Behavioral Finance: Applied Technique, Emotion, and Investor Outcomes

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Behavioral finance took a huge leap forward in 2017. Richard Thaler winning the Nobel for his work in the field focused a lot of attention on what many asset managers already know – investor emotions play a big role in how they perceive opportunities and shrink from risk, usually at the wrong time. There are some asset managers who operate from a core principle – behave the opposite of the prevailing market emotion, and you’ll reap big rewards. Any simplistic view of behavioral finance was severely tested this year.

2017 was a year where investor emotion ran rampant, and fear collided with optimism every time the markets hit a new high. Even Thaler was stumped. "We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping," he said, soon after winning the Nobel in October. "I admit to not understanding it." He was worried, and understandably so.1

Who can make sense of a nine-year-old bull market that has tripled in value since the 2007-2008 crash? Investors seem to be shrugging off political turmoil and global volatility and betting that past performance is a guarantee of future success.

How do we apply Behavioral Finance?

In the 1989 San Francisco earthquake, segments of the Oakland Bay Bridge collapsed. One driver pulled to the side, fired up his camcorder (this was pre-iPhone), and filmed cars driving off the end of a destroyed section. When I saw the clip, playing on every news channel at the time, I wanted to scream: “Stop filming, and run out with hands waving and try to stop them!”

Unfortunately for advisors, much of what behavioral finance literature offers is definitional. In other words, it’s great at identifying problems without presenting solutions.

Investor biases are a huge problem that affect millions of people. Poor timing when making investment choices causes investors to lose billions of dollars. Not only that, turbulent markets also erode investor peace of mind and their ability to achieve their life ambitions. The advisory community has historically addressed this by advocating greater discipline and education for investors. But it hasn’t worked.

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