Behavioural finance cover story

In: Uncategorized

9 Jul 2014

This is the main text of my recent Fund Strategy cover story on behavioral finance. For a related box see below.

Insights into investment behaviour sometimes come from unexpected directions.

Daniel Kahneman, who won the Nobel prize for economics in 2002 for his work on behavioural finance, has described what for him was a eureka moment. It happened in the mid-1960s when, as a psychology lecturer at the Hebrew University in Jerusalem, he was teaching a course to air force flight instructors. After he had cited studies showing reward is a more effective teaching tool than punishment, one of his students stood up to contradict him.

“With respect. Sir, what you’re saying is literally for the birds. I’ve often praised people warmly for beautifully executed manoeuvres, and the next time they almost always do worse. And I’ve screamed at people for badly executed manoeuvres, and by and large the next time they improve. Don’t tell me that reward works and punishment doesn’t. My experience contradicts it.” (Quoted in Kevin McKean, Decisions, Decisions, Discover Magazine, July 1985.)

Kahneman later recalled this as a “joyous moment of insight”. He concluded that the instructor’s observation was right but his reasoning was completely wrong. The behaviour the student was describing was in fact mean reversion. In other words, performance tends to revert towards the average after periods of outperformance. For example, if a footballer performs particularly well or badly in a game they are likely sooner or later to move back towards their average level.

It was not long before Kahneman related this story to Amos Tversky, another psychology lecturer at the same university. The anecdote helped to spark off an immensely productive three-decade collaboration. Their joint project was to study how people made decisions in conditions of uncertainty. Tversky died in 1996 but Kahneman went on to win the Nobel prize for his work in developing behavioural finance.

Although finance was not their original concern, it became clear that their work had implications in the investment arena. The phenomenon of mean reversion is even apparent in equity price movements. Shares that perform spectacularly tend to revert to the mean sooner or later. Looking at how decision-making happens in practice has many implications from a practical investment perspective. It is therefore not surprising that many investment professionals have taken it up.

The financial crisis that started to emerge in 2007, along with the subsequent turmoil, strengthened interest in the approach still further. Greg Davies, the head of behavioural finance at Barclays, says: “The advent of the financial crisis made a lot of people aware that there is a strong psychological and emotional component to good investment decision-making.”

This article will examine the uses of behavioural finance as well as considering its possible limitations. It will start by sketching the intellectual background to the discipline before discussing its practical uses. Proponents of the field argue it can shed light not only on investment behaviour but on that of corporate executives and investment analysts. The article will finally consider whether behavioural approaches can help to explain the financial crisis of recent years.

The basics

Behavioural finance is often defined by what it is not. It tends to be counterposed to the idea of rational economic man – that is, the idea that human behaviour tends to be motivated by narrow self-interest. This concept is also known by many other names including Econ (as opposed to Human), homo economicus (economic human) and Max U (short for Maximum Utility). Sometimes Mr Spock, the character from the original Star Trek series, is held up as the archetypal rational individual.

Even from this basic contrast it begins to become clear how mainstream and behavioural approaches to investment can differ. The rational investor reacts like a calculating machine to each new piece of information that appears in the market. He is impervious to emotions such as greed and fear. The behavioural approach sees investors as prone to a wide range of cognitive biases (see box). In this model the investor is a long way from his rational counterpart.

But although this counter-position provides a way of contrasting the two approaches it should be remembered that the discussion is often more sophisticated. At the highest level, each side has a more nuanced understanding of the topic than is sometimes acknowledged.

For example, Daniel Kahneman draws back from arguing that human behaviour is inherently irrational. “Irrational is a strong word [original emphasis], which connotes impulsivity, emotionality, and a stubborn resistance to a reasonable argument,” he says. “Although Humans are not irrational, they often need help to make more accurate judgments and better decisions, and in some cases policies and institutions can provide that help.” (Thinking, Fast and Slow, Penguin 2012).

It is in this spirit that many of the more sophisticated practitioners of behavioural finance operate. In their view behavioural finance can act to complement the conventional approach rather than necessarily contradicting it. Greg Davies of Barclays says: “I’m very resistant to the notion that the two have to be seen as in competition.”

Frances Hudson, global thematic strategist at Standard Life Investments, uses the metaphor of a toolbox to show that the two approaches can work together. In her view, behavioural finance “addresses part of the market where some of the other analytical tools perhaps do not work so well”. She argues it is particularly useful over the short run. “If you look in the short term, the things that are driving markets are nearly all to do with behaviour,” she says. These include the flow of funds to investors and the reaction to news flow. It is over the longer term, from two to three years, that conventional tools come into their own.

To be sure, there are experts willing to argue bluntly that human behaviour tends to be irrational. Dan Ariely, a professor at Duke University in New York, argues that “we are not only irrational, but predictably irrational”. (Predictably Irrational, HarperCollins, 2009.) “Our irrationality happens the same way, again and again,” he says.

For their part, the proponents of rational economic man often claim that the behaviourists caricature them. The rationalists argue that their idea of rational individuals is more sophisticated than the behaviourists contend. For example, Gary Becker, another Nobel laureate, argued in his 1992 prize lecture: “The economic approach I refer to does not assume that individuals are motivated solely by selfishness or gain. It is a method of analysis [original emphasis], not an assumption about particular motivations. Along with others, I have tried to pry economists away from narrow assumptions about self-interest. Behaviour is driven by a much richer set of values and preferences.”

He went on to claim that “the analysis assumes that individuals maximise welfare as they conceive it [original emphasis], whether they be selfish, altruistic, loyal, spiteful, or masochistic”.

