Behavioral Finance and Wealth Management

How to Build Investment Strategies That Account for Investor Biases

Michael M. Pompian

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118182291
• Edition: 2
• Topic: Betriebswirtschaft
• Subtopic: Investitionen & Wertpapiere

The book that applies behavioral finance to the real world

Understanding how to use behavioral finance theory in investing is a hot topic these days. Nobel laureate Daniel Kahneman has described financial advising as a prescriptive activity whose main objective should be to guide investors to make decisions that serve their best interests. The reality? That's easier said than done. In the Second Edition of Behavioral Finance and Wealth Management, Michael Pompian takes a practical approach to the growing science of behavioral finance, and puts it to use for real investors. He applies knowledge of 20 of the most prominent individual investor biases into "behaviorally-modified" asset allocation decisions. Offering investors and financial advisors a "self-help" book, Pompian shows how to create investment strategies that leverage the latest cutting edge research into behavioral biases of individual investors. This book:

• Shows investors and financial advisors how to either moderate or adapt to behavioral biases, in order to improve investment results and identifies "the best practical allocation" for investment portfolios. Using these two sound approaches for guiding investment decision-making, behavioral biases are incorporated into the portfolio management process
• Uses updated cases studies to show investors and financial advisors how an investor's behavior can be modified to improve investment decision-making
• Provides useable methods for creating behaviorally modified investment portfolios, which may help investors to reach their long term financial goals
• Heightens awareness of biases so that financial decisions and resulting economic outcomes are improved
• Offers advice on managing the effects of each bias in order to improve investment results

This Second Edition illustrates investors' behavioral biases in detail and offers financial advisors and their clients practical advice about how to apply the science of behavioral finance to improve overall investment decision making.

PART ONE

Introduction to Behavioral Finance

In Part One, we present three chapters: Chapter 1 poses the question ``What is Behavioral Finance?'' This chapter also includes a review of some of the most important figures in the field of behavioral finance. In Chapter 2, we review the history of behavioral finance placing particular emphasis on understanding the differences between rational and irrational behavioral economic theories that have been developed over the year. Chapter 3 provides an introduction to behavioral biases, 20 of which will be reviewed in the book.

Throughout this part of the book, the goal is to have readers understand the basics of as well as the effects of behavioral biases on the investment process. By doing so investors and their advisors may be able to improve economic outcomes and attain stated financial objectives.

CHAPTER 1

What Is Behavioral Finance?

People in standard finance are rational. People in behavioral finance are normal.

—Meir Statman, PhD, Santa Clara University

At its core, behavioral finance attempts to understand and explain actual investor and market behaviors versus theories of investor behavior. This idea differs from traditional (or standard) finance, which is based on assumptions of how investors and markets should behave. Wealth managers from around the world who want to better serve their clients have begun to realize that they cannot rely solely on theories or mathematical models to explain individual investor and market behavior. As Meir Statman's quote puts it, standard finance people are modeled as “rational,” whereas behavioral finance people are modeled as “normal.” This can be interpreted to mean that “normal” people may behave irrationally—but the reality is that almost no one (actually, I will go so far as to say absolutely no one) behaves perfectly rationally, and dealing with normal people is what this book is all about. We will delve into the topic of the irrational behaviors of markets at times; however, the focus of the book is on individual investor behavior.

Fundamentally, behavioral finance is about understanding how people make financial decisions, both individually and collectively. By understanding how investors and markets behave, it may be possible to modify or adapt to these behaviors in order to improve financial outcomes. In many instances, knowledge of and integration of behavioral finance may lead to better than expected results for both advisors and their clients. But advisors cannot view behavioral finance as a panacea or “the answer” to problems with clients. Working with clients is as much an art as it is a science. Behavioral finance can add many arrows to the art quiver.

We will begin this chapter with a review of the prominent researchers in the field of behavioral finance, all of whom promote a deeper understanding of the benefits of the behavioral finance discipline. We will then review the key differences debate between standard finance and behavioral finance. By doing so, we can establish a common understanding of what we mean when we say behavioral finance, which will in turn permit us to understand the use of this term as it applies directly to the practice of wealth management. This chapter will finish with a summary of the role of behavioral finance in dealing with private clients and how the practical application of behavioral finance can enhance an advisory relationship.

BEHAVIORAL FINANCE: THE BIG PICTURE

Behavioral finance, commonly defined as the application of psychology to finance, has become a very hot topic, generating credence with the rupture of the tech-stock bubble in March of 2000, and has been pushed to the forefront of both investors’ and advisors’ minds with the financial market meltdown of 2008–2009. While the term behavioral finance is bandied about in books, magazine articles, and investment papers, many people lack a firm understanding of the concepts behind behavioral finance. Additional confusion may arise from a proliferation of topics resembling behavioral finance, at least in name, including: behavioral science, investor psychology, cognitive psychology, behavioral economics, experimental economics, and cognitive science, to name a few. Furthermore, many investor psychology books that have entered the market recently refer to various aspects of behavioral finance but fail to fully define it. This section will try to communicate a more detailed understanding of the term behavioral finance. First, we will discuss some of the popular authors in the field and review the outstanding work they have done (not an exhaustive list), which will provide a broad overview of the subject. We will then examine the two primary subtopics in behavioral finance: behavioral finance micro and behavioral finance macro. Finally, we will observe the ways in which behavioral finance applies specifically to wealth management, the focus of this book.

