Finance Classes?! Oh, Do Behave!
Not pointless maybe, but close...
RICHARD THALER was this year awared the Nobel Prize for economics.
Here in this 2015 interview, the 'father of behavioural economics' speaks to MoneyWeek editor-in-chief Merryn Somerset Webb about pensions, central bankers and fund management fees.
Merryn Somerset Webb: I'm here today with Professor Richard Thaler, who is the author of this brilliant new book, Misbehaving, which is all about his special subject, behavioural economics.
Richard is also Professor of Behavioural Science and Economics at Chicago Booth University, and the president of the American Economic Association, which, as he says, is quite something, given that behavioural economics barely existed 40 years ago.
Now, I want to start, Richard, if you don't mind, by talking a little bit about personal finance education, because the only time we've met before is after I gave a talk at a conference we were both at about the pointlessness of personal finance education, and how it really wasn't worth the bother or the money, and there was a sharp intake of breath around the room, particularly from all the people running personal finance education charities.
And I was then absolutely thrilled to find that someone as important as you agreed with me.
Richard Thaler: Well, I'm not sure I would put it exactly the way you did. I wouldn't say it's pointless, I would say it's ineffective.
Merryn: Same thing.
Richard: Close. So, look, I believe that it would be better if people were more informed, and, you know, read your magazine more often, and...
Merryn: Take note of that, everybody.
Richard: ...and my books, right?
So the real point is not whether we should be teaching high school students about interest rates and compound interest, because obviously we should. The question is whether we think it's going to solve any problems, and the answer is that it won't. And the reason is that the problems people have to face in real life are so hard that the things you could teach them, say, in high school, or even in college, are not going to help much.
I mean, I sometimes ask an audience such as the one we were speaking to a few years ago how much they remember from their high school chemistry class. And if they're not a chemist, it's basically nothing. So, you know, if we teach people about compound interest, great. Will it help them 20 years later when they're ready to buy a home? Probably not.
Merryn: So you're in favour of 'just-in-time' education? People learning stuff just before they make one of these steps, getting a pension, getting a mortgage, etc.
Richard: Just in time education, and simple products. Make it simple.
Merryn: So this is where we come to your influence on the UK government, because you advised them when they set up what we now call the 'Nudge Unit', because you were co-author, of course, originally, of Nudge, the book that talked about using behavioural economics to push people into behaving in a way that we think they should. And we're now seeing the results of that in the UK, aren't we, when it comes to pensions in particular?
Richard: Yes, well, we're in the midst of a several-year rollout of a new pension scheme, one that's been heavily influenced by behavioural economics. When Lord Adair Turner was on a commission to create this, he decided, after having read the literature, that the method they would use is not to make it mandatory, but to use what we call automatic enrolment, so employees are enrolled unless they choose to opt out – sceptics said this won't work, we have to make this a requirement.
Merryn: But we're too lazy to opt out, aren't we? We just can't be bothered.
Richard: Well, yes. In a word, yes.
Merryn: Yes, we're too lazy to set pensions up, but if someone does it for us we're too lazy to opt out.
Richard: Exactly. So opt out rates are under 10%. So I think that's really working great.
I'm all for freedom, and it's clear that an annuity is not the best solution for everyone. On the other hand, taking the money and going on a cruise isn't, either
Merryn: Yes, but then we're also introducing the idea of just-in-time education with PensionWise, so that when people retire they get guidance from a government organisation on the point of retirement, which is pretty much exactly what you would suggest.
Richard: Yes, yes. And I think there's still work to be done. The reform of the pension scheme that the chancellor introduced about a year ago, I would say is a work in progress.
Merryn: This is 'pensions freedom', whereby you can access your cash on retirement as and when you like.
Merryn: Subject to paying a margin tax rate.
Richard: Right. And I'm all for freedom, and it's clear that an annuity – 100% annuitising – is not the best solution for everyone. On the other hand, if we're going to let people do whatever they want, probably taking the money and going on a cruise is not the best either, so I think with freedom comes a need for help and education. And frankly, we need to devise simple products that will help people deal with spending down their money, because one thing an annuity does is it gives you an allowance. And if, instead, you just have a pot of money, then people aren't sure what to do, because, as we know, people think they should spend the income and leave the principal intact, and that's a very silly idea when it comes to...
