Nobel Prize History
The Nobel Prize is the most prestigious award in the scientific world. It was created according to Mr. Alfred Nobel’s will to give a prize “to those who, during the preceding year, have conferred the greatest benefit to humankind” in physics, chemistry, physiology or medicine, literature, and peace.
A sixth prize would be later on created for economic sciences by the Swedish central bank, officially called the Prize in Economic Sciences, often better known as the Nobel Prize in Economics.
The decision of who to attribute the prize to belongs to multiple Swedish academic institutions.
Legacy Concerns
The decision to create the Nobel Prize came to Alfred Nobel after he read his own obituary, following a mistake by a French newspaper that misunderstood the news of his brother’s death. Titled “The Merchant of Death Is Dead”, the French article hammered Nobel for his invention of smokeless explosives, of which dynamite was the most famous one.
His inventions were very influential in shaping modern warfare, and Nobel purchased a massive iron and steel mill to turn it into a major armaments manufacturer. As he was first a chemist, engineer, and inventor, Nobel realized that he did not want his legacy to be one of a man remembered to have made a fortune over war and the death of others.
Nobel Prize
These days, Nobel’s Fortune is stored in a fund invested to generate income to finance the Nobel Foundation and the gold-plated green gold medal, diploma, and monetary award of 11 million SEK (around $1M) attributed to the winners.
Source: Britannica
Often, the Nobel Prize money is divided between several winners, especially in scientific fields where it is common for 2 or 3 leading figures to contribute together or in parallel to a groundbreaking discovery.
Over the years, the Nobel Prize became THE scientific prize, trying to strike a balance between theoretical and very practical discoveries. It has rewarded achievements that built the foundations of the modern world, like radioactivity, antibiotics, X-rays, or PCR, as well as fundamental science like the power source of the sun, the electron charge, atomic structure, or superfluidity.
Inefficient and Irrational Humans
For a long time – pretty much since its origins with Adam Smith – economic sciences have observed macroeconomics with the assumption that the people making up the economy are rational actors.
From such ideas stemmed central concepts of economic science, such as:
- People are driven by their self-interest, and the sums of these “egoist” choices create the “invisible hand of the market.
- Prices are determined by the balance between offer and demand.
- Trade is the voluntary exchange of goods.
- Financial markets are efficient, and asset prices reflect this.
- Etc.
This makes some sense, as people are mostly driven by their own interests, and most economics (trade, currency, etc.) involve logical and rational decisions. But at the same time, it is not so hard to find plenty of real-life examples where individuals, companies, or entire nations make all but rational choices. And especially when it comes to economics and money.
For example, someone might gamble his life savings away in a casino, even when knowing that the probabilities are against him. Or a company’s management might make risky gambles that endanger a corporation more than a century old.
This has long troubled economists, who knew deep inside that the “perfectly rational agent” assumed in most economic models is an oversimplification.
This led to the development of a new discipline, sitting at the junction between the study of economics, and the study of human psychology, called behavioral economics.
One key founder of this discipline has been Richard H. Thaler, who was rewarded with the Nobel Prize in Economics in 2017 for his contributions to behavioral economics.
Source: Nobel Prize
Documenting The Limit Of Rationality
Thaler was relentless in pushing the limits of economic sciences beyond the presumptions of “rational agents.” Notably, he published the regular “Anomalies” series in the Journal of Economic Perspectives, as well as many articles, comments, and books to push the idea that psychology should be integrated into economics.
Throughout his career, he would further elaborate and build a large array of analyses on the limited rationality, or sometimes irrationality, of our economic decisions. Among these are three key concepts:
- Limited rationality: how people take mental shortcuts and are exposed to natural bias like a deeper dislike for losses than an appreciation for gains.
- Social preferences: why fairness matters to us more than pure economic benefits.
- Lack of self-control: the preference for short-term rewards, even when we are aware of negative long-term consequences.
