By Michelle M. Waymire :

You're likely no stranger to behavioral finance -- it's been around since the 1980s, taking on even greater significance in the wake of the 2008 financial crisis. But as is the case with most interdisciplinary fields, it can be a rather elusive concept to define. As such, this post is the first in a series of six that will attempt to help financial advisors better understand the area of study, its applications for making good investment decisions, and implications for better understanding and serving your clients.

When asked the question, "What is behavioral finance?", my usual tongue-in-cheek response is, "It's the bastard child of traditional finance and psychology." In truth, that's a rather simplistic view, as the field has grown to encompass not just finance and psychology, but also behavioral economics, experimental economics and sociology.

Behavioral finance has informal origins dating back to Selden's 1912 Psychology of the Stock Market , as well as Fessinger's 1956 study of cognitive dissonance and Pratt's 1964 discussion of risk aversion and the utility function. However, the official start of behavioral finance is arguably 1979, which marks the release of Daniel Kahneman's and Amos Tversky's Prospect Theory: A Study of Decision Making Under Risk. They find that rather than calculating the universe of potential outcomes and selecting the optimal one, investors calculate outcomes against a subjective reference point, such as the purchase price of a stock. Moreover, investors are loss averse, which means they are willing to take on more risk in the face of losses, but become more afraid of risk when it comes to protecting their gains.

What's notable about this first behavioral finance paper is the authors' willingness to ask the question, "Is all what it seems?" with regards to traditional finance, as investment decisions in real life can drastically differ from their theoretical counterparts. More importantly, the paper posits that the notion of the rational man, or the "rational expectations wealth maximizer" -- the bedrock upon which traditional finance is based -- doesn't actually exist. If traditional finance answers the question, "How should rational decision makers act in the face of risk?", then behavioral finance answers the question, "How do real, actual humans act in the face of risk?"

Kahneman and Tversky were shortly thereafter joined by a third so-called founding father, Richard Thaler. In 1980, Thaler published a paper about investors' propensity towards mental accounting, a phenomenon wherein they tended to view their money as being in separate and disparate pools depending on function (retirement fund, vs. emergency fund vs. college fund, etc.). Together, Thaler, Kahneman, and Tversky began a robust body of literature on how people make financial decisions, using psychology to bridge the gap between real life and classic economic theory.

The work of the three "founding fathers" is frequently referred to as the "biases literature," the study of all the behavioral biases that trip up average and professional investors alike. However, their work is just the tip of the behavioral finance iceberg. An equally important aspect of the field involves identifying and explaining inefficiencies and mispricing such as asset pricing bubbles.

Take, for example, the seminal paper by Thaler and his colleague Werner F. M. De Bondt, "Does the stock market overreact?", published in the The Journal of Finance in 1985. In the study, De Bondt and Thaler examine the 35 best and worst performing stocks in the New York Stock Exchange over a three-year period. They create two portfolios, one for the "winners," and one for the "losers," and track them against a market index for three additional years. It turns out that the difference in cumulative returns between the two portfolios was 25%... but not in the direction you'd expect. The "winners" turned out to be the lowest performing, while the "losers" consistently outperformed the benchmark. This is known as the long-term reversal anomaly, which the authors explained by an investor overreaction. When investors sold losers out of fear, and bought winners out of greed, they drove the stock prices down and up, respectively.

Other researchers have since attempted to explain additional anomalies found in the markets, providing counter-evidence to the notion of market efficiency. Such areas of study include the equity risk premium (Benartzi and Thaler, 1995; Asness, 2000), the abnormally high first-day returns of IPOs (Loughran and Ritter, 2002), the limits of arbitrage (Barberis and Thaler, 2003), and situations under which informational efficiency is maximized (Grossman and Stiglitz, 1980; Shiller, 1981). Additional research focuses on recreating bubbles and mispricing in a laboratory setting (Smith, Suchanek, and Williams, 1988). In a way, these works on market anomalies serve as the macroeconomic foil to the microeconomic study of investor biases and individual decision-making processes.

The bottom line is that behavioral finance is a rich area of study, rife with implications for financial advisors and their clients. However, understanding this broader landscape will hopefully allow us to see the bigger picture when diving down some of the specific behavioral rabbit holes in the coming weeks.

Stay tuned for the following topics:

Article #2 - Protecting your Clients from the Top 10 Behavioral Biases

Article #3 - A Focus on Loss Aversion

Article #4 - Building A Better Risk Profile

Article #5 - Asset Pricing Bubbles

Article #6 - Behavioral Implications for Portfolio Managers

Sources:

Byrne, Alistair, CFA and Mike Brooks. Behavioral Finance: Theories and Evidence. The Research Foundation of CFA Literature Review. http://www.cfapubs.org/doi/pdf/10.2470/rflr.v3.n1.1

De Bondt, Werner F. M. and Richard Thaler. Does the Stock Market Overreact? The Journal of Finance. http://www.jstor.org/stable/2327804

Hammond, Robert Christopher. Behavioral finance: Its history and its future. Southeastern University. http://firescholars.seu.edu/cgi/viewcontent.cgi?article=1030&context=honors

Kahneman, Daniel and Amos Tversky. Prospect Theory: A Study of Decision Making Under Risk. Econometric Society. http://www.princeton.edu/~kahneman/docs/Publications/prospect_theory.pdf

Sewell, Martin. "Behavioral Finance." Behavioral Finance.net. http://www.behaviouralfinance.net/behavioural-finance.pdf

Smith, Noah. "Some essential papers in behavioral finance" Noahpinion Blog. http://noahpinionblog.blogspot.com/2013/06/some-essential-papers-in-behavioral.html

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