Behavioural finance: a study of the bleedin’ obvious

You can’t go to an investment conference, read an investment journal or even peruse the personal investment magazines without seeing reference to behavioural finance and the implications of the irrational behavioural biases exhibited by investors.

Economists, fund managers and advisers have become converts and are busily preaching behavioural finance findings to advisers and investors. Just recently, Princeton Professor Daniel Kahneman, a leader in the behavioural finance field, was awarded the Nobel Prize in Economics.

Now, I do not really have any major problem with this. In fact, when it comes to the debate between the ‘behavioural’ and the ‘efficient market’ school regarding what drives asset prices, I am definitely in the behavioural camp.

Markets are clearly driven by greed and fear, suffer from cycles of neglect and over-enthusiasm and in doing so, can experience significant overvaluation and undervaluation, at both an individual security and market level. This is not to suggest that taking advantage of such biases is easy, after all it is easy to become drawn into those same biases. However, I have seen too many instances where investors’ irrationality is setting prices, to believe in market efficiency.

Where I do have a concern is the extent to which many of those promoting the behavioural school seem to believe they have come up with something truly unique and new. Some even think they have stumbled on to a total and coherent theory of how markets operate.

In reality, drawing implications for investment strategies from the behavioural biases of individual investors and the market is nothing new. While the behavioural finance school has only come to the fore in the last decade, the assessment of investor behaviour and its implications for investment strategies is as old as markets themselves.

There are three investment classics which cover the behaviour and psychology of investors and strategies which foreshadowed the current trend in behavioural finance and contain much wisdom:The Intelligent Investorby famed value investor Ben Graham,The Battle for Investment Survivalby stockbroker Gerald Loeb andReminiscences of a Stock Operatorby Edwin Lefevere, about legendary speculator Jesse Livermore. All three books were first published around 75 years ago.

Having said this, there is no doubt that formalising the study of behavioural finance has helped to define and expand the knowledge of the irrational tendencies of individuals and markets. Helped by the explosion in computer power, behavioural biases have been better surveyed, proved and categorised.

But in the end, there is relatively little that is new in the conclusions, at least to experienced participants in financial markets. It therefore raises questions as to how useful these findings are, and to whom they are useful.

For example, how much additional knowledge do we gain from studies that prove that most investors display loss aversion — they value avoiding the downside more than participating in the upside? Surely the average planner already knows this. Or that they think about their money in terms of different baskets rather than as a total portfolio? Or that most active investors are over-confident, tend to over-trade and frame situations on the basis of, and over-react to, more recent information?

Perhaps by better defining and highlighting the errors, the errors are easier to avoid, but anyone who has seriously thought about, invested in or dealt with investors in markets over an extended period would already have identified and/or experienced many of the behavioural tendencies discussed in behavioural finance.

Given this, I was concerned by a February 2002 paper by the chief investments officer of a major global funds management group which stated that “we consider these (behavioural finance) findings to be significant, and we have begun to educate our investment professionals about them”.

“Begun to educate?” I would prefer to invest with active investment professionals who already understand the implications of behavioural factors in markets whether they explicitly recognise them or not.

There is no doubt that the better classification and proof behind these behavioural biases has made them more understandable to professionals and amateurs, but the key question is still: who benefits from this?

It may well be the case that increased explanation and exploitation of behavioural biases by both existing and new investors (or simply greater avoidance of mistakes) will actually make active investment management more difficult. As some of the anomalies highlighted by the behaviouralists are exploited by more investors (or at least irrational tendencies are avoided by more), inefficiencies and opportunities may well be arbitraged away. Those in the business of active funds management should realise that greater study of behavioural finance might actually make their job harder, not easier.

Of course, people will always be people, and to some extent many of the behavioural tendencies will continue to be prevalent.

However, some of the inefficiencies deriving from behavioural tendencies may be arbitraged away while others may mutate into other forms. The major inefficiencies of the future may well not be the ones that the behaviouralists are highlighting today. It is generally the case that what is widely known is rarely very useful in investment markets.

In any case, behavioural finance is not currently, and probably never will be, seen as a coherent theory of how markets work. It is simply a collection of investors’ behavioural tendencies that may have influenced how some prices are set in some markets.

On the other hand, while the efficient market view of the world does provide a coherent theory, it has rightly come under severe attack in recent decades following the discovery of many inefficiencies and anomalies (including many by the behavioralist school).

Behavioural finance is interesting, but it is not the Holy Grail for investors. Rather, it simply formalises what most smart investors already know, probably makes life harder for active investors, and does little to provide a coherent theory of how markets operate.

It may be useful, but it’s hardly revolutionary.