Merryn: Spending your pension money.
Merryn: This is something that the financial industry in the UK is, I think, slowly getting to grips with, because, you know, the financial industry is entirely geared towards accumulation. Helping people build money up.
Merryn: And because we've always had this annuity system, our financial industry is not geared at all to helping people 'deaccumulate'. It only knows how to build money up, while taking a major cut along the way. What it doesn't know how to do is to help people run down their cash, and that's a totally different skill for the industry, which it hasn't really had time to learn yet.
Richard: That's right. And so annuities were one solution, and of course they're sold by insurance companies, which is a different industry. And you're right, that the people who are selling mutual funds and savings plans haven't figured out the right ways, and you know, in a high interest rate environment, spending the interest, or a high dividend environment, one can make do with that, but when interest rates are low, and dividends are out of fashion, then people have to spend the money down. That's what they saved it up for.
Merryn: Yes, well, they have to understand that their return comes in capital gains as well as in income, and work with that.
Merryn: But one of the things that strikes me about pensions freedom is that the last couple of weeks have shown us how difficult it's going to be. Because, you know, let's say 20 years ago, we'd had a period of volatility like this, and you're a pensioner in a caravan park somewhere on the west coast of Scotland having a nice time, you pick up the paper, you see there's been this awful market volatility and a crash, what do you do? Nothing. Have another sausage sandwich, right? Doesn't make any difference to you, you've got an annuity.
Now you're the same pensioner, sitting in the same caravan, same bit of the west coast of Scotland today, or in ten years, you pick up the paper, and you see about this stunning market volatility, what do you do? You panic. You weep.
Individual investors have a knack for buying high and selling low. Long term investors in mutual funds underperformed the funds they owned by about 1.5%, purely because of the timing of their trades
Richard: Right, right.
Merryn: There's a whole new level of stress for pensioners about having to manage this money. And I wonder if that is going to make them spend less and less and less, you know, if you have this experience of your capital being drawn down very suddenly. That adds a whole new level of tension, fear, and miserliness, perhaps.
Richard: That's highly plausible. I don't know of any hard evidence that it's true, but it sounds plausible to me. What's also the case is that individual investors have a knack for buying high and selling low. So I'm certain that if that guy in the caravan did anything last week, he sold equities.
Merryn: At the low, rather than the high...
Richard: Right. There was a study done of long term investors in mutual funds, and they underperformed the funds they owned by about 1.5%, purely because of the timing of their trades. So they tend to buy when markets are high and sell when markets are low.
Merryn: So your advice to most pensioners would be don't buy the newspaper?
Richard: Exactly. Or your magazine!
Merryn: I think they should keep buying the magazine, it only comes out once a week, and it's full of useful and interesting advice on things other than trading stocks!
Merryn: And lots of things about investing well for the long term.
Richard: Well, let's agree on the following compromise: whatever they do, they should not turn on one of these cable financial news networks that's on 24/7.
Merryn: Definitely they shouldn't do that.
Richard: They should not do that.
Merryn: Nice leisurely read of the magazine in the bath instead.
Richard: Yes, right. Right.
The less attention people pay to the news, the better they're going to sleep, and the more money they'll have
Merryn: One of the chapters in your book, or part of one of the chapters, is about the equity risk premium, and you suggested it's higher than it should be, rationally, simply because of people thinking that stocks are much riskier than they actually are, because they look at short-term returns rather than long-term returns.
Richard: Well, that's right. I mean, if you think about Rip Van Winkle, who, you know, suppose he's an economist, so he has rational expectations, he knows he's about to go to sleep for 20 years, and calls his broker, and says put it all into equities. How's he going to sleep? Fine. There's never been a 20 year period when equities didn't go up, or didn't outperform bonds. So he's going to sleep very well. Compare that to somebody who's watching one of those financial news stations all the time, and the market has a week like it did recently, they're going to say equities, oh my God, 5% today volatility is just...
Merryn: ...this is too risky, don't touch it.
Richard: Right. So yes, I think the less attention people pay, the better they're going to sleep, and ironically, the more money they'll have.