The differences between the two schools cannot be resolved here but it is worth nothing that Kahneman’s approach rests on the premise that humans have two ways of thinking. System 1, or fast thinking, works automatically and quickly, with little sense of voluntary control. System 2, or slow thinking, involves mental efforts that demand a lot of effort and concentration.

The latter system is usually associated with reasoned choices, but the power and importance of System 1 is often under-appreciated.

Practical uses

If humans are prone to behavioural biases, it follows that a wide range of actors are affected. The effects are not confined to investors, whether they are private individuals or professional fund managers. Investment analysts and the executives of companies are also prone to behavioural influences. Even experts in behavioural finance typically acknowledge that they are not themselves immune to bias.

Most of the work of Barclays’ Davies and his team is focused on advising high net worth individuals (HNWIs). In his view this is not a question of making them aware of a long list of possible biases. It is rather a matter of helping them to understand their financial decision-making better.

For Davies this task has two key elements. First, examining whether investors are making the right financial decision for their financial objectives. Second, asking whether they are sufficiently comfortable with their decisions at any given time.

“It’s about people making better decisions through a combination of self-knowledge and a knowledge of how that plays out in their actions and their interventions in various ways,” he says.

An important element of this approach is for its clients to do a Financial Personality Assessment.

This involves measuring their attitudes in relation to six dimensions: risk tolerance, composure, market engagement, perceived financial expertise, desire for delegation and belief in skill.

In practical terms, he says, this means his team can serve its clients better. For instance, during the Wall Street crisis of September 2008 those clients with low composure – those in particular need of emotional security – were contacted first.

For fund managers the challenge is more about how to better run their portfolios rather than providing clients with a framework for investing. JP Morgan has had a large team specialising in behavioural finance since the 1990s.

Jonathan Ingram, a manager on the team, says: “Like any active manager we believe there are anomalies in the market that we believe we can exploit. What behavioural finance really does is give us a framework with which to understand what has caused those anomalies.”

The JP Morgan team, consisting of 44 people, uses behavioural tools to examine a universe of about 2,000 stocks in Britain and the rest of Europe. However, he is keen to emphasise that the approach is not simply about applying behavioural tools in a mechanical way. “The model’s not a substitute for common sense,” he says. “If it was purely a machine making decisions there wouldn’t be 44 people employed.”

Ingram acknowledges that his own team, like any other investors, could in principle be prone to behavioural biases. It tackles the problem by having safeguards in place. “You have to have a very rigorous control around your decision-making process,” he says.

Ardevora is, at least in terms of the size of its operation, at the other end of the scale from JP Morgan’s team. Yet behavioural insights are also central to its investment approach.

Jeremy Lang, one of four partners, is keen to emphasise that he harnesses behavioural insights, rather than referring to his approach as behavioural finance. “We head off in a slightly different direction,” he says.

By this he means that the focus is on the behaviour of corporate executives rather than on investor psychology. “Our view is that they are quite different in personality types and in incentivisation structures and in the environment they face than investors,” he says. “They are prone to different types of biases”. In particular, he sees corporate executives as particularly prone to an overconfidence that can “border on the sociopathic”.

This leads Lang to adopt practices that are in some cases the opposite of mainstream. For example, his first priority is to avoid companies that take undue risks, rather than finding those that offer the highest potential rewards. “It’s not about trying to find the good companies,” he says. “It’s much more about trying to find the environment where executives are more likely to behave in a sensible way.”

Lang also makes a point of avoiding face-to-face contact with corporate executives. This is because he wants to avoid subconsciously identifying with those managers he meets. “I’m recognising my own biases here,” he says. “I don’t want to get too close to them. I don’t want my view twisted by personal contact.”

Instead the emphasis is on learning about the companies and inferring lessons about corporate behaviour from “the boring old balance sheet”. Lang also trawls through written statements made by executives.

Broader explanations

Behavioural finance may offer insights into the behaviour of individual actors but it does not necessarily follow that it can explain how markets work overall. Nor can it necessarily explain how the causes of crises.

David Adler, the author of Snap Judgment (FT, 2009), says the approach is useful in some areas but not in others. “Behavioural is very good at finding different anomalies in prices in equities,” he says. “And it’s extremely strong and powerful in looking at individual behaviour.”

However, the New York-based expert says it does not help to explain the Wall Street crisis of 2008-09. “The problem is that the recent crisis occurred predominantly in institutional markets that were not exactly filled with naïve traders.”

In his view, behavioural finance is much better at explaining the behaviour of ordinary investors than that of highly skilled professionals.

The problem in 2008, in his view, lay with a poorly structured market and, in particular, the shadow banking system. “Markets went crazy but it was not because the participants were crazy,” he says. “It was because of poorly structured markets that got into these liquidity spirals.”

This is in contrast to the technology boom of the late 1990s and the subsequent bust in the early 2000s. The focus back then was much more on the equity markets. “The whole field of inquiry is deeply irrelevant to the current situation,” says Adler. “It was fine during the tech boom.”

It is also important to note that the conventional behavioural approach tends to downplay or even ignore the importance of the underlying economy. The emphasis is focused tightly on individuals and their cognitive biases. This precludes the possibility, for example, that surges of liquidity from the real economy can play a role in the emergence of bubbles. Inflated asset prices are not necessarily the result of investor psychology or any form of conscious decision-making. If anything, investors may be simply reacting to the circumstances they find themselves in.


It is widely accepted that behavioural factors can play a role in explaining investor behaviour and that of other market actors. Some financial institutions are willing to expend considerable resources on harnessing such insights. The application of these tools to explain market behaviour or even financial crises is a more contentious area.

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