Behavioural Finance Biases

Lessons and applications from Richard Thaler.

Over the past month, we’ve covered how to use prospect theory in trading, as well as how to use second-order thinking in investment choices. These have been very well received, so we wanted to continue down this theme today by examining some of the behavioural finance theories and the applications of them from Richard Thaler.

For those not familiar, Richard Thaler is an influential American economist and professor at the University of Chicago Booth School of Business.

Born on September 12, 1945, Thaler has significantly altered the landscape of economic theory by challenging the traditional assumption that individuals always act rationally in their financial decisions.

His research highlights the psychological and emotional factors that often lead to irrational behaviour, introducing concepts such as the endowment effect, mental accounting, and the theory of nudging (all three of which we’ll break down in this article).

Thaler's contributions to the field were recognized globally when he was awarded the Nobel Memorial Prize in Economic Sciences in 2017.

Down to this day, Thaler is a central figure in understanding the intersection of economics and human behaviour.

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The Endowment Effect

This is a cognitive bias where people ascribe more value to things simply because they own them, even if they would not be willing to pay that amount if they did not own the item.

To use an example, we turn to “Anomalies - The Endowment Effect, Loss Aversion, and Status Quo Bias” by none other than Daniel Kahneman, Jack Knetsch and Richard Thaler:

“A wine-loving economist we know purchased some nice Bordeaux wines years ago at low prices. The wines have greatly appreciated in value, so that a bottle that cost only $10 when purchased would now fetch $200 at auction. This economist now drinks some of this wine occasionally, but would neither be willing to sell the wine at the auction price nor buy an additional bottle at that price.”

Another example given is:

“The participants in this study were endowed with either a lottery ticket or with $2.00. Some time later, each subject was offered an opportunity to trade the lottery ticket for the money, or vice versa. Very few subjects chose to switch. Those who were given lottery tickets seemed to like them better than those who were given money.”

So we get the point being made here. But it’s important because it has a transfer impact over to the world of finance.

Simply put, investors tend to overvalue stocks, bonds, or other assets they own simply because they are part of their portfolio. This overvaluation can lead to a reluctance to sell, even when the market conditions suggest that selling would be the rational choice.

This is subtly different to loss aversion, as we’re not talking about the fear of losing money here. Rather, it’s to do with the attachment we have because we own the asset already, instead of having a more objective view.

It can also make it difficult to adjust a portfolio in response to changing market conditions. The impact of the endowment effect might mean there is resistance in selling a stock that has performed well in the past, even if future prospects are dim, because the investor feels attached to the past success.

Mental Accounting

Thaler published the article entitled “Mental accounting matters“ in the Journal of Behavioural Decision Making back in 1999.

In it, he describes the way individuals organize, evaluate, and keep track of financial activities by mentally dividing their money into different accounts. These "accounts" often have different rules and purposes, influencing how people spend, save, and perceive value.