Key Figures in the Field

In Chapter 2 we will review a history of behavioral finance. In this section, we will review some key figures in the field who have more recently contributed exceptionally brilliant work to the field of behavioral finance. Most of the people we will review here are active academics, but many of them have also been applying their work to the “real world,” which makes them especially worthy of our attention. While this is clearly not an exhaustive list, the names of the people we will review are: Professor Robert Shiller, Professor Richard Thaler, Professor Meir Statman, Professor Daniel Kahnemann, and Professor Vernon Smith.

Figure 1.1 Robert Shiller, former president of the Eastern Economic Association and best-selling author.

The first prominent figure we will discuss is Professor Robert Shiller (Figure 1.1). Some readers may be familiar with the work Irrational Exuberance, by Yale University professor Robert Shiller, PhD. Certainly, the title resonates; it's a reference to a now-famous admonition by Federal Reserve Chairman Alan Greenspan during his remarks at the Annual Dinner and Francis Boyer Lecture of the American Enterprise Institute for Public Policy Research in Washington, D.C., on December 5, 1996. In his speech, Greenspan acknowledged that the ongoing economic growth spurt had been accompanied by low inflation, generally an indicator of stability. “But,” he posed, “how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”1 In Shiller's Irrational Exuberance, which hit bookstores only days before the 1990s’ market peaked, Professor Shiller warns investors that stock prices, by various historical measures, have climbed too high. He cautions that the “public may be very disappointed with the performance of the stock market in coming years.”2 It was reported that Shiller's editor at Princeton University Press rushed the book to print, perhaps fearing a market crash and wanting to warn investors. Sadly, few heeded the alarm. Mr. Greenspan's prediction came true, and the bubble burst. Though the correction came earlier than the Fed Chairman had foreseen, the damage did not match the aftermath of the collapse of the Japanese asset price bubble (the specter Greenspan raised in his speech).

Figure 1.2 Richard Thaler, PhD, renowned behavioral finance theorist.

More recently, Professor Shiller has been active in indentifying the next bubble—in the U.S. housing market. Together with researcher Karl E. Case, Shiller has been collecting data on housing, which is now known as the S&P/Case-Shiller U.S. National Home Price Index. This is a composite of single-family home price indices for the nine U.S. Census divisions. As early as 2004, Shiller and Case asked, “Is there a bubble in the housing market?” They were early, but they were also quite correct. Mr. Shiller is an active commentator on news programs and is someone to whom, in my opinion, we should listen closely.

Another high-profile behavioral finance researcher, Professor Richard Thaler, PhD (Figure 1.2), of the University of Chicago Graduate School of Business, penned a classic commentary with Owen Lamont entitled “Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs,”3 also on the general topic of irrational investor behavior set amid the tech bubble. The work relates to 3Com Corporation's 1999 spin-off of Palm, Inc., and argues that if investor behavior was indeed rational, then 3Com would have sustained a positive market value for a few months after the Palm Pilot spin-off. In actuality, after 3Com distributed shares of Palm Pilot to shareholders in March 2000, Palm Pilot traded at levels exceeding the inherent value of the shares of the original company. “This would not happen in a rational world,” Thaler notes. Professor Thaler is also the author of the book Advances in Behavioral Finance, which was published in 1993.

More recently, Professor Thaler, in conjunction with Professor Cass Sunstein, wrote Nudge: Improving Decisions About Health, Wealth, and Happiness. In this work, Thaler and Sunstein support the idea that by “tilting” people's decision making in a positive direction, everyone can make society a better place. The following is an interesting and insightful excerpt from an interview Amazon.com did with Thaler and Sunstein.4 I particularly like the reference to choice architecture.

Amazon.com: What do you mean by “nudge” and why do people sometimes need to be nudged?

Thaler and Sunstein: By a nudge we mean anything that influences our choices. A school cafeteria might try to nudge kids toward good diets by putting the healthiest foods at front. We think that it's time for institutions, including government, to become much more user-friendly by enlisting the science of choice to make life easier for people and by gentling nudging them in directions that will make their lives better.

Amazon.com: Can you describe a nudge that is now being used successfully?

Thaler and Sunstein: One example is the Save More Tomorrow program. Firms offer employees who are not saving very much the option of joining a program in which their saving rates are automatically increased whenever the employee gets a raise. This plan has more than tripled saving rates in some firms, and is now offered by thousands of employers.

Amazon.com: What is “choice architecture” and how does it affect the average person's daily life?

Thaler and Sunstein: Choice architecture is the context in which you make your choice. Suppose you go into a cafeteria. What do you see first, the salad bar or the burger and fries stand? Where's the chocolate cake? Where's the fruit? These features influence what you will choose to eat, so the person who decides how to display the food is the choice architect of the cafeteria. All of our choices are similarly influenced by choice architects. The architecture includes rules deciding what happens if you do nothing; what's said and what isn't said; what you see and what you don’t. Doctors, employers, credit card companies, banks, and even parents are choice architects.

We show that by carefully designing the choice architecture, we can make dramatic improvements in the decisions people make, without forcing anyone to do anything. For example, we can help people save more...