

Stop Sabotaging Your Stock Portfolio, Richard Thaler Says

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Dr. Richard Thaler |

Photograph by Andrew Segreti
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For Barron’s readers, Richard Thaler is the 2017 Nobel Laureate who popularized the notion that people’s biases and impulses are profoundly relevant to the study of economics. His academic work is extensive, and he’s written more mainstream books such as Misbehaving: The Making of Behavioral Economics, an account of his career and battles with the economics establishment, and Nudge: Improving Decisions About Health, Wealth, and Happiness, which he cowrote with legal scholar Cass Sunstein.

Thaler may be better known, however, for his notable cameo in The Big Short, the film adaptation of the Michael Lewis book that documents the financial crisis, in which Thaler teams up with pop star Selena Gomez to explain synthetic collateralized debt obligations.

Thaler also cofounded Fuller & Thaler, which runs six mutual funds that try to profit from behavioral biases, including JPMorgan’s $5.4 billion Undiscovered Managers Behavioral Value (ticker: UBVAX) and the $2.2 billion Fuller & Thaler Behavioral Small-Cap Equity (FTHNX).

In a recent freewheeling discussion with a roomful of Barron’s writers and editors, Thaler expanded on what he views as investors’ common mistakes, overconfidence, and nudging. Below are edited excerpts of the conversation.

Barron’s: It’s the new year. What behavioral errors should people watch out for?

Thaler: Every year, at Fuller & Thaler, when we pay bonuses, we go to everyone individually and say, “You haven’t maxed out your 401(k). Would you like to take some of the bonus and top it up?” Anybody who isn’t at least maxing out the match is throwing away money. Most people are under-saving. I blame the plan sponsors, because it means they haven’t employed my favorite intervention called “Save More Tomorrow,” where you automatically increase the saving rate over time.

We know that the best way to reduce biases is just to make decisions automatic. Investors are less stupid if they’re in a target date fund that prevents them from panicking when the market goes down, and they do better in 401(k)s if we automatically enroll them, and then automatically escalate them up to some sensible saving rate.

What are some other errors investors make?

The biggest mistake people make in life is overconfidence. In investing—unless people are explicitly investing to manage for taxes, which we know they typically get wrong—it’s not clear they have any business buying and selling individual securities. Most active managers underperform, at least by their fees, or more. So if professionals with their Bloomberg terminals and access to all kinds of information can’t do better than throwing darts, why should individual investors think they can? My own personal conjecture is that the rise of individual investing in the 1990s, which contributed to the tech bubble, was caused by the illusion of information. Everybody had Yahoo! Finance or whatever, and people felt that they were better at figuring things out than other people, and that the information was private to them. When the market was going up 30% a year, it was very easy to convince yourself that you’re a good investor.

I think picking individual stocks for your own account is a fool’s errand. I don’t do it. I give the money to people at our firm who know how to do it and do it for a living. I already knew it wasn’t something in my level of competence, any more than was trying to return Roger Federer’s serve, or to hit a major league curve ball. Some things we can’t do. It’s why we go to restaurants. They cook better.

Is overconfidence a particular risk now?

If you’re asking me any questions about what’s going to happen going forward, I’m going to say I don’t know. We have a highly uncertain political environment in the U.S., in the U.K., in China, in half a dozen other places around the world. In spite of all of that, the market seems to have record-low volatility. How that can be true is just a puzzle. The amount of yawning by the markets is the thing that I find most surprising.

Is the market’s changing structure—big gains in the largest companies, endless flows into passive funds—a form of overconfidence?

It could be a contributing factor, but it doesn’t sound to me like it would be more than second order. Things happen twice a week [now] that might have caused 500-point moves in the past. Maybe it’s like when you have a loud restaurant; eventually you get used to it. I think no one should be particularly confident.

What’s an investor to do? Put everything in the bank?

I put my money in the stock market. I was on a morning show once, and someone asked what my advice would be the next time there’s market turmoil. I said, well, it would be to switch off this network and leave things alone. I was not invited back.

In my retirement accounts, I have mostly index funds from Vanguard or TIAA-CREF [Nuveen]. The only actively managed funds that I own are ours. I try to be globally diversified, and I try not to do things that I don’t know how to do.

How do you view the strong flows into bond funds and out of equity funds?

I haven’t seen a good study of it. One conjecture is that it’s just demographics: The Boomers are starting to retire, and they’re adjusting their portfolios, or their target-date funds are doing it for them. Or maybe other people are looking at the same things as me and worrying. I’m not worried that we’ll have a crash. I’m just puzzled. A lot of things are happening that my macro economist friends assured me all my life couldn’t happen, like negative interest rates.

