Real-World Applications of Behavioral Finance

Investing
Investing Behavioral Finance

Humans are not robots. Emotion and other illogical factors often influence our decisions. For example, you might know someone who invests in Facebook just because everyone he knows uses it. Or you might know someone who refuses to sell anything because he gets sentimental.

Behavioral finance is a field that combines cognitive and behavioral psychology with finance and helps explain the irrational choices people make. But how can behavioral finance help you make money or save money?

To find out, let’s look at some real-world examples.

Save for Retirement

In recent years, many policy makers have sought to use behavioral economics to influence workers’ retirement savings. In Nudge, a book by Cass Sunstein and Richard Thaler, a leading behavioral finance professor, the two recommend that companies institute autopilot 401 (k) savings plans. Autopilot savings counteract reluctant savers who are prone to inertia by automatically enrolling them. Plans where participants need to opt-in have 68% rates of participation after 36 months of employment whereas plans where participants are automatically enrolled and need to opt-out to leave, have a 98% rate of participation.

Besides increasing the number of participants, behavioral finance principles can be applied to increase the amount saved. Thaler and Shlomo Bernartzi, a UCLA economics professor, developed a savings plan called Save for Tomorrow where participants committed to saving portions of their future income increases for retirement. When experimenting with the Save for Tomorrow plan, Thaler and Bernartzi found that within half a year, those who had previously had trouble saving, were saving three percent of their paychecks. After three and a half years, they were saving nearly 14 percent of their paychecks. In 2006, the Save for Tomorrow plan was incorporated into the Pension Protection Act, a law that clarifies legal issues regarding automatic income reduction and helps specify appropriate default investments.

Be Honest with Yourself

For individual investors or money managers, behavioral finance experts suggest a few strategies to be more rational. Most of their suggestions are complements to traditional quantitative methods of evaluating investments. Although some behavioral finance biases are hard to correct, here are two easy strategies to help you become more rational:

  • Find a partner: Investors should consult partners or objective parties so that they can talk through their investments. Objective parties can help better assess risk and might not be affected by the same biases.
  • Keep track of investments: Investors should keep track of the investments they make as well as the investments they do not make. By keeping track of investments, investors might be able to identify their illogical tendencies.

While behavioral finance can be used to minimize investors’ mistakes, it can also be used to take advantage of others’ missteps. Behavioral finance’s increasing popularity has spawned a rise in the number of funds hoping to capitalize on behavioral finance principles.

Fuller and Thaler Growth Fund

The Fuller and Thaler Growth Fund hopes to locate assets that are mispriced because of market under reaction. The Growth Fund focuses on companies in mature industries or who have financial difficulties. When evaluating companies, they use a three-step process. First, similar to standard investment firms, they evaluate companies using quantitative methods. Second, they determine whether a company’s earnings increases are temporary or permanent. Third, if the companies have surprise earnings increases, they use behavioral analysis to see the market is underreacting. Since the companies have a history of financial difficulties or are in mature industries, the market suffer from anchoring biases or overconfidence and believe the earnings to be a fluke.

Sentiment Analysis

One tool fund managers use to capitalize on investor irrationality is market sentiment analysis.  Instead of using quantitative methods of evaluating the market, companies such as MarketPsych and Lexalytics mine the news and social media to evaluate trends in the market. Fund managers can then use the information to help determine market attitudes towards certain companies and use this information to locate mispriced assets.

Expert Analysis

Katsuhiko Okada, Kwansei Gakuin University Institute of Business and Accounting and CEO of Magne-Max Capital Management, uses behavioral finance principles to make investment decisions:

“Our fund aims to capture Japanese Investor psychology through text-mining the media sentiment in the market. We obtain massive textual data from the news media as well as social media such as Message boards and Twitter. In order to decompose the Japanese text into to an analyzable format, we use technologies developed in the area of Informatics, specifically Natural Language Processing (NLP) area. We then create a dictionary of words defining sentiment. At the moment, we have 6000 words and phrases in the dictionary that determine the sentiment of the investors to each one of the listed stocks in the Tokyo Stock Exchange. We call it “Sentiment Index.” We monitor corporate events and market events simultaneously and use the Sentiment index to filter out the stocks that we should go long or short. This sentiment filtering works in favor of the sharp ratio. It reduces the volatility of our NAV by substantial margin.

“Our hedge fund is composed of three practitioners and three tenured professors with three different disciplines: Finance, Informatics and Computer Science. In order to successfully apply behavioral finance to money management, an interdisciplinary system development is a must. Also, one has to have a flexible and adaptive decision making system because the history rarely repeats itself in the market.”

Greg B. Davies, Head of Behavioral and Quantitative Investment Philosophy at Barclays, believes that behavioral finance will help spawn future innovations in finance:

“It is a mistake to think that learning more about behavioral (and classical) finance will on its own enable us to make better decisions in times of stress. We need structure and rules to help us govern our innate response to the immediate environment and context.

“In terms of innovations, there are a number of things that can help in the future. They are largely about making it easier for investors to govern their decisions over time – decision support tools. For example, there will increasingly be products designed to provide built in emotional insurance – they will help investors to both access the markets and simultaneously reduce anxiety along the journey.

“Investors will use technology to track decisions, identify individual proclivities and biases, and then provide assistance to improve decision making over time. We already use sophisticated psychometric profiling to establish individual’s financial personality, and then use this to tailor portfolios that provide the greatest return, for the lowest emotional discomfort.

“We’re developing tools to help investors build an Investor Constitution they can use to govern their investment decisions, thus rendering many of these abstract notions more concrete and usable.”

Mike Ervolini, the CEO of Cabot Research, says fund managers benefit greatly from behavioral finance feedback tools:

“Cabot Research is the only behavioral finance consulting firm in the entire globe that helps equity portfolio managers.  We’ve built analytics from the ground up just to help equity portfolio managers become more self-aware and improve. We allow them to use their own histories and we analyze their profits in such a way where they learn key things like how much of your profits come from buying or selling.

85% of the time a manager engages in a type of behavior that is costing the portfolio over 1% a year. And in 40% of the situations, the behavior is costing the portfolio over 2.5% a year. Traditional analytics can’t correct for these detrimental behaviors. In the future we will see fund managers increasingly relying on behavioral finance feedback.”

Victor Ricciardi, Goucher College Professor of Finance, believes that financial advisors with knowledge of behavioral finance can help investors make better decisions about retirement savings:

“I think seeing a financial advisor should be like seeing a doctor. You go every year to evaluate your investments and to correct for behavioral tendencies. Behavioral finance isn’t a replacement for standard finance–it’s complements our knowledge of how markets work. Behavioral finance can help people better understand their financial decisions and make better investment decisions. For example, many investors suffer from inattention bias. Financial advisors can help a client assess their level of risk tolerance and develop the proper asset allocation approach and then monitor their portfolio every year.”

BYU Professor Colbrin Wright believes that behavioral finance is best used to aid investors’ decision making and it is unclear whether or not funds using behavioral finance strategies are effective:

Behavioral finance is still a very young field. It will be quite a while before we will truly know how to apply ideas from behavioral finance to investing. If you evaluate a lot of the funds that claim to have use behavioral finance strategies, it’s questionable whether or not they are successful. The successful funds end up using strategies that look very similar to value investing, which has been around for decades. For the academics that believe they can beat the market, they might be know-it-alls who have more than a little hubris.”

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