Cannon Financial Institute

Applied Behavioral Finance: An Introduction

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We all have seen a miraculous recovery in asset prices in the wake of the GFC (global financial crisis).  But we should not forget that in the eight years prior to then we saw two of the four worst bear markets of the last 100 years.  In 2008-2009, estimates of upwards of $15 trillion in asset values evaporated, wiping out capital gains earned in the bull markets of both the 1990’s and 2000’s. 

Clients were shell-shocked, often frozen like deer in the headlights as to what to do.  And just as history has shown markets are cyclical, another bear market will occur again; it’s just a matter of time.   When times are good, like we’ve had for the past seven years, our skills as financial professionals can get “dull” because we haven’t had to deal with panicky, stressed-out clients.  But it is crucial to “stay on top of your game” and keep your skills sharp.  That is what these articles are all about – keeping sharp and doing the best possible job we can for our clients by incorporating behavioral finance into our practice.  I’ve been doing so for over fifteen years and it has paid large dividends for me.  In this article I will review the background of why we should incorporate behavioral finance into our practice and will provide an overview of the subject.

Background

Basic risk-tolerance questionnaires have failed to profile adequately the true character and needs of private clients.  Understanding how investors make investment decisions is no longer a “nice to have” skill.  In this new era of volatile markets, financial advisors are now required to be able to diagnose irrational behaviors and advise their clients accordingly.  Don’t believe it?  Consider that many top advisors across the globe were already applying behavioral finance to their practices even before the crisis.   Several years ago, I surveyed 290 sophisticated financial advisors[1] in 30 countries asking them about their interest in and use of behavioral finance with their clients.  Ninety three percent of advisors surveyed reported that they were aware of key behavioral finance biases and 94% were using behavioral finance principles with their clients.  Some less experienced and quantitatively oriented advisors, however, are needlessly struggling with understanding their clients’ behavior.  This article introduces a foundation of behavioral finance knowledge.  More advanced topics such as identifying behavioral investor types (BITs), the subject of another article in this series , will be a much easier to comprehend. 

We begin with a review of the two main branches of behavioral finance, behavioral finance macro and behavioral finance micro.  Next, we compare standard finance, which stands on principles of rational behavior of individuals and markets to behavioral finance, which examines how humans actually behave.  After that, we discuss the foundation of the practical application of behavioral finance:  the irrational biases that clients display.  We conclude with a summary of the role of behavioral finance in dealing with private clients and how it can enhance the advisory relationship.

Behavioral Finance Micro (BFMI) vs. Behavioral Finance Macro (BFMA)

Even though the term “behavioral finance” – generally defined as the application of psychology to finance - appears regularly in books, magazine articles, and investment papers, many investors and advisors lack a common understanding what it is. This lack of understanding may be due to a proliferation of topics resembling behavioral finance, such as: behavioral economics, investor psychology, cognitive psychology, behavioral science, experimental economics and cognitive science.  To make the subject easier to comprehend, and to differentiate the study of individual investor behavior from market behavior, I adopted, about 10 years ago, an approach favored by traditional economics textbooks by breaking down the topic down into two subtopics: Behavioral Finance Micro (BFMI) and Behavioral Finance Macro (BFMA).  BFMI examines behaviors or biases of individual investors that distinguish them from the rational actors envisioned in classical economic theory.  BFMA detects and describes abnormalities in the efficient market hypothesis, such as technical and calendar anomalies.  As wealth management practitioners, our primary focus is BFMI. Specifically, we want to identify relevant psychological biases and investigate their influence on asset allocation decisions, so that we can manage the effects of those biases on the investment process.

Each of these two sub-topics corresponds to a distinct set of issues within the standard finance versus behavioral finance discussion. With regard to BFMA, the question is: are markets “efficient,” or are they subject to behavioral effects? With BFMI, the question is: are individual investors perfectly rational, or can cognitive and emotional errors impact their financial decisions?  It is critical to understand that much of today’s economic and financial theory is based on the notion that individuals act rationally and consider all available information in the decision-making process. However, academic researchers have documented abundant evidence of irrational behavior and repeated errors in judgment by adult human subjects. The next section will review the two basic concepts in standard finance that behavioral finance disputes: rational economic man and rational markets. It will also cover the basis on which behavioral finance proponents challenge each tenet and discuss some evidence that has emerged in favor of the behavioral approach. 

