MODERN PORTFOLIO THEORY
BEHAVIORAL FINANCE
MEET BEHAVIORAL FINANCE
Advocates of behavioral finance-sometimes known as behavioral economics or investor psychology- have spent nearly 50 years exploring the investment decisions people make and why they make them.
BEHAVIORAL FINANCE
Shortcuts to Choice
The Pain of Loss
Framing Decisions
Opening Mental Accounts
These researches and practitioners have observed, for example, that people often:
Most of this isn't news to you, and you could probably add several items to a list of illogical investment decisions. What you may not know is why investors act in the ways they do. That's why becoming familiar with the psychological and physiological perspectives that behavioral finance provides can help make you more effective at recognizing and dealing with the conflicting emotions that underlie many poor investment decisions.
If you can help your clients recognize the reasons they make some of the choices they do, they may make better ones. That's one reason why behaviorism, according to recent Nobel laureate Daniel McFadden, "is a fundamental re-examination of the field. It's where gravity is pulling economic science."
Intuition and emotion play a major role in decision-making.
The origins of behavioral finance are rooted in cognitive psychology, which is the study of how people learn, what they know, and how they act on what they know.
As the field evolves, its focus has been and continues to be on two related phenomena:
Those interests are built on the four cornerstones of the field: an understanding of heuristics, prospect theory, and the concepts of framing and mental accounting.
Amos Tversky and Daniel Kahneman, psychologists whose research laid the groundwork for behavioral economics, concluded after investigating decision-making in a variety of settings, that many people use heuristics, or mental shortcuts, to arrive at intuitive conclusions based on limited and often unreliable information.
When these findings were published in 1973, they evoked outrage in some quarters- and accusations that Tversky and Kahneman were arrogantly condemning people for not thinking straight. But further study has confirmed not only the existence of mental shortcuts but also their impact on decision-making.
Kahneman himself elaborated on this idea in 2002 when he observed that human judgments can be produced in two ways: one a "rapid, associative, automatic and effortless intuitive process" and the other "slower, rule-governed, deliberate, and effortful." The second judgment process, he says, recognizes that the first approach sometimes results in errors and may or may not overrule it.
In 1979, Tyversky and Kahneman published a similarly groundbreaking study of the powerful impact that aversion to loss on people's financial decision-making.
In one of the experiments conducted in their research, one group of participants was told they had $1,000 and were asked to choose between (a) a sure gain of $500 and (b) a 50% chance to gain additional $1,000 and a 50% chance to gain nothing.
A second group was told they had $2,000 and were asked to choose between (a) a sure loss of $500 and (b) a 50% chance to lose $1,000 and a 50% chance to lose nothing.
The results of either choice posed to the two groups are identical: in choice (a), participants end up with $1,500, and in choice (b) they end up with either $2,000 or $1,000. Despite the identical end results for the first and second groups, 84% in the first group selected the known gain (option a) rather than risk a loss (option b). But in the second group, 69% chose option (b) indicating that they were willing to assume the greater risk of losing $1,000 rather than face the certain loss of $500, a result that has been validated in subsequent tests. The study generated years of additional investigation and more evidence about why investors behave the way they do. One of the key findings was that prospective losses bother investors much more than prospective gains please them.
According to Kahneman, their work on this topic, which they labeled "Prospect Theory," also made it irrefutably clear that the choices people make are based on their subjective version of the situation, not on some objective reality.
It's not what you say, it's how you say it. This adage has taken on new meaning in behavioral finance where it is becoming increasingly clear that the ways in which alternatives are presented to people can make substantive differences in the financial choices they make. The way that things are presented is known as framing.
One often noted example of framing involved representatives of the credit card industry who, faced with justifying higher charges for purchases made by card than those paid for in cash, preferred to account for the price differential as a cash discount rather than what it really was- a surcharge to help cover credit processing fees.
Richard Thaler, the economist who first discussed the impact of framing, also pointed out that how people hear what is said, as well as how alternatives are framed, impacts the decisions they make. Typically, their perceptions are influenced by their recent past experiences, associations, intuitions, and a range of other factors that may or may not include a conscious effort to make a rational decision.
The concept of mental accounting, which Thaler called narrow framing, describes an approach many people use to organize their financial assets in their minds, creating separate compartments for money they've designated for specific purposes and refusing to mix and match. For example, they might segregate what they need for living expense in one mental account, money to buy a home in another, money invested for specific long-term goals in a third, and money for vacations in a fourth.
When mental accounting works, it keeps investors from borrowing from their 401 (k) account to spend it on a vacation. But being too rigid can lead to poor choices, sometimes involving significant amounts of money. For example, there is the often-cited case of a person who chooses to finance a car rather than purchase it outright with money available in a savings account because the account has been designated for another use in a mental accounting system.
As an advisor, you might point out that a client who has the discipline to repay a lender could borrow the purchase amount from his or her savings and repay part of the principal plus market-rate interest each month. But you might have to overcome the objections of a mental accountant to succeed.
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