Limited Rationality
Working With Relative Comparisons
Thaler’s first insight was into people’s tendency to make economic decisions based on gains and losses relative to some reference point. This differed from conventional economic wisdom, assuming a rational choice for a given amount of wealth or utility (like health).
He also demonstrated it in multiple studies where he investigated people’s preferences when facing hypothetical scenarios. For example, a $100 to a $200 gain (or loss) has a larger utility impact than moving from a $10,100 to a $10,200 gain (or loss), despite the gain/loss being actually identical.
Another example is how taxi drivers drive less on days with high demand and more on days with low demand.
This is not rational economic behavior, but it makes sense if the mental goal is to reach a certain reference revenue for the day instead of maximizing profits over time.
Loss Aversion
A key influence is that people are known to be much more averse to loss than appreciative of gains. This can sometimes manifest as an order of magnitude greater sensitivity to losses or fear of losses than greed for gains.
So, for example, when faced with equal chances of the risk of losing $100 versus winning $200, many people will prefer not to take a chance even if they know that they will win money statistically.
This would later on be elaborated further by researchers like Tversky and Kahneman who would demonstrate that more risk-adverse individuals tend to opt for preserving the status quo, even against their rational interests.
Later on, Thaler with fellow economists Kahneman and Knetsch proved that these effects persist when dealing with real money. It also persisted even when participants had time to learn about the market and be aware of the limited rationality they displayed.
Mental Accounting
Another not-so-rational component of human behavior when it comes to money is the tendency to separate topics by category. For example, many people will have separate defined budgets for different categories (housing, food, clothes, etc.).
These categories will often not be fully interchangeable (limited fungibility in economic terms). So the value a person attributes to a certain sum of money might depend on the context more than the sum in itself.
This can also have consequences regarding the perception of the link between payment (unpleasant) and the consumption of a good (pleasant).
When the link between payment and consumption is not evident, like, for example, a wine bottle paid a long time ago, the mental accounting tends to see the wine bottle as “free”.
A mental account also encourages to delay losses. For example, this is a key motivator for why investors prefer to not sell stocks at a loss, instead selling the stocks standing at a profit, as the sale makes the loss “real”, by closing the associated mental account.
Social Preferences
Not all personal and economic decisions we make are selfish. People have an inherent tendency to value fairness, even when it might be to their personal detriment.
Through multiple experiments and tests, Thaler demonstrated multiple behaviors where the impulse to enforce fairness drives people more than “rational” economic interests:
- Fairness is valued, even in anonymous settings without reputational concerns.
- Some individuals are willing to lose resources to punish individuals who behaved unfairly towards them.
- Some individuals are willing to lose resources to punish unfair behavior and norm violations even if the unfair behavior was directed toward someone else.
Psychologists have explained these tendencies, as well as the capacity for empathy, as an evolutive tool to favor cooperation inside a group.
In turn, cooperation optimizes the evolutive fitness of the group as a whole, making it advantageous to display fairness, even if it might not be advantageous to individual members of the group.
Punishing unfairness also might be instinctively understood as creating long-term personal advantage. If you accept an unfair deal today, you might be forced to do so again in the future.
Frame Of Reference
One finding of Thaler is that changes in prices are perceived differently depending on their context. And fairness plays a large role in why it is so.
For instance, a price increase of $200 for a new car is deemed more unfair if it is framed as an increase in the list price than if it is framed as a reduced discount on the list price.
The perception of an “abusive” rise in price can also make the same price increase less well accepted. For example, a consumer-price increase is typically acceptable if it is due to an increase in input prices, but not if it is due to an increase in market power.
The second case is perceived as unfair, even if the price increase is objectively having the same impact on the buyer’s finances.
Lack Of Self-Control
It is well known from psychological experiences and even ancient philosophy that many people overvalue current consumption over future rewards.
Thaler would provide the first experimental proof of the tendency to constantly postpone long-term good decisions, something called by economists hyperbolic discount.
For example, this tendency explains why we will regularly plan to “soon” stop smoking or start saving for retirement, while not doing so when the planned date arrives in the future.
