In the last few decades, academics and practitioners have studied, defined and begun to exploit anomalies arising from human nature. The result is a burgeoning field known as behavioral economics, which traces its roots as far back as Adam Smith and studies the convergence of traditional economic theory and psychology. It appears that the confluence of certain social, cognitive and emotional factors can provide significant, and perhaps superior, explanatory power as it relates to financial modeling.
While the efficient market hypothesis makes a lot of sense in a world where investors act in a rational and predictable fashion, what happens when these assumptions don’t hold and markets confound even the most seasoned investment professionals? Enter the role of behavioral biases that might better explain the actions of security prices and financial markets.
Madison Avenue and Wall Street have thrived by taking advantage of the fact that we act irrationally, have difficulty with self-control and, in general, are selfish. There are limits to our cognitive abilities that result in decision-making processes that often involve shortcuts or rules of thumb, and we are influenced by our culture and individual circumstances. In short, we are emotional beings.
If we are so unpredictable, how can something like behavioral economics provide investors with an advantage? The key lies in identifying consistent patterns of behavior that not only are scientifically proven, but also make common sense. Daniel Kahneman and Amos Tversky are considered pioneers in behavioral economics, and some of their early research illustrates how our behavior can lead to exploitable opportunities.
For example, mean reversion is often utilized as an investment strategy for determining whether stocks are over- or undervalued and should thereby be purchased or sold. So why should a mean reversion strategy work if markets are, indeed, efficient? A likely explanation lies in behavioral biases, including the availability heuristic, aversion to losses and anchoring.