Merryn: Now, you are also the principal of a fund management company.
Richard: That's correct.
Merryn: Is it Fuller and Thaler?
Richard: Yes, very good.
Merryn: Thank you. And how does that invest? Obviously in line with your own principles, but you just buy some stuff and then don't touch it for 20 years?
Richard: No. But I practise what I preach in the sense that I couldn't name a security that we own.
Merryn: Presumably there's someone else, though, who...?
Richard: There is somebody who could. Many people who could, who can – well, not many, but we have four portfolio managers. But the ideas that we use are to say: what are the mistakes other investors make, and what investing opportunities do those create? And then we try to take advantage of those.
Merryn: Now, that presumably makes you very value-orientated, because another one of the things you've written about quite a lot is the mispricing of value stocks.
Richard : We're not exclusively value, but the fund that has the most of our money is a value fund, and you know, it starts with the very first finance article I ever wrote, with a former student and it was the simplest article you could imagine. We just went back to 1926, which is when financial data begins, and for each five-year period looked at the stocks that had gone down the most, and the stocks that went up the most, formed portfolios, watched them for the next five years, and looked to see what happened.
And the ones that went down the most outperformed the market, and the ones that went up the most went down. So...
Merryn : This investing business is really simple, isn't it?
Richa rd: Yes , so, you know...and I never thought of that as a viable investing strategy in and of itself, but it does illustrate the idea of investor over-reaction. That over some period of time, stocks – it's almost like stereotyping. That a company, after trailing the market for a few years, it just gets the reputation of being a bad company. And, you know, we all remember when Apple was a bad company. Nobody would think of buying stock in that company that's about to go under...
Merryn: Yes, no one would buy it at any price.
Richard: Right. And now it's just the opposite, it's a company that can't possibly do anything wrong. And obviously neither of those views is correct. So, you know, I don't know whether we owned Apple back then, but the Apple that was long suffering would be the kind of company we would be looking at. And then we would be looking for some signs that it's not a loser that's headed for extinction, signs like insiders are buying it, and are repurchasing their shares, and if the CFO is adding to his portfolio of the stock, that's often a good sign that things are turning around.
Merryn: Yes, interesting. And the opposite isn't necessarily true, is it, because the CFO can be selling for all sorts of reasons.
Merryn: Divorce, education, whatever it is.
Merryn: But when he buys it's a very positive sign.
Richard: Right, exactly.
Merryn: Interesting. Now one of the things we also talked about at that same conference was the fund management industry, the financial industry, how mistrusted it is, how badly it's behaved, how difficult it is to get it in general to behave well. And I know you've thought a bit about that. How can we use behavioural methods to improve the financial industry? Tough one, isn't it?
Richard: Actually I'm not sure exactly where you're going.
Merryn: I suppose the very high salaries that we pay, particularly in the fund management industry, the incentives inside. Say you're a fund manager, your incentives are to have a huge fund and run it in a mediocre way. Your incentive is not to have a small, well performing fund, because that's not really where the money is.
Richard: Okay, right.
Merryn: How can we change this around?
Richard: Right, well, certainly there are lots of bad incentives. One is when to close a fund. This is a problem that we're facing at our firm. We have a small-cap value strategy that can handle three or four billion, maybe five, certainly not ten. And if we're going to be responsible, we'll have to stop selling it. And obviously that's a hard decision for a company to make.
Merryn: Well, for a profit-maximising company, that's a very difficult decision.
Richard: Right. But if you want to be true to your clients, then you have to just do it. And, you know, there's all kinds of other shenanigans that go on. Every large fund company is starting new funds left and right, and seeding them, and then by luck some of them will do well, and they'll have a nice track record, and then they'll sell them.
Merryn: And they'll close down the other ones.
Richard: And they'll close down the ones that didn't work, and there's no particular reason to think that the one that was lucky for a while will continue to be lucky, so...
Merryn: And how should fund managers charge, do you think? Should they be charging, as they do at the moment, ad valorem, plus a performance fee, or is the performance fee just a distorting mechanism? What's the best way to charge for a fund?
