Valuation-Informed Indexing #45: Value Investing Is Behavioral Finance In Action

    by Rob Bennett

    Warren Buffett is the leader of the Behavioral Finance school of investing analysis.

    Many people don’t even think of Buffett as being in the Behavioral Finance school. Buffett is a Value Investor. He studies the numbers, determines how much a company is worth, and then invests in it if the earnings stream available from buying it can be had at a good price. That’s fundamental analysis.

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    Those in the Behavioral Finance school study human behavior and its effect on investing decisions. Buffett doesn’t study human behavior. He studies economic realities. What’s that got to do with Behavioral Finance?

    Only everything.

    If you don’t understand the point I am making here, I’d be grateful if you would try to consider the question from a different perspective.

    I agree that Buffet focuses on numbers, the hard stuff, not the soft side emotional stuff that most people associate with Behavioral Finance. My question to you is this: Why doesn’t everyone do that?

    What Buffett does is so obviously the right way to approach investing that, in a sane world, everyone would be a Value Investor. If everyone were studying value propositions, stocks could never have become so insanely overpriced as they did in the 1990s. So everyone obviously is not following the commonsense approach. Everyone is not following Value Investing principles.

    What sort of principles are they following? What is the alternative to considering value propositions when you invest?

    The alternative is irrationality. There is no rational case that can be made for not focusing on value propositions when you invest.

    Behavioral Finance is the study of why smart people make stupid investing decisions. Another way of putting it is — Behavioral Finance is the study of emotional impulses that cause some investors to fail to follow Value Investing principles.

    Value Investors don’t need Behavioral Finance. They’re already doing it right!

    The purpose of Behavioral Finance should be to lead people to Value Investing. No?

    So who is the real leader of the Behavioral Finance School: (1) Shiller, who is a genius at understanding and describing the psychological causes for why investors who mess up?; or (2) Buffett, who doesn’t bother with any of the psychological doo-dah and just shows us what works?

    I love Shiller. He’s my hero. But, if I was stuck on a desert island and could only have the works of Buffett or the works of Shiller to guide my investing decisions, I would choose the works of Buffett. Shiller’s insights are implicit in Buffett’s strategies. Shiller explains why many of us don’t get it right. Buffett illustrates the right way to do it.

    I don’t for two seconds mean to suggest that Shiller’s work is not of immense importance. Buffett (and Graham before him) has been around for a long time and there is still a whole lot of bad investing going on out there. Shiller is helping those who are today getting it wrong learn why they are such goof-ups.

    But I find it frustrating when leaders in the Behavioral Finance school spend hundreds of pages describing the mess-ups without ever breaking down and telling investors what to do in practical terms. Irrational Exuberance is the best book ever published on stock investing. But it would be twice as powerful if it included one extra chapter of perhaps 200 words saying something to the effect of: “Now that you know what doesn’t work and why you are drawn to it, please review the work of Warren Buffett and others in the Value Investing school to learn how to invest sensibly.”

    I am in the Behavioral Finance School. But I get bored with the deep psychological explanations of investor mistakes. It doesn’t get real for me until someone says what works. What works is to study value propositions before you put money on the table and put money at risk only when the value proposition obtained in return is strong. That’s Value Investing. It was around long before people used the term “Behavioral Finance” and it will be around long after the good work of those in the Behavioral Finance School has persuaded everyone to follow in Buffett’s footsteps.

    Behavioral Finance shouldn’t be about describing investor mistakes. It should be about fixing them. The ultimate fix is to become a Value Investor.

    Rob Bennett is co-developer of a stock cycles calculator called “The Returns-Sequence Reality Checker.” His bio is here.