Fellow investors, 

Somebody recently asked me what I do for a living. I instantly blurted out, “I try to figure out why smart people do stupid things with their money.”

That’s old news to Richard Thaler and Alex Imas. Thaler won a Nobel prize in economics in 2017 for his research into the limits of rationality and self-control. Imas is a rising star who studies behavioral economics at the University of Chicago.

Together, they’ve updated Thaler’s classic 1992 book, The Winner’s Curse. A new edition comes out Oct. 21.

Over the past few weeks, I’ve had the pleasure of chatting online with Thaler and Imas about the question that, frankly, unites us all: Why do we do stupid things with our money?

Here are highlights from our conversation.

Zweig: Many investors like to buy investments with huge dividend yields. They don’t seem to notice that they’re losing money on the principal. What would you advise these people?

Thaler: It took a long time for universities and foundations to learn this lesson. They used to hold lots of bonds and high dividend stocks, spending the “income” and leaving the principal alone. Eventually they realized it was better to set a spending rule such as: Spend (say) 4% of a moving average of wealth and then invest to maximize long-run returns. (Whether they have done that latter part well is another story.) But my advice is to keep your investment strategy separate from your spending rules.

Zweig: In other words, if you need regular income, you don’t have to invest in a risky “high-income” fund? You should focus on total return and simply withdraw what you need from a safer fund, whether it’s income or principal?

Thaler: That’s right.

Zweig: We all hate to lose money, and being reminded of our short-term losses can distract us from our pursuit of long-term gains. What are the likely effects of Robinhood and other brokerage apps that provide continuous pricing updates, as well as streaming alerts and notifications?

Imas: These apps seem to exploit a host of behavioral biases—myopia, self-control problems, loss-chasing, preference for lottery-like stocks—to get people to invest in very sophisticated financial products. As our colleague Taisiya Sikorskaya finds, one of the most popular financial products on Robinhood are weekly options, which have lottery-like characteristics. These options also happen to have the biggest bid-ask spread, which is how Robinhood makes its money. [Her research suggests that] retail traders [have suffered] upwards of $2 billion in losses over a two-year period and $6.4 billion in trading costs. Maybe we need to refine that old saw to say: “There’s no such thing as a free trading app”?

Zweig: Is the speculation we've seen over the past few years in "meme stocks," crypto and leveraged single-stock ETFs something new, or just the latest manifestation of old speculative behaviors?

Imas: We’ve certainly seen such speculation before. Some of the first "meme stocks” were Dutch tulips during the so-called “tulip mania” of the 1630s. If you read history, we see cycles where bubbles are the rule rather than the exception.

Everyone knew [the 1720 South Sea speculation] was a bubble, but they were just betting that enough other suckers would buy that they could sell before the bubble popped.

Just like today, people thought they’d make quick money by buying something that everyone else was buying. Of course, it all eventually came crashing down, and many were left holding the bag.

The main difference between then and now is the presence of the internet.

Forums like WallStreetBets allow people to coordinate their actions on a massive scale. Bubbles typically burst when some people start selling and others can’t viably coordinate in holding the position. [But] phrases like “diamond hands” inspire people to collectively hold a position for much longer than before information technology was so widespread.

Second, the internet allows many more assets to become bubbles in the first place. It now can take only a small group of people coordinating on stocks like Kohl’s or AMC to start what seems to be a trend.

The end result is many more bubbles that will potentially last longer than in previous periods.

Zweig: Why are investors so reluctant to sell until they get back to “breakeven,” or what they paid in the first place?

Imas: People react quite differently to realized outcomes compared to paper [gains and losses].

This leads to all sorts of interesting patterns, including the disposition effect (the greater willingness to sell winners than losers). Another is the motivation to chase losses: If I’m in the hole and want to avoid realizing a loss, I could just take on more risk in hopes of getting back in the black.

This tendency to chase losses leads people to make riskier investments they would otherwise avoid. They would be well advised to follow the sound advice: “When you’re in a hole, stop digging.”

Zweig: So how can investors improve their procedures for cutting losses and letting winners ride?

Imas: One straightforward way is to slow down the investment process. Time naturally puts distance between yourself and the reference point [your purchase price], which mitigates this motivation to chase losses and realize gains.

Thaler: Another way is to delegate the process to someone else. There are investment products that automatically “harvest” losses for their tax benefits, replacing those investments with other similar stocks, or just wait to re-buy while delaying the sale of winners as long as possible. Notice how much nicer “harvesting” losses sounds than “taking” or “absorbing” losses. Good advice requires careful choice of words.

Zweig: Is there a better way to get people to commit to long-term buy-and-hold investing?

Thaler: The data suggest that very few individual investors should be trading individual securities. If most mutual funds cannot do better than their benchmark, why should an amateur think they can do it? It’s fine to have investing as a hobby, but treat it that way. Put the vast majority of your investments into well-diversified portfolios, and if you like to “play the market” don’t risk more than you would on a new e-bike or set of golf clubs.

Zweig: What are your favorite practical applications of behavioral economics? And what’s left to be solved?

Thaler: Well, the creation of high-quality, low-fee target-date funds as the default investment vehicles [in 401(k)s] has been a big deal. As recently as the George W. Bush administration, it was not permissible to have a default investment product in a retirement account that could go down in value, so investors were defaulted into money-market accounts in an era with low interest rates.

Still, two major changes are needed. First, many American workers still don’t have a retirement savings plan at their workplace, and [people often] find it very difficult to reliably invest unless the money is taken from their paycheck before they can spend it. Several states have adopted plans to fix this, but it is crazy that we do not have a national plan. The U.K. has a plan worthy of our attention.

Second, our current system does not work well for workers who change jobs often. Employer contributions may not be vested, and the worker’s savings often gets cashed out (and spent) if the balance is modest. A national retirement plan depository where small account balances could be automatically rolled over and then be available for transfer into a new employer’s plan or for further contributions would be a major improvement for many low- to middle-income workers.

Alexander Hamilton’s plan to restructure the U.S. debt was approved by Congress in 1790. In the Sept. 9 issue of this newsletter, in the item about Abigail Adams, I incorrectly gave the date as 1791. Thanks to financial historian Richard Sylla of New York University for catching my error.

Be well and invest well,

Jason

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Reason’s last step is the recognition that there are an infinite number of things which are beyond it.
—Blaise Pascal

In The Intelligent Investor, Jason Zweig writes about investment strategy and how to think about money. To send feedback, reply to this email or send a note to intelligentinvestor@wsj.com. Sign up to get an email alert every time Jason publishes a column. Got a tip for us? Here’s how to submit.

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