Behavioral Finance: Finance for Normal People

Posted by Admin on Dec 10, 2015 5:00:00 PM

We often hear that behavioral finance is nothing more than a collection of stories about investors swayed by cognitive errors and misleading emotions; that it lacks the unified structure of standard finance. Yet today's standard finance no longer is unified, because wide cracks have opened between its theory and the evidence. In a book I am writing, , to be published by Oxford University Press, I present behavioral finance as a unified structure that incorporates parts of standard finance, replaces others, and includes bridges between theory, evidence, and practice. I also dive into these topics in IMCA’s new online Applied Behavioral Finance certificate program, which you can learn more about on IMCA’s website.

Standard finance is built on four foundation blocks:

  1. People are rational.
  2. People should design portfolios by the rules of mean-variance portfolio theory.
  3. Expected returns of investments are described by standard asset-pricing theory, where differences in expected returns are determined only by differences in risk.
  4. Markets are efficient, in the sense that prices equal values and in the sense that they are hard to beat.

Behavioral finance offers an alternative foundation block for each of the foundation blocks of standard finance. According to behavioral finance:

  1. People are normal.
  2. People design portfolios by the rules of behavioral portfolio theory.
  3. Expected returns of investments are described by behavioral asset-pricing theory, where differences in expected returns are determined by more than risk.
  4. Markets are not efficient in the sense that prices equal values, but they are efficient in the sense that they hard to beat.

Here is an example focused on market efficiency:

The Nobel Prize committee’s decision to award the 2013 Nobel Memorial Prize in Economics to Eugene Fama and Robert Shiller puzzled many. “If you’ve been wondering whether it’s possible to regularly beat the stock market averages,” wrote Steven Rattner, a Wall Street financier, “you didn’t get any guidance from the Nobel Prize committee this year."1

Rattner placed Shiller at one corner, claiming that he “argues that markets are often irrational and therefore beatable.” He placed Fama at the opposite corner, describing him as “the father of the view that markets are efficient,” whose “followers believe that investors who try to beat the averages will inevitably fail.”

The efficient market hypothesis is central to standard finance and many believe that behavioral finance refutes it. Indeed, many believe that refutation of the efficient market hypothesis is the most important contribution of behavioral finance. Yet discussions are unfocused when they fail to distinguish between two notions of efficient markets and their corresponding efficient market hypotheses, the price-equals-value market hypothesis and the And discussions are lacking when they fail to explain why so many investors believe that markets are easy to beat when, in truth, they are hard to beat.

Behavioral finance provides evidence contradicting the price-equals-value market hypothesis but its evidence is generally consistent with the Behavioral finance also explains why so many investors believe that markets are easy to beat when, in truth, they are hard to beat.

Price-equals-value markets are markets where investments’ prices always equal their intrinsic values and the price-equals-value market hypothesis is the claim that investment prices always equal their intrinsic values. Hard-to-beat markets are markets where a few investors are able to beat the market, earning consistent excess returns, but most are unable to do so. Excess returns generally correspond to above-average returns. More precisely, they are returns in excess of returns that can be expected according to a correct asset-pricing model.

Price-equals-value markets are impossible to beat because excess returns come from exploiting gaps between prices and intrinsic values, gaps absent in price-equals-value markets. But hard-to-beat markets are not necessarily price-equals-value markets. It might be that prices deviate greatly from values but deviations are hard to identify in time or difficult to exploit for excess returns.

The rational investors of standard finance know that markets are hard to beat, but many normal investors of behavioral finance believe, in error, that markets are easy to beat. Other normal investors satisfy their wants of expressive and emotional benefits that accompany playing the market and the utilitarian benefits of beating it. Yet most investors are more likely to be beaten by the market than to beat it, sacrificing returns and their utilitarian benefits for the expressive benefits of the image of an active rather than a investor and the emotional benefits of hope of beating the market.

Kenneth French estimated that active investors—those who try to beat the market—would have saved an annual 0.67 percent of the aggregate value of their investments, on average, if they refrained from attempts to beat the market and chose match-the-market low-cost index funds. That percentage amounted to more than $100 billion in 2006 alone.2 John Bogle’s estimate of the potential savings is even higher.3

Why do active investors continue to play a negative sum game?” asked French. He drew his answers from behavioral finance. One part of the answer is ignorance. “Many are unaware that the average active investor would increase his return if he switched to a passive strategy.” Another part is cognitive errors such as overconfidence. “There is evidence that overconfidence leads to active trading … Investors who are overconfident about their ability to produce superior returns are unlikely to be discouraged by the knowledge that the average active trader must lose.” Yet another part is wants of expressive and emotional benefits. “Some investors may accept a lower expected return in exchange for the bragging rights that come with a fund that has performed well. Others may give up the low cost and diversification of a passive mutual fund for the prestige of their own separate account.”

Visit Meir Statman’s website at

Endnotes

1 Steven Rattner, “Who’s Right on the Stock Market?” (November 15, 2013): A29, http://www.nytimes.com/2013/11/15/opinion/rattner-whos-right-on-the-stoc....

2 Kenneth French, “The Cost of Active Investing,” 63, no. 4 (2008): 1,537–1,573.

3 John Bogle, “A Question So Important That It Should Be Hard to Think About Anything Else,” 34, no. 2 (Winter 2008): 95–102.

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