was awarded the Nobel Prize for Economics in October 2017 for his work in behavioural economics. His citation refers to his contribution to building a bridge between economic and psychological analysis in individual decision making.
Professor Thaler has been writing about poor decision making by individual investors for over 20 years and his work deserves to be at the forefront of, for example, charity investment committees to help them avoid the trap of what he terms “myopic loss aversion” arising from too short-term a focus and too frequent re-allocation between asset classes.
There is a considerable body of evidence that the individual investment horizon is too short giving rise to “reckless conservatism” revealed by under-allocation to risk assets resulting from loss aversion and underestimation of the investment horizon. Experimental data reveals that individuals at the point of retirement consistently under-estimate their surviving life expectancy by as much as five years. At the same time, they over-estimate the risk of loss from real asset classes forgetting that anyone investing in the MSCI world equity index for at least a twelve-year period since 1970 would have secured a nominal gain; indeed, for the majority of holding periods an annual return of between 5% and 15% would have been achieved.
For those who are now at the point of retirement and can take a 30-year view of their investment horizon Professor Thaler would advocate a 90% allocation to equities, a strategy that would be at the extreme edge of what investment advisers typically suggest to the newly retired today. However, individuals’ tendency towards irrational loss aversion in investment choices is well-illustrated by the amounts invested into cash ISAs rather than their stocks and shares equivalents. Investing in a product designed as a vehicle for the long-term, in an asset class currently earning negative real returns, can only be explained by loss aversion: an unwillingness to accept any loss to accumulated capital while trading away the prospect of any gains.
I deliberately began by describing the poor investment choices made by individuals before moving on to consider some lessons from behavioural economics for investment committees. Collective decision making in a committee context is informed by the experience of the individuals who comprise it so that individual behaviour has to be understood. Individuals bring to the table their own experiences, they display availability bias in applying what they know and are familiar with to new and less familiar situations. If individuals demonstrably struggle to invest wisely, and with a poor grasp of their personal time horizon, they will find it hard to adapt to the possibly perpetual time horizon required in investing a permanent endowment fund.