Morningstar Advisor - October/November 2009 - 33

Macro to Micro Breaking Behavioral Finance Down ers, however, have documented abundant evidence of irrational behavior and repeated errors in judgment by human subjects. Standard Finance and Homo Economicus Perhaps one hindrance to behavioral finance being widely used in advisory practices is a lack of a common understanding of what it is. There is a proliferation of topics resembling behavioral finance, such as behavioral economics, investor psychology, cognitive psychology, behavioral science, experimental economics, and cognitive science. To make behavioral finance easier to understand, and to differentiate the study of individual investor behavior from market behavior, I adopted an approach favored by traditional economics textbooks. I broke down the subject into two subtopics: micro and macro. Behavioral finance micro examines behaviors or biases of individual investors that distinguish them from the rational actors envisioned in classical economic theory. Behavioral finance macro detects and describes abnormalities in the efficient market hypothesis, such as technical and calendar anomalies. As financial advisors, our focus is on BF micro. We want to identify relevant psychological biases and investigate their influence on investors’ asset-allocation decisions so that we can manage the effects of those biases on the investment process. Each of these two subtopics corresponds to a distinct set of issues within the discussion of standard finance versus behavioral finance. With BF macro, the question is: Are markets efficient or are they subject to behavioral effects? With BF micro, the question is: Are individual investors perfectly rational or can cognitive and emotional errors affect 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 their decision-making process. Academic research- Standard finance theory is designed to provide mathematically elegant explanations for financial questions that, when posed in real life, are complicated by imprecise, inelegant conditions. The standard finance approach relies on assumptions that oversimplify reality. It 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 psychological phenomena at work in markets and in the heads of investors. Standard finance grounds its assumptions in idealized financial behavior; behavioral finance is grounded in observed financial behavior. For centuries, there has been a widely held belief that markets are “perfect.” In a perfect securities market populated with wellinformed investors, the theory says, investments are appropriately priced and reflect all available information. This idea is, at its core, the efficient market hypothesis. If a market is efficient, no amount of information or rigorous analysis can be expected to result in outperformance of a selected benchmark. A key assumption of the efficient market hypothesis 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. Another important part of standard finance is the notion of “homo economicus,” or rational economic humans, which prescribes that people make perfectly rational economic decisions at all times. Homo economicus is a simple model of human economic behavior. It assumes that principles of perfect rationality, perfect self-interest, and perfect information govern economic decisions made by individuals. Of course, these assumptions, in practice, are incorrect. Instead, people are subject to a concept known as ”bounded rationality.” They have limitations that hinder their decision-making. For example, people are not good at evaluating all their choices, calculating the probabilities of outcomes, and making perfectly optimal decisions. Rationality is not the sole driver of human behavior. In fact, many psychologists believe that the human intellect is 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. Many studies also 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 be unlikely to prevail as they have over centuries, and people would not perform unselfish deeds such as volunteering, helping the needy, and serving in the military. And it is impossible 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. Get Inside Their Heads The Biases Practitioners of behavioral finance want to understand these human behaviors, and the biases they create, and incorporate them into the investing process. When advisors have insights to the mental process that clients use to make decisions, they can tailor their advice in ways that help clients overcome their biases and become better investors. In the investment realm, behavioral biases are defined as systematic errors in financial judgment or imperfections in the perception of economic reality. Researchers have identified a long list of investor biases. For this article, I introduce 20 of the most common biases that I have encountered with clients and MorningstarAdvisor.com 33

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Morningstar Advisor - October/November 2009

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