How One Can Apply Behavioral Finance
by C. Thomas Howard, PhD, 26th March 2018
Just some extracts here (full text under link below).
"We have to distance ourselves from the presumption that financial markets always work well and that price changes always reflect genuine information...The challenge for economists is to make this reality a better part of their models."
Robert Shiller, "From Efficient Markets Theory to Behavioral Finance"
Professor Shiller wrote those words in 2003. Ten years later he received the 2013 Nobel Prize in Economics for his pioneering behavioral finance research, sharing the prize with Lars Peter Hansen and Eugene Fama. Naming Fama as co-recipient created a Machiavellian buzz in anticipation of the award ceremony, as Shiller had described Fama's efficient market hypothesis (EMH) as "the most remarkable error in the history of economic thought."
Who says the Nobel committee didn't have a twisted sense of humor?
The shift to behavioral finance received a further boost in 2017 when the Nobel Prize in Economics was awarded to Richard Thaler of the University of Chicago, also home to Fama. Throughout his career, Thaler focused on the cognitive errors made by individuals and how government and business policy can be revised in order to "nudge" people to make better decisions. Thaler and Fama are good friends and regularly play golf together. Most likely the EMH joins religion and politics as taboo topics while enjoying a friendly round!
Today, behavioral finance appears everywhere in the financial services industry.
The 15 years since Shiller's statement above has seen an avalanche of new academically verified pricing anomalies, further challenging the notion "that price changes always reflect genuine information." This has gotten to the point that we have to wonder if collective cognitive errors are the primary drivers of investment returns, displacing new information as the most important driver.
A behavioral framework
Viewing investors and markets as emotional decision makers rather than as rational computational entities forces us to reconsider every aspect of how we operate in financial markets. The behavioral financial markets (BFM) concepts I discuss below provide a framework for rethinking asset allocation & Co.
Shifting to a behavioral perspective is the first step in becoming a behavioral financial professional. It might seem like a radical step, but really it is just the formal recognition of the obvious. Wisdom is seeing the world for what it is, not what we would prefer it to be. After recognition comes a formal transition to improved analytic tools, some of which I will discuss.
As Shiller suggests, it is time to move away from the EMH, one of the pillars of modern portfolio theory (MPT), to a more promising alternative, behavioral finance. Behavioral finance's more realistic representation of financial markets and human behavior will eventually replace MPT as the paradigm of choice.
People understand the world by means of stories. The more detailed the story, the more believable it becomes in the eyes of the public. Interestingly enough, more detailed stories are much more likely to be wrong, highlighting one of the many cognitive errors so frequently observed.
So, if we're asked by clients why the market, a stock, or other security moved the way it did on a particular day, the correct answer is almost always, "I have no idea." Unsettling as this may be, it is the consequence of the first BFM concept: emotions - not fundamentals - are the main movers of financial markets (IN THE SHORT RUN !!).
When asked such a question, I respond as follows: "I have no idea why the market went down today. Some days it goes up and some days it goes own and I don’t know why. But I do know 55/65/75: the stock market produces a positive return in 55% of days, 65% of months, and 75% of years. I like those odds and so I keep playing this game over and over!"