Valuation-Informed Indexing #58:
Behavioral Finance 2.0

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by Rob Bennett

There are two basic things that we need to understand to become good investors.

First, we need to understand stocks.

Second, we need to understand the humans who buy the stocks.

It’s the humans that cause all the trouble.

Take them out of the equation and becoming an effective investor would be an easy matter indeed. Buy-and-Hold would work! If it weren’t for those darn humans and their annoying emotions, stocks really would always be best for the long run and timing really wouldn’t be necessary and it really would be a difficult business trying to beat the market. If we could only get rid of the humans, how simple life could be.

We cannot get rid of the humans. We’re stuck with them. Like it or not, we’re just going to have to get about the business of trying to figure them out.

They refer to the people who think it is as important to examine the behavior of the humans who buy the stocks as it is to examine the stocks themselves as members of the Behavioral Finance School. So I guess that’s the school I’m in.

There are a few things about this school that don’t impress me, however. I thought I would make a list of five.

1) Those in the behavioral finance school often fail to offer practical investing advice.

I rate Robert Shiller’s Irrational Exuberance as the most important book ever published on investing. However, there is one thing very much missing from it — Advice on how to invest! People who are persuaded that Shiller’s ideas are the right ones need to know what they should be doing with their money given that they believe that.

2) Those in the behavioral finance school don’t criticize Buy-and-Hold sharply enough.

Buy-and-Hold ignores the effects of investor emotions (this is why Buy-and-Holders don’t adjust their allocations in response to valuation swings, which are caused by emotion swings). The behavioral finance school believes that emotions matter. So shouldn’t those in the behavioral finance school be openly and directly critical of Buy-and-Hold?

I certainly don’t mean to suggest that anyone should be impolite. I’m saying that since the ideas of the Buy-and-Holders and the ideas of those in the behavioral finance school are in direct conflict, there should be intellectual fireworks whenever representatives of the two schools show up at the same event. Too often members of the behavioral finance school paper over their differences. That has caused many to come to have far more confidence in Buy-and-Hold that they would possess if they frequently heard it challenged.

3) Those in the behavioral finance school are too critical of investors and not critical enough of investing experts.

Our current troubles were caused in part because investing experts were too eager to tell investors what they wanted to hear and in part because investors are by nature drawn to Get Rich Quick strategies. I do not say that investors are helpless victims who played no role in bringing on their troubles.

However, I believe that those in the behavioral finance school are too focused on how human psychology causes investors to forsake logic and reason. There are great insights to be mined by exploring that sort of thing and I am of course grateful for the many advances that have been made by doing so. But many of our problems are caused by the fact that experts in this field face financial pressures to push stocks even when stocks do not offer a strong long-term value proposition and thus give advice that exploits the emotional vulnerabilities of investors.

This is a big part of the behavioral finance story. We need more work done on how the financial realities of the investing advice industry corrupt the delivery of the advice that investors use to make decisions.

4) Those in the behavioral finance school are too numbers-focused.

Investing is not a science. It involves people and their emotions. An effective investing analyst requires the skills of a detective and the skills of a novelist and the skills of a marriage counselor. Most working in this field today possess primarily numbers skills. Numbers skills are a plus, to be sure. But we’ve got that one more than covered with our current band of experts. We need to hear from some new voices coming at the problem from different sorts of skill sets.

Those in the behavioral finance school should be pushing us in this direction. I rarely hear the problem mentioned.

5) Those in the behavioral finance school should be listening in on internet discussions to discover the emotional strengths and weaknesses of investors.

I have learned amazing things about investing by participating in discussion-board conversations. To give just one example, I have seen investors argue in support of Buy-and-Hold on grounds that it is supported by academic research and then insist that a ban on discussion of the last 30 years of research be adopted at the boards at which they participate. Huh?

It’s not enough just to generate lots of studies. We need to know how investors are making use of the studies provided to them. Is the use of academic research making investors more confident in their strategies? Or are investors just picking and choosing among the studies available to them to convince themselves that there is something “scientific” about the investing choices to which they are emotionally drawn?

There is a wealth of insights to be found on investing boards and blogs today. Researchers in the behavioral finance school should be writing it up.

I think the time is ripe to take behavioral finance ideas in some exciting new directions I believe that we are in the early days of development of a Behavioral FInance 2.0.

Rob Bennett reports that sex is overrated (or at least so his wife often observes). His bio is here.


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