Investors pay much less attention to fund fees than to recent returns, in spite of the fact that next year's fee is almost certainly the same as this year's, and next year's performance has got nothing to do with last year's
Richard: You know, look, I think performance fees, in principle, are fine. You know, hedge funds that are charging two and 20, so 2% of assets plus 20% of the profits, and especially if it's 20% above zero, or above the interest rate, which is zero, it's very hard for the investor to get a return if they're giving away that much. You know, on the other hand, for long-only mutual funds, personally I think it would be good if more of them had performance fees.
Merryn: And lower annual fees?
Richard: Yes. And...
Merryn: You don't think that a performance fee encourages them to overtrade, to take too big risks at the end of a year, etc?
Richard: I mean, you have to worry a little bit, and maybe you'd like the performance fee to be smoothed over a few years, with some clawbacks, but notice that it would solve the problem of encouraging funds to close appropriately. Because if they're getting some of their money from beating the market, and they can't beat the market if they take too much money, then...so we do want to align incentives, but obviously, you know, there's a trade-off, funds are there to make money, and so they charge the fees that they think...
Merryn: ...they can get away with.
Richard: Yes, and buyers should obviously be paying attention to fees.
Merryn: Yes, and buyers don't, though, do they?
Richard: They pay much less attention to fees than to recent returns, in spite of the fact that next year's fee is almost certainly the same as this year's, and next year's performance has got nothing to do with last year's.
Merryn: Well, that's what we say at the magazine, the first thing you should look at...
Richard: ...what a good magazine...
Merryn: ...it is a good magazine. This is a good book, by the way.
Richard: Oh really? Excellent.
Merryn: We always say that the thing you should look at first, and actually sometimes the only thing you should ever look at, is the fee, because it's the only number that you know. You are never going to know what the performance is going to be, you're never going to know who's going to be running it, people come and go, etc, but what's absolutely set in stone is that fee.
Merryn: So it's almost the only number that matters.
Richard: It's certainly a very important number. And look, you're right, in the active fund management business, although my retirement income, which is from a set of funds that the university selects, is all in index funds, so...
Merryn: Is it? I was going to ask you about that. You're effectively an active fund manager, but I'm guessing you probably do approve of passive investment.
Richard: Absolutely. I think everyone should invest their money either in index funds or in the funds managed by Fuller and Thaler.
Merryn: Index funds or your funds. I think that's perfectly reasonable as a suggestion.
Merryn: Can I just ask you a little, before we finish, about macro-economics? I know this isn't your speciality, but it's one area where behavioural economics is not really used, so at the moment we are obviously in this very, very low interest rate environment, which in theory should be working, but there are all sorts of behavioural issues around the edge that may be affecting the way it works. And we touched on this earlier, when we talked about people refusing to spend capital, because one of the things that QE is supposed to have done, and low interests are supposed to do, is to raise the price of assets, which they've done very well, and then we're supposed to feel wealthier, and then we're supposed to spend more.
But, if people don't like to spend capital, they only like to spend income, well, their capital has risen in value, but their income has fallen very dramatically. So instead of spending as they should, based on, you know, normal theory, they're actually spending less. So there's all these things that come into macro-economics that are not really established as things people put into their models.
We have some really bad roads and bad airports, and we could have been spending the last eight years rebuilding those roads, borrowing the money at zero rate of interest, and employing people without jobs
Richard: Right, so you're right, I end the book by saying one of the things I hope that the next generation of behavioural economists takes on is macro-economics, and these are exactly the kind of questions that we need to be asking. So in the standard economic model, where everybody is as smart as the smartest economist, or possibly even the smartest economists thinks he is, which is really smart...
Merryn: ...really, really smart...
Richard: ...really, really smart. If we start to say, well, gee, we've driven up asset prices, but people are unwilling to spend down those assets, then what's happening? That could easily change the way policymakers think. And, you know, it's also the case that this affects government policy. I think governments around the world, including governments I've helped advise, are not taking advantage as much as they should of their current ability to borrow at negative interest rates, and build infrastructure. I know in America we have thousands of bridges that are in peril of falling into rivers.
Merryn : And you have really horrible airports, and some terrible roads.
Richard : We have some really bad roads and bad airports, and we could have been spending the last eight years rebuilding those roads, borrowing the money at zero rate of interest, and employing people without jobs, and...