Thaler developed a model he called the planner-doer. In it, the doer part of an individual’s mind looks to maximize immediate satisfaction while the planner anticipates future needs.
While the planner can “force” the doer to restrain his consumption, it exerts an effort of willpower on the person’s mind. We can think of the planner as the prefrontal cortex (“the executive of the brain”) and the doer as the limbic system (which generates short-term emotions and desires).
While every person will be subjected to the tension between the doer and the planner, individual levels of willpower and intelligence will impact the ability of the planner to take over.
Policy Implications
As an individual might not make the best decision due to the “doer” impulsivity, this makes an argument for policymakers to provide help to the “planner” part of the population.
This led Thaler to promote what he called libertarian paternalism.
According to this view, beneficial changes in behavior can be achieved by minimally invasive policies that nudge people to make the right decisions for themselves.
This approach emphasizes the use of choice architecture, that is, the design of the environment where choices take place.
This can justify new types of public policies, to limit the effort demanded from the “planner” part of the mind, providing people with beneficial default options can bring positive results.
For example, automatically saving for retirement and having to opt-out to not do it actively. Such automatic enrolment has been shown to change the participation rate in a 401(k) savings plan from 49% to 86%.
Investing Consequences Of Behavioral Economics
Behavioral economics demonstrates that our behaviors are far from purely rational when it comes to money. This impacts how we invest and, therefore, how markets are reacting to news and asset price fluctuations.
Loss Aversion & Price Crash
Because we are naturally more sensitive to losses, investors are very reluctant to buy stocks that have recently fallen in price.
This is despite, as Thaler demonstrated, the superior returns of “loser” stocks (stocks that recently dropped in value) compared to “winner” stocks (stocks that recently increased in value).
Time Preference
In general, it has been shown that investors overvalue recent news. Such “recency bias” can lead to mistakes in the investment process, where less relevant information is taken into consideration over better data-points simply because it is more recent.
This is true for stocks that recently crashed and for stocks that reached an all-time high. As a result, psychological bias toward recent events can exacerbate both bubbles and crises beyond what would be reasonable looking solely at the fundamentals.
Herd Behaviors
Humans are social creatures, and fairness is not the only ingrained “irrational” trait we display for the sake of social interactions.
Investors tend to behave often like a herd, following together the same trends because “everybody does it”. Such an attitude does not have to be rational, but it makes a lot of sense to preserve social consensus and stability. However, for investors, it can lead to unthinking bubble chasing or panic selling en masse.
Overconfidence
While not something Thaler investigated, another implication of behavioral economics is the tendency to overestimate our own skills and knowledge.
For example, it is famously said that 80% of drivers believe to be better than the average driver. It means that at the very least 30% of drivers are overestimating their skill, as by mathematical definition, only 50% of drivers can be above average.
Similarly, traders and investors tend to overestimate the role their skill or intelligence plays in successful investments. This in turn can create a pattern of overconfidence, and difficulty in sticking to low-risk investment practices, despite their overall better track records over the long term.
Learning From Behavioral Economics
One key lesson from the field pioneered by Thaler is that not only are people not perfectly rational economic agents, but this also persists when a large number of them interact in markets.
If anything, large crowds can create new biases and pricing deformation that individual investors would not display, like herd behaviors.
Another takeaway for investors is that no one is protected from the biases discovered by behavioral economics. While some might be more able to limit the impact of these mental limitations, being human means being susceptible to them.
So, investors need to carefully craft investment strategies that inherently reduce the impact of these biases. This can be among many things:
- Strict rules about the financial multiples (P/E, price-to-sales, etc.) we consider investable, therefore avoiding bubble chasing, recency bias, and herd behavior.
- Sticking to our “circle of competence”, therefore avoiding becoming overconfident in areas we actually do not understand as well as we would like to believe.
- Automatic stop-loss orders set in advance, limiting the tendency to refuse to take into mental account the losses that have already occurred.
- Limiting trading activity and frequency of transactions, to avoid reacting to the maybe not-so-important latest news.