Efficient Markets vs. Irrational Markets And Rational Economic Man vs. Behaviorally Biased Man

Standard finance theory is designed to provide mathematically elegant explanations for financial questions that, when posed in real life, are often complicated by imprecise, inelegant conditions. The standard finance approach relies on a set of assumptions that tend to oversimplify reality.  Standard finance is built upon rules about how investors “should” behave rather than how they actually behave. Behavioral finance, on the other hand, attempts to identify and learn from the human psychological phenomena at work in financial markets and within individual investors. Standard finance grounds its assumptions in idealized financial behavior; behavioral finance, in observed financial behavior.   

Efficient Markets vs. Irrational Markets

There is a widely held belief, going back to the turn of the 19th century, that markets are “perfect.”  By perfect we mean that in a securities market populated by many well-informed investors, investments will be appropriately priced and reflect all available information.  This idea is, at its core, the efficient market hypothesis (EMH).  The crux of EMH is that if a market is efficient, no amount of information or rigorous analysis can be expected to result in out-performance of a selected benchmark. An efficient market can be defined as a market wherein large numbers of rational investors act to profit-maximize in the direction of individual securities. A key assumption is that relevant information is freely available to all participants. This competition among market participants results in a market wherein, at any point in time, prices of individual investments reflect the total effects of all information – including information about events that have already happened, as well as events that the market expects to take place in the future. In sum, at any given time in an efficient market, the price of a security will match that security’s intrinsic value.   There are three forms of market efficiency:  The "Weak" form contends that all past market prices and data are fully reflected in securities prices; technical analysis is of little or no value. The "Semistrong" form contends that all publicly available information is fully reflected in securities prices; fundamental analysis is of no value.  Finally, the "Strong" form contends that all information is fully reflected in securities prices; insider information is of no value.

Rational Economic Man vs. Behaviorally Biased Man

Another important part of standard finance is the notion of “Homo Economicus,” or rational economic man, which prescribes that humans make perfectly rational economic decisions at all times.  Homo Economicus is a simple model of human economic behavior, which assumes that principles of perfect rationality, perfect self-interest, and perfect information govern economic decisions made by individuals.  Perfect rationality assumes that humans are rational thinkers and have the ability to reason and make beneficial judgments at all times. However, rationality is not the sole driver of human behavior. In fact, many psychologists believe that the human intellect is actually subservient to human emotions such as fear, love, hate, pleasure, and pain and that we use our intellect only to achieve or avoid emotional outcomes.  Perfect self-interest is the idea that humans are perfectly selfish. Many studies have shown that people are not perfectly self interested. If they were, philanthropy would not exist. Religions prizing selflessness, sacrifice and kindness to strangers would also be unlikely to prevail as they have over centuries. Perfect self-interest would preclude people from performing unselfish deeds such as volunteering, helping the needy, or serving in the military. Having perfect information assumes that people possess perfect or near-perfect information on certain subjects.  It is impossible, however, for every person to enjoy perfect knowledge of every subject. In the world of investing, there is nearly an infinite amount to know and learn, and even the most successful investors don’t master all disciplines.

The Foundation Of Practical Application Of Behavioral Finance :  The Biases

The dictionary defines a bias as “a preference or an inclination, especially one that inhibits impartial judgment or an unfair act or policy stemming from prejudice.”  In the investment realm, behavioral biases are defined as systematic errors in financial judgment or imperfections in the perception of economic reality.  Over the past 25 or so years, researchers have identified a long list of investor biases.   In this section, we introduce twenty of the most common biases that are encountered with actual clients and which type each bias is:  cognitive or emotional.  Table 1 briefly describes twenty of the most common biases.

Table 1:  Twenty common behavioral biases

Endowment (Emotional)—Irrationally holding onto an investment regardless of a possibly poor expected outcome.

Loss Aversion (Emotional)—Feeling the pain of losses more acutely than the pleasure of gains.

Status Quo (Emotional)—Choosing whatever available option will keep conditions as they are.

Regret (Emotional)—Avoiding a decision because of a fear of poor results.

Anchoring (Cognitive)—Clinging to arbitrary pricing levels when considering an investment.

Mental Accounting (Cognitive)—Treating various sums of money differently based on how one mentally categorizes them.

Recency (Cognitive)—Over-emphasizing, and extrapolating from, those events that are most recent.

Hindsight (Cognitive)—Perceiving that the eventual outcome of an event was predictable, even when it wasn’t.

Framing (Cognitive)—Being unduly influenced by the context in which a choice is presented, and thereby excluding other crucial factors in the decision.

Cognitive Dissonance (Cognitive)—Making a poor decision despite evidence that the decision is a bad one.

Outcome (Cognitive)—Focusing on the outcome of an event rather than the process used to achieve the outcome.

Conservatism (Cognitive)—Clinging to an initial forecast despite updated information.

Availability (Cognitive)—Estimating the probability of an outcome based on its prevalence one’s life.