Merryn : Although someone would still have to pay that money back in the end, and it's cheap, but it's not a gift.
Richar d: But we're going to have...well, that's true, but we're going to have to build those roads...
Richard: ...anyway, and it's going to cost a lot more, because we won't be hiring unemployed resources, we won't have excess capacity, so we're going to be just like the investors we talked about earlier. You know, we're going to be buying high and selling low.
Merryn: Interesting. Anything else that you think might change the way we look at macro-economics in the future? I mean, it's much harder to do, I know, because with the micro-economics and with pensions, etc, you can test, you can test how people will react to any particular thing, but it's very hard to say, gosh, I wonder what would happen if we put interest rates up to 6% instead of keeping them at 0.5%. You know, we'll do it in Germany but not in the UK, and see which works.
Merryn: That's not really going to work for people, so it's much harder.
Richard: Right. I'm trying to get all of the central bankers to agree to let me run experiments.
Richard: Where, you know, I set the monetary policy in each country and then see what happens, but...
Merryn: No, no one's biting.
Richard: But so far, you know – Janet, I've tried; she's a friend, but she's not...
Merryn: But she's interested in the idea, right? She's interested in behavioural economics.
Richard: She is interested in behavioural economics, most people don't realise she's married to George Ackerloff, Nobel Prize winning economist, who's done work in behavioural economics, and...
Merryn: They say behind every important woman there's a powerful man.
Richard: No, but in this case there happens to be a very smart man, and they have a couple of co-authored papers on behavioural economics.
Merryn: Interesting. Okay, we should read those.
Richard: And, you know, I think there are questions that psychologists might be interested in. You know, there's been lots of talk about so called 'forward guidance', what should central bankers be saying to everyone about their plans for the future. Now, there are some economists who say it just doesn't matter, because everybody's smart enough to realise that what they say doesn't mean anything, so they'll just ignore it. But we know that's completely wrong, because every word that the central banker utters is parsed, and I remember Janet gave some speech where she said that they were going into a phase where they were expecting to be less patient about raising interest rates, which was not to say that they were going to be impatient, and the market freaked out.
Now, I don't know how you could have given a more measured...
Merryn: Do you think it would just be better if she never said anything at all? In that, because central bankers are constantly offering guidance here, guidance there, people think about where are interest rates going to go all the time, and they're constantly trying to second guess and make their plans around where they think interest rates might be, whereas if all these people would just shut up we would just go ahead and make our plans based on our lives.
Richard: Well, maybe, but I think, you know, the alternative is that central bankers build up some trust.
Merryn: Really? Central bankers have trust? Globally?
Richard: Well, so, you know, I will say, you know, I haven't followed things as closely in the UK as in the US, but Bernanke and Yellen have been preaching kind of the same line for quite a long time, they've for years been saying they're going to keep interest rates low for a long time.
Maybe after another decade or two, there will be some trust that, when central bankers say interest rates will be kept low for a period of years, people will think that will really happen
Merryn: And they have.
Richard: It's been a long time. They now have been saying for quite a while that they will start gradually raising interest rates some time soon, I'm guessing...
Merryn: You see, this is meaningless.
Richard: Well, I mean, I think – so, my prediction is...
Merryn: What do you think?
Richard: Within the next year, interest rates will start to go up slowly. And, you know, maybe after another decade or two, there will be some trust that, when they say interest rates will be kept low for a period of years, people will think that maybe that will really happen.
Merryn: Okay. I hope you're right. I'd like it to be a situation where we could all trust our central bankers all the time. But I worry, and I don't know if you do, slightly off topic, I worry that we put so much power in the hands of our central bankers. You know, we've basically delegated the running of the global economy to a group of unelected people, who are all jolly clever and nice, but nonetheless, unelected and wedded to the same theories. It's a strange environment.
Richard: Well, how much experience have you had studying the US Congress?
Merryn: Very little, but enough to know that – but maybe better...?
Richard: Would you rather have them doing it? I rest my case.
Merryn: Okay, you win. You win, entirely. Absolutely. In fact, on every point.
Richard: Thank you very much.
Merryn: So obviously, read the book.
Richard, thank you very, very much for your time.
Richard: My pleasure.