Behavioral Finance and Behavioral Investing

Behavioral finance studies how to systematically take advantage of errors caused by human thinking and emotion. Behavioral investing, on the other hand, aims to cash in on the irrational investor. How is behavioral finance different from behavioral investing?

Some definitions:

• Behavioral Finance studies the interaction between finances and human psychology. It is, in essence, the study of heuristics and biases and why they cause misbehavior. It is the successor of modern portfolio theory, as we learned that neither the markets nor individual investors are genuinely rational. Behavioral finance is a sub-field of behavioral economics.
• Behavioral Investing, then, attempts to use behavioral finance to find and utilize inefficiencies in the market caused by emotional miscues. Questions to consider here: how do you measure the effects of heuristics and biases in prices, and how do you take advantage of them? An irrational investor does not understand behavioral finances.

Don’t be an irrational investor! But learn the truth—we all are!

So, how can you understand Behavioral Finance and thus profit from Behavioral Investing? Start with this: know that you, too, have the same biases and behavioral glitches as everyone else. Right?

Just like how people are different when it comes to losing weight.

 

Weight Loss and Behavioral Finance/Investing

Think about weight issues in modern society for a second. Everyone knows that you can eat less, exercise more, and thus obtain an ideal weight. Knowledge is not enough. That is like knowledge of Behavioral Finance.

Actually losing weight is behavioral investing. If we conceive how complicated weight is, we begin to understand why it is so easy to lose money.

Just like not everyone is cut out for losing weight, not everyone should be interested in behavioral investing, either.

 

Behavioral Investing

Behavioral investing is a style of investing that stems from an age-old battle in investment theory. The fundamental question: are investors mostly rational or irrational?

If they are irrational, then can you develop an investment thesis that profits from the irrational (and thus unpredictable) behavior? For example, are there predictable pricing distortions in the market due to investors’ emotional errors? Or, since they are irrational, do errant emotional responses not provide actionable investment theses?

Rational or irrational, this battle pits traditional modern portfolio theory (which argues that the market and individuals are rational) against behavioral finance (which argues that investors have inherent biases). Can either make you money?

Let’s look at behavioral investing and try to find “behavioral alpha,” that is, excessive returns derived from understanding people’s cognitive biases.

 

Understanding Behavioral Investing: The Central Thesis

The central thesis of behavioral investing is that to outperform the market average; you must understand behavioral finance. If people are irrational, which leads to price inefficiencies, how do you take advantage of the inefficiencies to improve investment performance?

The keys to the central thesis of behavioral investing:

1. How can you measure the price distortions caused by behavioral errors?
2. Once measured, can you consistently take advantage of them?

Before answering those key questions, let’s review traditional investment theory: modern portfolio therapy. From there, we can understand the age-old battle and the evolution of behavioral investing.

 

Modern Portfolio Theory and Bubbles

Modern portfolio theory (MPT) became the standard investing theory by 1980. At its core, there is the assumption that markets and people are rational. The theory is useful because it clearly defines inputs and allows modeling based on these rational (linear and non-adaptive) inputs. Markets are efficient, and people respond rationally to them.

Slowly at first, folks noticed that MPT could not model the foibles of the stock market of the 80s and 90s. Thus over time, Behavioral Finance is born.  [Nod to Kahneman and, of course, Richard Thaler (of Nudge fame)]

The damning truth is that MPT cannot explain bubbles, momentum investing, actual investor returns, or any number of phenomena seen in the stock market. Neurologist-turned finance guru William Bernstein decimates MPT in his books, but see especially his most recent book The Delusion of Crowds: Why People Go Mad in Groups.

QED: how are bubbles rational?

MPT remains necessary to model rational behaviors, but behavioral finance fills in the many gaps. The market is a complex, non-linear, and adaptive system better explained by behavioral Finance than MPT.

This is not just about just being contrarian—behavioral finance helps define herd mentality and why shortcuts in thinking (heuristics) and emotions (biases) cause assets to be mispriced

The explanatory power is strong—in theory.

 

Who Shouldn’t be a Behavioral Investor

Not everyone is cut out to be a behavioral investor.

What kind of investor are you? First, let’s group investors by type and then attempt to understand some basic heuristics and biases.

Let’s look at growth investing, value investing, dividend investing, MPT investing, and finally, behavioral investing:

 

• Growth Investing: the truth is 4% of stocks drive all of the return of the index (the other 96% return, on average, is the same as the risk-free rate). Stock pickers think that they can outperform the index by finding these needles in the haystack. For those who understand the evidence-based idea that the market gets the median return, for most, picking stocks is a fool’s errand. Not everyone is above average.
• Value Investing: You try to buy low and sell high (or never sell). Stocks can be cheap because they deserve to be or because they are a diamond in the rough. To have an advantage, you need to know the future or figure out which details matter in a financial statement. Nothing the DIY investor cares to do…
• Dividend Investing: perhaps the worst of both worlds, dividend investors believe that income is the answer. The short of the matter is dividend stocks are a non-optimal and tax-inefficient way to invest.
• MPT Investing: buy-and-hold the efficient frontier. This can get average returns, which is a great goal for DIY investors. If you can invest tax-efficiently and with low fees, your average returns will put you in the top quartile decade after decade.
• Behavioral Investing: the most difficult to do you need to understand where others fail and, more importantly, how you can take advantage of the irrational behavior. All while understanding and battling your heuristics and biases.

 

As a DIY investor drawn to complexity (see Rick Ferri’s Evolution of an Index Investor), I still think it is possible to do better than the market (which is described better by chaos theory than current models). Not by picking growth or value stocks and not by picking trends or sectors, but by understanding my weaknesses. There are many!

As humans, recency and overconfidence bias are firmly entrenched after a decade-plus bull market. Who has actually lost money in the last decade? Well, anyone not 100% invested in the S&P 500.

More critical than resulting and relying on what worked in the past (because it only works well until it stops working well), it is knowing your thesis for the next 5 or 10 years. Care to predict the future?

I predict that people will still have heuristics and biases 5 or 10 years from now.

So now, how do I profit from that prediction?

 

Behavioral Alpha—Investors (including you) will continue to have biases in the future

So, I hope you understand the theory—the one thing that won’t change—that people are irrational. Therefore, markets are made up of people and are also irrational.

Behavioral investing attempts to identify measurable and persistent distortions in prices. These data are derived empirically. From the data, what strategy can you use to take advantage of other people’s irrationality?

Understand there is positive behavioral alpha to be found if you reject MPT and use behavioral finance as the underpinning of your long-term portfolio. Separate your long-term portfolio (via mental accounting) and ignore volatility! Risk is not volatility; it is not meeting your investment goals.

 Summary—Behavioral Finance and Behavioral Investing

In Summary, there is behavioral alpha in the market. Both negative (chasing returns, worrying about volatility in long-term portfolios) and positive (understanding and meeting your long-term goals).

You can look for it in the investment to select (behavioral investing), the funds that you don’t pick (those active funds that will likely underperform indexes), and also in you.

Yes, you are irrational, too. You have heuristics and biases, but honestly, it is easier to see them in others than it is to see them in ourselves. Remember, you can be an excellent DIY Physician investor!

 

That people are—and will remain—irrational seems to be given. Given that irrationality is unpredictable, positive behavioral alpha is hard to come by.

One way to profit is to wall off your long-term investments and don’t concern yourself with short-term volatility. Easier said than done?

So, can a DIY investor use behavioral investing to meet long-term goals? Yes! It is as easy as losing weight.