Valuation-Informed Indexing #120
by Rob Bennett
I am in the Behavioral Finance School of investing analysis. I think that the study of the real-world behavior of investors is the piece that has been missing from investing analysis. I think that Behavioral Finance ideas are going to change this discipline in a very big way and in a very positive way in not too long a time from now.
Unfortunately, I don’t think that Behavioral Finance has amounted to much yet. The people doing work in this field have generated hundreds of amazing insights. I read Predictably Irrational on a recent airplane flight and was blown away as each chapter hit me with several insights that will make me a better investor for many years to come. And Predictably Irrational was not even intended to be an investing guide!
There’s one big problem done by people working in the Behavioral Finance School. They avoid giving practical investing advice.
Robert Shiller is the model, both on the good side and on the bad side. His book Irrational Exuberance is the most important investing guide ever published, in my assessment. We will be mining new implications of his research decades from now. But not once in Shiller’s book does he give investors even a hint as to what they should do with their money if they have confidence that his findings are on the mark. He tells us that the stock market becomes a “Ponzi scheme” (those are Shiller’s words) when we reach high levels of overvaluation. But he doesn’t say that we should lower our stock allocations to avoid the price crash that is coming.
I think the problem is that most of the people working in the Behavioral Finance School are academics. They are smart. They love doing research. They enjoy helping people. They obtain satisfaction from generating insights. But they don’t manage portfolios. They don’t solicit clients or seek to retain them. They don’t head up mutual funds. They don’t market themselves or their ideas.
Because of all this, they are not taken seriously by the Big Shot moneymakers who dominate the investing advice field. Behavioral Finance ideas are sometimes discussed in investing publications. But usually in a patronizing way. The Behavioral Finance people are permitted to advance their ideas. But only to the extent that they do not conflict with the more serious (we are led to believe) advice advanced by the “professionals.”
The most popular book putting forward Behavioral Finance ideas is Why Smart People Make Big Money Mistakes. The book does a fine job of summarizing a good number of powerful ideas. But it does not argue for why investors need to tune out “Stocks for the Long Run” admonitions and lower their stock allocations at times of insane overvaluation.
To the extent that the need to make changes in one’s allocation is addressed at all, it is discouraged. The book points out that research shows that investors are more adverse to loses than they are drawn to gains. It’s true. The research does show this. But the bigger problem in a bull market (the book was published during the biggest runaway bull market in U.S. history) is investors failing to protect themselves from big losses by failing to sell once prices get too high. It’s hard not to suspect that the reason this point was not stressed is that the money in this field is made by selling stocks and the professionals in the field would prefer that investors not be told to flee stocks even when they are dangerous.
I’ve seen numerous videos in which Robert Shiller has been asked what he would advise investors to do. Shiller doesn’t perform particularly well in these interviews. My sense is that he knows important things that he wants to pass along but that he holds back because it would take too much explaining to tell the interviewer why he is offering the advice he is offering.
Investing advice that is rooted in Behavioral Finance insights is very different from advice that is not rooted in those insights and most of the viewers of these videos are people who are interested not in theory but in practical investing tips. Behavioral Finance experts can offer tips. But they know it would be dangerous to do so without explaining the “why” of the tips. People won’t have confidence in advice that they don’t understand and people will not stick with advice they do not understand. So the Behavioral Finance experts often punt on “how to” questions.
The rise of the Behavioral Finance School is a big deal. With index funds available to us today, investing can be made very simple for the vast majority of investors. But Behavioral Finance cannot be sold in the same manner as earlier forms of investing advice. The idea with Behavioral Finance is for the investor to train himself to respond to investing ups and downs in a more rational fashion. The type of help that those in the Behavioral Finance school can offer usually cannot be reduced to a “tip.” The advice is of great value but it comes in a form that is different from what most investors expect.
Behavioral Finance can be marketed effectively. Holistic solutions have become popular in the fields of nutrition and schooling and health. There’s a market here. But investing analysis has been a numbers-driven thing for so many years that those working this field have not yet figured out how best to get their ideas before a large number of investors in an appealing and effective way. Let’s hope that some smart person will achieve the breakthrough soon!