Behavioral Finance—Nothing New Under the Sun

January 29, 2012

This article was originally published in Arab Times

 

According to a recent survey, an overwhelming majority of members of the CFA Society of the UK believebehavioural analysis is a useful addition to modern portfolio theory but is insufficient to replace it. Following an earlier article in the Financial Times (FTfm supplement) Stephen Horan, CFA, head of professional education content and Mandagolathur Raghu, President of CFA Kuwait CFA discuss the role of behavioral finance in investment decision making.

 

The GCC stock market has for a long time depicted behavioral biases swinging between irrational exuberance and deep remorse. The speculative character of the market combined with lack of institutional investors lends itself to this problem. Retail investors in the region exhibit wild mood swings and distort valuation based pricing even during the medium term. This article aims to clarify certain recent trends in behavioral finance and how an understanding of this evolving subject can be useful for GCC investors.

 

What is behavioral finance?

 

Behavioral finance combines the classical theories of economics and psychology. In essence, it attempts to explain deviations from the standard view that economic actors make purely unemotional or rational decisions. In forecasting, for example, investors tend to be overly confident in their accuracy, place undue emphasis on recent experience, and anchor their expectations using others’ predictions. 

 

How long has the field existed?

 

It is often traced back to the late 1970s when academicians such as Daniel Kahneman, Amos Trversky, Robert Shiller, Hersh Shefrin, Richard Thaler and Meir Statman started researching investor decision making in a robust manner. As far back as 1934, however, in the first edition of Security Analysis, Ben Graham referred to investors having “unlimited optimism” followed by periods of “deepest despair.”

 

Around that same time, John Maynard Keynes spoke of “instability due to the characteristic of human nature that a large part of our positive activities depend on spontaneous optimism rather than on mathematical expectation.” Behavioral economists refer to this as optimism bias.

 

What role has behavioral finance played in the investment landscape?

 

The principles of behavioral finance do not lend themselves to mathematical modeling because they are typically advanced in the form of cognitive biases. Recognizing, for instance, that investors are often overconfident in their abilities does little to help them determine whether a particular asset (or the market) is over or undervalued.

 

Whether they are an accurate depiction of reality or not, most classical valuation and macroeconomic models are based on the assumption that investors are purely utility maximizing rational decision makers. The weakness of these models is that they often suffer from the illusion of precision. Although not suffering from the illusion of precision, at the opposite extreme, behavioral finance is extremely difficult to model.

 

What are the latest developments?

 

Recently, researchers have been using MRI technology to map the neurological reactions investors have to making a profit, suffering a loss, confirming an expectation, or experiencing a surprise. This fascinating research, called neuroeconomics, shows that reactions in the brain to some investment experiences can be similar to when an addict takes drugs or a gambler wins a bet. 

 

The field is also benefiting from evolutionary biology insights that help explain how heuristics, which can sometimes lead to “irrational” decision making, play a critical role in survival because they help peopleefficiently avoid catastrophic outcomes.

 

What are some remaining challenges?

 

Behavioral finance still lacks a set of unifying principles that tie together observations of human behavior and brain activity in a way that not only explains behavior but can also be used to model corrective action or profitable trading opportunities. 

 

Does behavioral finance create profitable trading opportunities?

 

Yes, in fact, many mutual funds exist that implement some level of behavioral finance in their investment strategies. A 2008 study of these funds in the Journal Investing, however, found that they did not generate abnormal returns during the period examined.

 

At its core, the discipline of value investing is largely based on behavioral finance principles. Implementing a strict value-based or contrarian investment philosophy can require exceptional fortitude, especially in volatile markets when it might be difficult to convince one’s investors’ of its wisdom.

 

What lessons can investors draw from behavioral finance?

 

Individuals can learn that they are susceptible to overreactions in both bull and bear markets. The best way to stay focused on a long-term investment strategy is to document it in an investment policy statement along with an investor’s return requirements, risk tolerance, and investment constraints. It can then serve as a useful reference in both quiescent and turbulent markets.

 

What are the lessons for fund managers?

 

First, managers might consider maintaining liquidity, limiting leverage, and creating other cushions in anticipation of possible market stress. If “irrational” investor behavior creates opportunistic mispricing, it may take considerable time to dissipate and may get worse before it gets better.

 

Second, even if strict behavioral finance investment strategies are not highly successful, managers might augment their existing strategies to avoid herding, overreaction, regret aversion, and other behavioral biases that interfere with their effective implementation. For example, a diverse investment committee can help to encourage fresh ideas and minimize groupthink; and procedures to measure, monitor, and control some behavioral biases can help improve decision making.

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