Studying Behavioral Finance Can Lead to Better Investment Decisions

Neuroeconomics. Microsoft Word’s spell check does not recognize the word just yet, but Yale University’s Professor of Economics Robert Shiller expects the field to thrive over the next decade. In his recent article “The Neuroecomics Revolution,” Shiller insists that ongoing neuroscience research into how people make decisions will one day alter how economists analyze world economies.

According to Shiller, the neuroeconomic revolution achieved an important milestone with the 2010 publication of neuroscientist Paul Glimcher’s book Foundations of Neuroeconomic Analysis—a variation on the title of economist Paul Samuelson’s 1947 classic, Foundations of Economic Analysis, which launched an earlier revolution in economic theory. That is, largely due to Samuelson’s work, much of modern economic theory is based on the assumption that people are rational beings seeking to systematically maximize their own happiness. As Shiller point out, generations of economists have “based their research not on any physical structure underlying thought and behavior, but only on the assumption of rationality.” Conversely, he describes Glimcher as “skeptical of prevailing economic theory,” and seeking a “physical basis” in the brain for decision making.

Shiller applauds the recent linking of neuroscience to economics and has high expectations for the new field. He writes, “Revolutions in science tend to come from completely unexpected places. A field of science can turn barren if no fundamentally new approaches to research are on the horizon. Scholars can become so trapped in their methods—in the language and assumptions of the accepted approach to their discipline—that their research becomes repetitive or trivial.”

There’s no question that research into how the brain deals with ambiguous situations with unpredictable outcomes has the potential to help investors understand and improve their financial decision-making. Illustrating the scope of the problem, studies continue to report how investors’ emotionally driven financial decisions negatively impact their returns. For example, published in April 2011, DALBAR’s annual Qualitative Analysis of Investor Behavior (QAIB) report again found that mutual fund investors’ returns lagged market averages. Specifically, for the 20-year period ended on December 31, 2010, equity investors earned 3.83% compared to the S&P 500 return of 9.14%. For the same period, fixed-income investors earned 1.01% compared to the Barclays Aggregate Bond Index return of 6.89%. The DALBAR study concluded that this underperformance is not a reflection of poor investment choices, but, rather, poorly timed buy and sell decisions.

Of course, making better portfolio decisions requires harnessing our emotions – and that’s easier said than done. In fact, in Minding the Markets, psychiatrist David Tuckett interviewed more than 50 professional portfolio managers, only to conclude that many have a troublesome love/hate relationship with their stocks. In Tuckett’s view, the characteristics of financial assets, from their potential for extreme volatility to their abstract nature, often exacerbate investors’ harmful behavioral biases.

While we must accept that predicting the market’s performance is outside our control, we can work to control our responses to market fluctuations. In fact, studying and reflecting on our own behavior may have more positive portfolio implications than spending time researching new investments. Simply put, investors need to be wary of the following:

  • Herding—believing that the group knows best
  • Narrow framing—making a quick decision without gathering and evaluating all the facts
  • Oversimplification—using mental shortcuts that reduce the complexity of a situation and lead to estimating the answer without fully digesting all the information

Additionally, we have to monitor our natural tendency for anchoring (becoming emotionally attached to investments and focusing on the positives while ignoring the negatives) and loss aversion, which causes us to place more emphasis on avoiding loss than on seeking a gain. Finally, I’d caution about reacting emotionally to financial news stories. Remember, headlines are written to sell newspapers and magazines.
Now that you know what potentially can go wrong with your financial decision-making, how can you overcome your innate biases and make rational investment decisions? Your first line of defense is to know why you are investing. We work with you to define those specific goals in your investment policy statement, along with your risk tolerance and additional quantitative investment criteria, to help you avoid investing on emotion, rumors, and other biases.

It’s also important to resist adopting the short-term mindset our society so actively encourages. Lengthening your investment time frame and evaluating your portfolio in the context of both your comprehensive financial plan and the market’s history makes you less prone to be swayed by behavioral tendencies from narrow framing to anchoring. Further, it’s helpful to review your entire net worth annually, including assets such as real estate. This helps to underscore that your investment portfolio is not an isolated account, but one asset among many. Above all, working with a trusted investment professional, a fiduciary who understands your goals and always puts your interests first, can help you remain more objective and control instinctive behaviors that can harm investment performance.

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