Cass Sunstein, the Harvard law professor who brought the latest in behavioural economics research to the ambitious task of improving and simplifying a host of U.S. regulations during President Barack Obama's first term, has some simple advice for investors: Don't follow your instincts or intuition.
"If you're deciding how to invest your savings, your gut may speak clearly and simply. Please ignore it," Prof. Sunstein writes in his latest book, Simpler: The Future of Government.
It is only one of the all-too-human tendencies that can lead investors down dangerous paths, particularly when the siren song of an impressive equity rally beckons.
Another is our widely noted aversion to losses, which was undoubtedly helpful to our survival as a species but causes us to fear losing money far more than we like making it. As a result, we are prone to hang on too long to losing bets and sell winners too early. Then, there is what the behaviourial crowd labels "myopic loss aversion" – a combination of the huge dislike of losses with an undue focus on the short-term moves of longer-term investments.
"Those are two potentially problematic sources of investment behaviour, by which a loss today or this week looms very large even over the course of a year or five years," leading to missed opportunities, Prof. Sunstein says. It helps explain why so many investors are still sitting on mountains of cash and unprofitable government bonds years after the global meltdown.
The clouds are out when we meet for breakfast to discuss his three years at the helm of the bureaucratic-sounding but influential White House Office of Information and Regulatory Affairs. It seems grey, rainy days make people more reluctant to embrace risk. Yes, folks, the weather influences decisions even by investment pros.
"It's true that on a bright, sunny day, there seems to be more risk-taking," Prof. Sunstein says, as he bites into his bagel with cream cheese. "But some risk-taking is good. What I don't know is whether I make better investment decisions on a cloudy or a sunny day. I don't know if we have that data."
Besides taking more gambles when the sun is out, here are a few other things behaviourial research has taught us: Human tendencies run counter to rational investing; how much we paid for something affects how we value it; despite the effects of loss aversion, people lean toward unrealistic optimism; seeking to avoid regrets causes us to run with the herd, another obstacle to market success.
Prof. Sunstein spent a big chunk of his academic career as a law professor at the University of Chicago, before joining his former colleague, Mr. Obama, in Washington. The famed Chicago school of economics was all about rational choice theory and the efficient-market hypothesis, which led to some heated academic disputes between the old guard and the new behaviourial champions in the late 1990s.
"I do remember a time when the economists and economically oriented lawyers thought of behaviourial economics as a fad and as kind of trivial. I'm sure there are some people who think that [today], but they are few. The days of rational economic man are completely done."
Still, Prof. Sunstein says it would be a mistake to regard the traditional economists' view of how the world works as obsolete or irrelevant. "Students should learn about rational actor models," he argues. "It's not as if they are completely wrong. If the government imposed a tax of, say, $5 on voting, you would see less voting. That's rational behaviour."
Famed University of Chicago economist Gary Becker, a Nobel laureate, asserts that people respond to incentives. "That's essentially true," says Prof. Sunstein, who is the director of Harvard's behaviourial economics and public policy program. "So we have to figure out where the rationality assumption turns out not to be essentially true. We still need to learn a lot – and we will over the next 20 years – about exactly when the departures from rationality occur, when they're especially important and how they interact with one another."
Meanwhile, the best way to leave bad habits and emotions out of the investing equation is to build a diversified portfolio of assets across different classes and geographic regions, keep costs down, stick it out for the longer term and never act in haste, Prof. Sunstein says. "To get all excited by what seems like a coming boom or all depressed by what seems like a tough month can lead to undue trading."
That's his own investing formula, he says, adding with a smile: "I wouldn't take myself as an investment adviser."
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IN HIS OWN WORDS
Cass Sunstein
On why new financial rules are taking so long
"Rome wasn't built in a day, and this is the most important financial regulatory reform since the 1930s. If things are taking longer than anticipated, it's partly just a reflection of the difficulty of the task. It's better to do things right than to do them now."
On worsening political polarization
"Some of the polarization we observe in our societies is that you might get people who are to the left reading something and reacting in a way that fortifies their convictions. People on the right do exactly the same thing. And it's the same material. Each side …believes the stuff that supports their view and discredits the stuff the other way."
On the rise of simplification in business
"I expect we'll see a flowering of products, whether they're computers or tablets or cellphones, even credit cards and mortgages, that put a premium on ease of interaction and comprehensibility."
On consumer reforms
"In multiple domains, people are stuck with deals they didn't fully understand, whether it's late fees for credit cards or penalties associated with mortgages or [lack of] transparency with cellphone packages. … The notion is that if people are getting a mortgage or school loan, they should 'know before they owe,' so they aren't insufficiently informed about what the agreement they're entering into is. That can be a big safeguard against hardship."
On economic theory
"It is the case that the standard economic emphasis on the importance of incentives and their centrality to what happens is intact. …The rationality assumption is not all we need to know. But it is something we need to know."