Behavioral Finance 2.0

Behavioral Finance 2.0

The Journal of Portfolio Management
Summer 2012

Bob Jones*

Over the last decade or so, the findings of cognitive and behavioral psychologists have found their way into finance. No longer do we assume that all economic agents are rational actors only interested in maximizing marginal utility. Instead, they are just normal human beings with all of our cognitive foibles and faults, including overconfidence, loss aversion, reference points, emotional responses, positives illusions, confirmatory bias, framing, illusion of control, hindsight bias, availability, representativeness, outcome bias, preference reversal, and so on, and on, and on. It's amazing markets are as efficient as they are - or at least so hard to beat.
     The implications of these well-documented behavioral tendencies have yet to be fully realized in our profession. Behavioral economists have generally focused on how cognitive biases can distort market efficiency. They find that documented decision-making biases can explain many widely noted market anomalies, including excess volatility, excess trading, the value effect, the momentum effect, and bubbles and crashes.
     In fairness, however,  other theories can explain these anomalies too. Academics have yet to develop an accepted behavioral model that incorporates the effects of individual biases on capital market equilibrium - that is, how these biases aggregate in equilibrium - although I think Lo's adaptive market market hypothesis has potential. Markets are certainly competitive, as in hard to beat, but that doesn't necessarily mean they process information rationally or efficiently. Some open research questions include the following:

* Are markets informationally efficient, as in reflecting the expectations and preferences of fully rational participants with access to all public information known at the time? And how can we ever really know?

* Studies show that people with higher IQs often exhibit fewer/weaker cognitive biases. Do higher IQ investors have better investment results?

* Studies show that people make worse decisions when under stress. Do stress-reduction techniques result in fewer decision-making biases and improved investment performance?

* Is there any correlation between basic personality traits (e.g., extraversion, openness, conscientiousness, agreeableness, and neuroticism) and susceptibility to biases? If so, do certain personality types make better investors?

* Has information processing efficiency varied over time or cross-sectionally as a result of behavioral factors (e.g., learning to overcome biases), as opposed to, say, better disclosure rules, faster information dissemination, changing accounting standards, and the like?

* If so, has this led to any variation in economic efficiency  (i.e., what are the potential economic gains from reducing biases and improving information processing efficiency in capital markets)?

* Do different market structures, trading instrument, margin requirements, or trading rules have an impact on decision biases and thereby information processing efficiency?

     Practitioners have also just begun to consider the full implications of behavioral finance - both on their own business and those of the organizations in which they invest. Unfortunately, but predictably, we practitioners so far have used behavioral finance primarily in marketing - to explain why other investors make systemic investment mistakes and why our own approach can add value by taking advantage of the resulting inefficiencies.
     Practitioners, heal ourselves! It's time for us to start using the findings of cognitive psychology to improve our own decisions. The real potential of behavioral finance is not so much in helping us take advantage of others - after all, investor irrationalities may get diluted or cancel out in a broad, competitive market - but rather in helping all of us to make better, less biased investment decisions.
     Investors who are quickest and most zealous in this effort will reap the greatest benefits. Overcoming biases is not easy, but studies point to some  promising techniques, and the payoffs can be large. As more and more of us learn to overcome our biases, however, markets will become even more informationally efficient and harder to beat. Such is the nature of competitive markets; they adapt and learn, often quite quickly, with brutal consequences for those who lag behind. But there are virtuous consequences as well: Markets should become even more informationally efficient, leading to better capital allocations and greater economic growth.
     So what are the lessons of behavioral finance that we should all take to heart? First and foremost: we are all human and just as biased as the next guy. In his fascinating intellectual memoir, Thinking, Fast and Slow, the Nobel-prize winning behavioral economist, Daniel Kahneman, often makes this exact point: this means you (and me) too. None of us are immune to the cognitive irrationalities that affect our species - to think otherwise, however, is itself a pervasive human bias (overconfidence).
     So how will we know when behavioral finance has finally begun to realize its potential with practitioners? Here are a few signposts: We'll Know When....

* When - assets quit chasing past performance and investors start to pick funds and managers using relevant, predictive information.

* When - sponsors quit hiring managers based on who appeared most persuasive and (over) confident in a finals presentation.

 * When -  personal impressions from interviews become less important in hiring decisions for both managers and employees.

* When - investors stop letting the halo effect from a smooth or glib CEO affect their views of a company's prospects or valuation.

* When - managers who admit uncertainty are respected rather than dismissed.

* When - (tax exempt) investors no longer consider purchase price when deciding whether to sell a stock.

* When - committee chairs look for alternative views rather than consensus or take independent, blind votes on a topic before discussing it.

* When - important or complex decisions are based more on checklists and rules and less on intuition and holistic appraisals.

* When - quants start to realize that their models may be mis-specified, over-fit, or just one of many possible approaches to statistical forecasting.

* When - fundamental analysts begin to question company managements on their decisions and decision-making methods with an eye toward detecting potential biases.

* When - markets become less volatile, with less noise trading and fewer persistent anomalies.

     Will any of this happen tomorrow or even in our investment lifetimes? Maybe, maybe not. But the behavioral implications are clear, and those who fail to heed will face ever-increasing odds. It's time to start using behavioral finance as a mirror to find and fix our own blemishes, rather than as a magnifying glass to study the warts of yesterday's investors.


*Bob Jones is Chairman and CIO of System Two Advisors and Chairman of Arwen Advisors in Summit, New Jersey.