September 30, 2009

Oh, Behave!

This article will discuss behavioral finance and define some of the most common behavioral traits that researchers have identified. We will then examine ways in which investors can mitigate the effects of behavioral biases before concluding with a discussion of some biases that might be particularly prevalent among local agency investors. After reading this article, investors should have a better understanding of behavioral finance, and armed with this knowledge, be better prepared to manage their portfolio in an optimal manner.

Defining behavioral finance

Behavioral finance was founded in the late 1960s in response to traditional finance and its belief in efficient markets and rational investors. Behavioral finance is based upon the fact that financial market prices are a manifestation of millions of unique decisions made by thousands of different individuals. These individuals are subject to emotional traits and biases that often result in less than optimally efficient investment decisions. Proponents of behavioral finance have been encouraged by seemingly irrational market events such as the stock market crash of October 1987, the technology stock bubble of the late 1990s, and the financial crisis of 2008.

As might be expected, some traditional finance theorists are critical of behavioral finance. Some argue that even if markets appear to behave irrationally in the short-term, in the long run, markets return to an efficient state. Others believe that even seemingly irrational behavior such as bidding stocks up to unsustainable prices is effectively a rational response to expectations that other investors will bid prices even higher in the future. However, despite these criticisms behavioral finance has been increasing in popularity and many experts agree that investors can benefit from an awareness of behavioral traits and methods for mitigating their effects.

Common behavioral finance traits

Anchoring occurs in situations where investors do not fully incorporate new information into their analysis. Instead, an investor's opinion is "anchored" to their original forecast. New information may alter the forecast, but not to the degree that it would if investors were entirely unbiased.

Myopic loss aversion occurs when investors become too cautious due to an overemphasis on short-term performance. This can cause investors to reject investment strategies that promise attractive risk-adjusted long-term returns. This can occur even if the investment portfolio is designed to meet long-term objectives and can withstand principal fluctuations in the interim.

Confirmation bias is present when investors actively seek out information that reinforces their existing opinion. Financial markets are constantly in flux, and investors can benefit from examining the variety of opinions available in the marketplace. This type of critical thinking is far more beneficial than seeking out information that corroborates what the investor already believes.

Herd behavior occurs when investors are afraid of missing the latest investment trend or fad. Herd behavior is at the root of nearly every market bubble that has ever occurred. A recent example was when many individuals purchased overvalued technology stocks in the late 1990s because they were afraid of missing out on the gains that their fellow investors appeared to be enjoying. While some individuals do profit from this sort of investing, it requires nearly perfect timing in order to be successful over the long run.

Many investors, especially professionals, fall prey to the overconfidence bias. Simply stated, overconfidence refers to situations in which investors place more faith in their ability than their track record justifies. Overconfidence can lead to excessive risk-taking, overly active trading, or a lack of proper diversification. Many studies have shown that male investors are more prone to the overconfidence bias than female investors.

Prospect theory refers to the concept that investors view gains and losses differently. In other words, the satisfaction that investors receive when they make money does not equal the unhappiness that they feel when they lose money. Prospect theory often manifests in a tendency for investors to sell their winners too soon and hold onto their losers too long.

Correcting behavioral biases

Because behavioral biases represent deeply rooted psychological traits, correcting and overcoming them is difficult. Most investors are aware that they should attempt to avoid the emotions of greed or fear when it comes to managing their portfolio, and, ideally, individuals would prefer to invest in a rational and logical manner. However, because they are human beings it is impossible for investors to fully free themselves from their emotions. In spite of this, there are steps that investors can take in order to mitigate the negative effects of behavioral biases.

The first step in correcting behavioral biases is to be aware of them. As with any habit, it is impossible to correct the bias without first recognizing its presence and effects. Once investors are aware that they are subject to irrational biases, they will be alert for manifestations in their investment decisions. A second important step is to have an investment strategy and stick to that strategy. Investment policy statements can help in this regard by codifying and defining the objectives and constraints of the investment program as well as how success or failure will be measured. Having an objective framework in which to manage the investment program can prevent some of the worst manifestations of behavioral biases. For example, an investor whose policy limited them to holding 10% in technology stocks would have avoided overexposure to the sector during the bubble and subsequent crash of the late 1990s.

Finally, practice makes perfect when it comes to correcting behavioral biases. The more an investor practices acting rationally, the easier it will become.

Local agency implications

As with all investors, local agency investors can be subject to behavioral biases. Three biases in particular that local agency investors should be aware of are herd behavior, myopic loss aversion, and prospect theory. Having an appropriate investment policy in place is an important step in preventing herd behavior. This is particularly true during times when market consensus is overwhelmingly aligned in a certain direction (for example, a widespread belief that interest rates will move higher.) Even more importantly, an investment policy can help to prevent rash investment decisions during times of market crisis (such as autumn 2008.)

Some local agency investors are subject to the myopic loss aversion bias. When this occurs, the investor focuses too closely upon short-term losses as opposed to long-term portfolio performance. Some local agency portfolios are designed to serve as a long-term strategic reserve or to fund capital projects that will occur well in the future. In these instances, investors should focus upon long-term performance and the ability of the portfolio to help meet their financial goals. By being aware of the possibility of myopic loss aversion, investors may be better able to set aside concerns over short-term fluctuations and instead focus upon long-term portfolio performance.

The concept of myopic loss aversion also dovetails closely with prospect theory. When an investor is subject to prospect theory, they value gains and losses differently. This is the case for many local agency investors for whom political considerations enter into risk-return calculations. In other words, many local agency investors may not be rewarded for superior performance but their careers can be negatively impacted if they suffer large investment losses. This can create an overly conservative mindset in some investors. Knowledge of prospect theory can help investors decide whether they are prudently evaluating investment risks (both financial and career) or whether they are excessively risk-averse in how they analyze risk and return. In many instances they may find that an incremental increase in risk can substantially enhance portfolio returns over time with little possibility of significant losses.

Conclusion

Behavioral finance concepts such as herd behavior, myopic loss aversion and prospect theory play an important role in local agency investing. Unfortunately, simple knowledge of these concepts will not instantly relieve an investor of concern over short-term losses or fear of career damage resulting from such losses. However, knowledge will allow for a more sober assessment of the true level of risk in the portfolio and a reevaluation of the superior long-term returns that are often available without a substantial increase in risk. Employing these strategies can increase portfolio performance over time, benefiting not only local agency investors but also the taxpayer.

Brian Perry (brian.perry@chandlerasset.com) is a vice president and investment strategist at Chandler Asset Management in San Diego.

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