Investing In Behavioral Economics
There are many ways to integrate behavioral economics into our investment strategies, including the ones we described above.
Another option to remove our inherent irrational behavior from the equation is to move to passive investing strategies. By investing regularly in “the market” as a whole, we take away from ourselves a lot of (bad) decision-making abilities.
You can invest through many brokers, and you can find here, on securities.io, our recommendations for the best brokers in the USA, Canada, Australia, the UK, as well as many other countries.
If you are not interested in stock picking, or have become convinced you prefer passive investing, you can also look into ETFs designed for passive investing, either in the US market or globally, like SPDR S&P 500 ETF Trust (SPY), the Vanguard Total Stock Market ETF (VTI), or the iShares MSCI ACWI UCITS ETF USD (SSAC), which will provide a more diversified exposure to capitalize on the growth of the overall economy.
Behavioral Economics Companies
1. BlackRock
The rise in the academic circles of behavioral economics has also created a similar rise in the acceptance of passive investment, as removing decision-making removes biases as well.
This in turn made many people skeptical of investing in the stock market more open to the idea. Especially if they do not have to learn a lot or take risks they feel they are not qualified to take.
This has greatly benefitted companies creating ETFs (Exchanged Traded Funds), which are a perfect vehicle for designing passive or semi-passive investment strategies.
Each ETF usually collects very small fees over the funds managed. However, when most investors globally turn toward passive investing, a 0.5% or 1% fee on trillions can make a lot of money.
BlackRock is the world leader in ETF creation and investing vehicles in general, with more than $2.8T of ETF assets under management, and $9.1T of assets in total.
Source: BlackRock
These assets come from 40 million people using the company’s 1,300+ ETFs, and 35 million Americans with retirement assets managed by BlackRock.
The company is also investing massively in technology, notably its Aladdin portfolio management software, one of the most complete in the industry globally.
Source: BlackRock
Despite its massive size, the company still has plenty of venue for growth:
- Global expansion, with the current activity still very US-centric (2/3rd of current assets under management).
- Moving from the current public markets into private market and venture capital.
- Growth of the ETF industry from $10T in 2023 to an estimated $25T by 2030.
- Industry consolidation, with most of the investment industry still very fragmented.
Source: BlackRock
Overall, BlackRock’s sheer size is a competitive advantage, giving access to better data, software, reputation, and a wider ETF portfolio than almost all its competitors, with only Vanguard coming close in ETF assets under management.
2. Lemonade
Insurance is notoriously a segment prone to psychological biases, as it is by nature a business dealing with uncertain risks in a potentially very distant future.
Considering what behavioral economics teaches us about recency bias, tolerance for losses, and overconfidence, it is not a surprise that people might make sub-optimal decisions when it comes to their insurance policies.
On top of it, many people have little trust in insurance companies, which compounds due to complex pricing, byzantine procedure, and overall a difficult process, bringing into action all the biases about fairness as well.
One insurance company that has embraced this problem is Lemonade. For example, its leading message when you arrive on its website insists on transparent pricing & “instant everything,” as well as calling itself “The (Almost) 5 Star Insurance Company (4.9 stars) and bragging about “super fast” payment of insurance claims.
Source: Lemonade
One key part of their offer is their AI assistant, Maya, following new clients and helping them actually understand their insurance contracts.
It also uses the insight of behavioral psychology to reduce the difficulty in making decisions for signing an insurance contract, reducing the mental load and complexity of the process.
Not only does this increase the conversion rate of potential clients, but it also sets their expectations right from the beginning. As a result of this consumer focus, their in-force premium (IFP) has doubled in 2 years since Q2 2022.
It is also getting an improving loss ratio, a key metric among insurers, as it illustrates the company is not underselling its contracts for the sake of growth, at the risk of future losses.
Source: Lemonade
Behavioral economics is teaching us all the limits of the human mind when it comes to dealing with money.
Lemonade is a good example of how it can be put to good use to help people, making painfully complex tasks a lot more simple. And certainly, more “fair” if you ask Lemonade users.
