Value Investing

How Advisors Can Apply Behavioral Finance

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Indeed, we have to distance ourselves from the presumption that financial markets always work well and that price changes always reflect genuine information…The challenge for economists is to make this reality a better part of their models.

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Advisors Behavioral Finance
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Robert Shiller, “From Efficient Markets Theory to Behavioral Finance”

Professor Shiller wrote those words in 2003. Ten years later he received the 2013 Nobel Prize in Economics for his pioneering behavioral finance research, sharing the prize with Lars Peter Hansen and Eugene Fama. Naming Fama as co-recipient created a Machiavellian buzz in anticipation of the award ceremony, as Shiller had described Fama’s efficient market hypothesis (EMH) as “the most remarkable error in the history of economic thought.”

Who says the Nobel committee didn’t have a twisted sense of humor?

The shift to behavioral finance received a further boost in 2017 when the Nobel Prize in Economics was awarded to Richard Thaler of the University of Chicago, also home to Fama. Throughout his career, Thaler focused on the cognitive errors made by individuals and how government and business policy can be revised in order to “nudge” people to make better decisions. Thaler and Fama are good friends and regularly play golf together. Most likely the EMH joins religion and politics as taboo topics while enjoying a friendly round!

Today, behavioral finance appears everywhere in the financial services industry. Advisors are warming to the notion that behavioral coaching is important for the successful execution of a client’s financial plan. Many are concluding such coaching should represent a significant portion of time spent with clients.

The 15 years since Shiller’s statement above has seen an avalanche of new academically verified pricing anomalies, further challenging the notion “that price changes always reflect genuine information.” This has gotten to the point that we have to wonder if collective cognitive errors are the primary drivers of investment returns, displacing new information as the most important driver.

A behavioral framework

Viewing investors and markets as emotional decision makers rather than as rational computational entities forces us to reconsider every aspect of how we operate in financial markets. The behavioral financial markets (BFM) concepts I discuss below provide a framework for rethinking client financial planning, asset allocation, investment manager selection and the creation and execution of investment strategies.

Shifting to a behavioral perspective is the first step in becoming a behavioral financial professional. It might seem like a radical step, but really it is just the formal recognition of the obvious. Wisdom is seeing the world for what it is, not what we would prefer it to be. After recognition comes a formal transition to improved analytic tools, some of which I will discuss.

As Shiller suggests, it is time to move away from the EMH, one of the pillars of modern portfolio theory (MPT), to a more promising alternative, behavioral finance. Behavioral finance’s more realistic representation of financial markets and human behavior will eventually replace MPT as the paradigm of choice

Read the full article here by C. Thomas Howard, PhD, Advisor Perspectives