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The Practical Application of Behavioral Finance

July 2nd, 2013

by Mitchell D. Eichen and John M. Longo

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

From the Dot-Com bubble onward, traditional investment models have repeatedly disappointed those who relied on them. When compared to mathematically based models, behavioral finance provides a superior foundation. Here is an alternative investment paradigm, grounded in behavioral finance, that is practical and effective over time periods that are relevant for a significant portion of investors.

The list of investment models that have failed professional investors include the following:

  • Markowitz Portfolio Theory
  • Capital Asset Pricing Model (CAPM)
  • Efficient Market Hypothesis (EMH) (along with the unhedged-index strategies flowing from it)
  • Traditional Hedge Fund Model
  • Endowment Model

These models may work in specific circumstances. They may even work over the long run. But as John Maynard Keynes noted, in the long run, we are all dead.”

Professional investors and their constituencies have more practical time horizons. The long-term models cited above require one to remain fully invested and endure losses for extended periods of time to avoid the inevitable pitfalls of market timing. Telling institutional or individual investors they may have to suffer large losses is neither practical nor satisfactory. This is particularly true for those who need to meet short- to intermediate-term obligations or for whom nearer-term results take on greater importance, for economic or emotional reasons.

Our thesis, which borrows heavily from the field of behavioral finance, makes an important contribution to the field. This article reintroduces and explains an alternative investment paradigm that has been in use since 2009. Our aim is to deliver consistent and predictable returns for specific market outlooks.

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