Can you apply behavioral theories at all to the way monetary policy has worked?

Picking individual stocks for your own account is a fool’s errand. I don’t do it.

— Richard Thaler

Forward guidance is behavioral. It’s making a promise. There are economists in my home university who still think investors are rational and won’t pay any attention to what the Fed says because it’s just cheap talk. I don’t think that’s right. Forward guidance has been largely successful, and it’s partly because the central bankers have been trustworthy. [Former Fed chiefs] Ben Bernanke and Janet Yellen and [current Fed Chairman] Jerome Powell all seem like straight-shooters who you can take at their word.

Yet Powell did a 180-degree turn in the last 12 months.

He was being nudged.

Does the nudging hurt their credibility for guidance and molding expectations?

Certainly it’s not helpful. The tradition of the independent central bank was very healthy. The idea that the Fed chair would be bullied by the president is an uncomfortable precedent. Now, I don’t think Powell has done anything rash. There are some signs that growth is slowing down a little bit.

What do you make of algorithmic trading? Are algos akin to what you call “rational economic men” since they actually make dozens of opportunity-cost decisions at any given time?

Algorithms, at least until now, are written by humans. We can certainly imagine the day that there are self-generated algorithms. What’s true is that a model, if followed, is reliable and predictable. In many situations, replacing humans with algorithms makes sense. In the medical domain, two friends of mine just wrote a paper in which a machine-learning algorithm documents the conventional wisdom that we do too much [medical] testing—but that there’s also systematic under-testing because we don’t test the right people. We could save money and lives by improving the process.

The outperformance of value has been a well-known factor over several decades, with the exception of the past decade, when growth stomped value. Is there a behavioral explanation?

It also happened in the ’90s. I don’t think there’s any explanation for why growth is beating value now, except that no strategy can work all the time, or it would be arbitraged away. So it has to be the case that these styles go in and out of favor, and it has to be the case that they do so unpredictably. So most efforts to time style shifts have been unsuccessful.

It’s intuitively appealing idea that as growth becomes more expensive, we should shift to value. I was teaching a Ph.D. course in behavioral finance in the fall of 1997, the year of the Amazon IPO. The first day of class, I said “Who buys that company? You know they lose money on every book.” One kid raised his hand and said he bought 1,000 shares and it had doubled. For the next 10 weeks, he and I bantered. By the end of the quarter, it had quadrupled. So I said “OK, you know more than me.” My partner, Russ Fuller, and I believed in the late ’90s that Internet stocks were overvalued. You can have a very interesting discussion about whether we were right or wrong. If we had shorted, we would have been broke before we were right. That’s not what investors hire us to do. If they put money in our small-cap value fund, they expect us to find the best small-cap value stocks that we can find, to try to beat our benchmark.

Why did Fuller & Thaler start out with a small-company fund? Because of the small-cap effect?

I personally was never convinced of the small-firm effect. It was because there’s less competition. The bigger the stock, the harder it is to make money. In the top 50 stocks, a thousand funds are all trying to decide whether Apple (AAPL) or Alphabet (GOOGL) or Amazon (AMZN) are over- or undervalued. And we’re a firm with 20 employees. Even in our unconstrained all-cap strategy, we generally don’t hold mega-caps. That [small-cap] market seems less efficient, and less-liquid stocks seem less efficient.

What’s next for you?

I’ve been thinking a lot about decision-making generally. I’m a long-term sports fan. One thing I’ve found curious is that there are things sports teams do that are dumb, and that persist. Let me give you an example: A famous macroeconomist named David Romer wrote a paper about football 15 years ago, showing that teams punt too often. If you look at the effect that paper had on the behavior of NFL teams, it was basically zip. Two years ago, they were getting it right a third of the time, instead of a quarter. The Baltimore Ravens finally put an analytics guy in the booth upstairs who whispers to [head coach John] Harbaugh. This kid calls himself a behavioral economist. He says in this situation, your win probability is 40% if you punt and 45% if you go for it.

Are you and Selena Gomez going to make another movie?

I have been assured that my movie career is short.

Thanks, Richard.

Write to Leslie P. Norton at leslie.norton@barrons.com

Corrections & Amplifications

JPMorgan offers a fund called Undiscovered Managers Behavioral Value. An earlier version of this story included JPMorgan in the fund’s name.