June 5, 2018

Behavioral finance is the study of traditional finance theories coupled with the study of psychology. Three Nobel Prizes in economics have been awarded to professors for their advances in behavioral finance. One of the recipients, Professor Daniel Kahneman of Princeton University, wrote a New York Times bestseller, Thinking, Fast and Slow, and was the subject of another, The Undoing Projectwritten by Michael Lewis. Reflecting the increased importance ascribed to the field, college courses in behavioral finance are now common at top universities across the United States. 

Traditional finance studies a fictional person known as “rational economic man,” an automaton who possesses perfect information and is able to perfectly process that information in order to reach his personal economic goals and, by the way, is also able to flawlessly adjust to new and contradictory information as it appears. Do you know anyone like that? Neither do I!

Behavioral finance studies what real people do and why they do it. Unlike traditional finance—which assumes that any deviation from rational economic man means that humans are irrational—behavioral finance assumes that we are rational and normal. It utilizes observed investor behavior, using things like actual studies of investors’ brokerage statements, in the hope of finding ways to optimize investing results going forward. It has been found that investors make errors that are consistent and predictable due to a variety of common biases.

"It has been found that investors make errors that are consistent and predictable due to a variety of common biases."

This article describes a few of these biases so we can be aware of them and hopefully minimize their impact on our investing efforts. The astute reader will notice these same biases are present in many other areas of human life. There is great value in being able to recognize and correct these biases in your thinking processes, but admittedly it is far easier to spot them in other people than it is to spot them in yourself!

The first behavioral bias we will discuss is overconfidence. Although well-founded confidence is a fine thing and is quite useful in many ways, studies have shown that many of us, including company CEOs, physicians, lawyers, students, and Wall Street analysts, are overconfident in their ability to predict the future. They maintain that overconfidence by only remembering their accurate forecasts while conveniently forgetting those that don’t turn out as they expected.

How does this overconfidence hurt investment returns? Overconfident investors tend to trade more frequently, purchase higher-risk stocks, and have under-diversified portfolios. These investors have a high level of conviction in their ability to make the right call at the right time. After all, if you just knew which stock would perform the best over the next few years, you would simply buy that one and diversification would be unnecessary. The only problem with that is, as the old saying goes, “the only thing difficult to predict is the future,” and most of us would not want to risk our future standard of living on a few high-risk investments.

Excessive trading also hurts long-term investment results. Professors Brad Barber and Terrance Odean studied 38,000 brokerage accounts and divided them into quintiles based on their level of portfolio turnover, which is the rate at which the investor bought and sold stocks. They found that those whose turnover was in the lowest 20% group had an 18.4% average annual return over the time period measured from 1991 to 1997 versus those whose turnover was in the highest 20% group and whose annual return was 11.5%, almost 7% lower per year. The study also did not reveal good results for men, who traded more often than women did and consequently showed lower portfolio returns.

Traditional finance also assumes that investors understand risk and return, and wish to earn the highest level of return available for the amount of risk they are willing to take. But surveys of investors show that investors’ perceptions of risk and potential returns change based on recent returns in the markets in which they invest. In February 2000, after a prolonged stock market rise, Gallup (a management consulting company known for the public opinion polls it conducts) polled investors as to whether it was a good time to invest in the financial markets; 78 percent said that it was. After the markets suffered a 50 percent decline over the next three years, Gallup asked the question again; this time, with much lower prices for investors to prospectively take advantage of, only 41 percent answered that it was a good time to invest. The same principle can apply to other investments as well, such as gold and real estate. Maybe former heavyweight champion Mike Tyson was right about not only boxing but also investors’ risk tolerance when he said about a vanquished opponent, “They all have a plan until they get hit.”

Traditional finance assumes that investors view their investments and wealth-producing ability as one unified whole, with all the elements fitting together perfectly and the risks and returns from each perfectly offsetting one another in order for an investor to safely reach their individual goals. Certainly that would be an optimal way for one to operate, but is that how people really manage their money?

Behavioral finance asserts that people often use mental accounting, with different pockets of money being saved for different purposes with different time frames, such as daily living expenses, college funding and retirement funding. Mental accounting leads to a pyramid-like approach to money management, with different layers of the pyramid representing different types of investments to serve their individual purposes. The base of the pyramid represents safer investments, such as cash and emergency funds, which are used in order to fund daily living expenses and to insure oneself against loss of income. Intermediate-term investments, such as college funding, might represent the next level of the pyramid, and are funded with more growth-oriented investments until the child gets closer to college age. Retirement funding would reside on the next and higher level, with even more growth-oriented investments in order to fund an even longer time frame. If there is money left over for the top of the pyramid, investors might select a few speculative “get-rich-quick” types of investments if they feel there will be no threat to their standard of living.

Though many Nobel Prize winners and finance professors might frown upon this pyramid approach and the mental accounting that leads to it as suboptimal, it works well for many people, and isn’t that the point? It is, after all, your money.

It is our hope that you have enjoyed our little trip into these few areas of behavioral finance and can utilize some of these principles to benefit your financial future. Clifford Swan’s investment team works hard through its due diligence processes in an effort to minimize these biases for the benefit of our clients. Those who might wish to delve deeper into these topics should consider reading the aforementioned Thinking, Fast and Slow or Finance for Normal People: How Investors and Markets Behave by Meir Statman.

Download Article: A Very Short Course in Behavioral Finance 

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