Confirmation (Cognitive)—Seeking out information that supports a preferred position, while avoiding information that undercuts the position.

Representative (Cognitive)—Letting pre-existing ideas unduly influence how new information is processed.

Self-Attribution (Cognitive)—Ascribing successes to innate talents, and blaming failures on outside influences.

Overconfidence (Emotional)—An unwarranted faith in one’s abilities or thinking.

Self-Control (Cognitive)— Spending today at the expense of saving for tomorrow.

Affinity (Emotional)— Making investment decisions based on companies or investments that are compatible with one’s own world view.

Illusion of Control (Cognitive)—Believing that one can influence events that are actually out of one’s control.

Differences Between Cognitive And Emotional Biases       

Both cognitive and emotional behavioral biases yield irrational judgments.  Understanding the differences between cognitive and emotional biases is important because advisors will want to advise emotionally-biased clients differently than cognitively-biased ones.  These concepts will be explored more fully in future articles

A cognitive bias can be technically defined as basic statistical, information processing, or memory errors that are common to all human beings.  They can also be thought of as “blind spots” or distortions in the human mind.  Cognitive biases do not result from emotional or intellectual predisposition toward certain judgments, but rather from subconscious mental procedures for processing information.  Because cognitive biases stem from faulty reasoning, better information and advice can often correct them.  On the opposite side of the spectrum are emotional biases.  Although emotion has no single universally accepted definition, an emotion is a mental state that arises spontaneously rather than through conscious effort.  Emotions are physical expressions, often involuntary, related to feelings, perceptions or beliefs about elements, objects or relations between them, in reality or in the imagination. Emotions can be undesired to the individual feeling them; he or she may wish to control feelings, but often cannot.  Investors sometimes make emotionally biased investment decisions, and may make sub-optimal decisions by having emotions affect these decisions.  Often, because emotional biases originate from impulse or intuition rather than conscious calculations, they are difficult to correct.   

How Practical Application Of Behavioral Finance Can Create A Successful Advisory Relationship

Wealth management practitioners have different ways of measuring the success of an advisory relationship. Few could argue that every successful relationship shares a few fundamental characteristics. Understanding how investor psychology impacts investment outcomes will generate insights that benefit the advisory relationship.  We will explore four characteristics of a successful advisory relationship and how behavioral finance can help:

Understanding Financial Goals

Experienced financial advisors know helping a client create his or her financial goals is critical to creating an appropriate investment program. To best define financial goals, it is helpful to understand the psychology and emotions underlying the decisions behind creating these goals.  Such insights equip the advisor in deepening the bond with the client, producing a better investment outcome and achieving a better advisory relationship.

Maintaining a Consistent Approach

Most successful advisors exercise a very consistent approach to delivering wealth management services. Incorporating the benefits of behavioral finance can become part of that discipline, and would not mandate large-scale changes in the advisor’s methods. Behavioral finance can also add more professionalism and structure to the relationship because advisors can use it in the process for getting to know the client, which precedes the delivery of any actual investment advice. 

Delivering What the Client Expects

Perhaps there is no other aspect of the advisory relationship that could benefit more from behavioral finance. Addressing client expectations is essential to a successful relationship; in many unfortunate instances, the advisor doesn’t deliver the client’s expectations because the advisor doesn’t understand the needs of the client. Behavioral finance provides a context in which the advisor can “take a step back” and attempt to understand the motivations of the client.

Ensuring Mutual Benefits

It is well-known by experienced individual investor advisors that investment results (unless abysmal) are not the primary reason that a client seeks a new advisor. The number one reason that practitioners lose clients is that clients do not feel as though their advisors understand, or attempt to understand, the clients’ financial objectives – resulting in poor relationships. The primary benefit that behavioral finance offers is the ability to develop a strong bond between client and advisor. By getting “inside the head” of the client and developing a comprehensive grasp of his or her motives and fears, the advisor can help the client to better understand why a portfolio is designed the way it is, and why it is the “right” portfolio for him or her – regardless of what happens from day to day in the markets.

Readers should now have a fundamental understanding of behavioral finance concepts and how behavioral finance can enhance the client-advisor relationship.  You should now be more comfortable with moving on to more advanced behavioral finance topics to enhance their advisory practice.

[1] In order to be “eligible” to receive a survey invitation, advisors needed to have some kind of advanced professional or academic designation – an MBA, CPA, CFA, CFP or other professional accomplishment.

To learn more on this topic, register for our Certificate in Applied Behavioral Finance course or learn more about our other offerings at www.cannonfinancial.com.

Copyright ©2015 Michael M. Pompian - All Rights Reserved

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