Behavioural Finance and Investment Management
Research Foundation of CFA Institute, edited by Arnold S. Wood (2010)

This book provides an excellent overview of the field of behavioural finance. It assembles leading academic and practitioner views and discusses this topic from several perspectives (reviewed below): (a) Behavioural Finance in the Context of Modern Portfolio Theory (Statman and Thaler), (b) Fear and Irrationality (Zweig and Shiller), (c) Lessons from Neuro-Economics, i.e., the operation of the brain (Sapra and Zak), and (d) The Sociology of Markets (Mauboussin).

Behavioural Finance in the Context of Modern Portfolio Theory
Nancy Flynn

Meir Statman describes the four building blocks of modern portfolio theory (MPT) and the alternatives offered by behavioural finance theory (BFT):

1. In MPT, investors are rational, but in BFT, they are “normal.” Loss aversion and hindsight bias are two of the more important behavioural traits that detract from rationality.
2. In MPT, markets are assumed to be efficient, but not so in BFT. Efficiency means a stock’s price is always equal to its fundamental value. Studies have found, however, that typically only 20 percent of changes in stock prices are due to fundamental value and that many changes in indices occur with no change in fundamentals at all.
3. In MPT, investors build portfolios using mean-variance analysis, but in BFT, portfolio construction is goal-oriented and involves quite different risk orientations for different types of investment objectives.
4. In MPT, return is determined mainly by “beta” (a measure of risk), but in BFT, return is a function of a wide array of factors, including market cap, value/growth, and momentum.

Statman makes the point that, while mean-variance and the Capital Asset Pricing Model (CAPM) are very elegant models, they are not very realistic in their assumptions and have consequently declined in usage. He also notes that the frequent criticism of BFT is not appropriate— its theories are elegant too, more complicated, but also more realistic.

Richard Thaler discusses the evidence legitimizing BFT and concludes that the term will in the future become a redundant phrase, as in, “What other kind of finance is there?” His conclusions also include the following:

¾    Investigation of BFT has led to models that explain aggregation of individual behaviour, grounded in both psychology and economics— important because opponents of BFT often argue that individual actions are irrelevant in aggregate.

¾    BFT theory on loss aversion explains the long-standing puzzle of why the long-term equity risk premium is so high.

¾    As noted earlier, BFT empirical research has uncovered frequent and widespread anomalies that question market efficiency.

Fear and Irrationality
Jason Zweig and Robert Shiller

Jason Zweig and Robert Shiller discuss fear and irrationality, respectively. Zweig has written and spoken extensively on fear as in impediment to rational actions. A number of his webcasts are available on the CFA Institute website and are worth watching. His chapter discusses how fears are often mistaken or inflated, causing investors to react reflexively—often to their detriment. Shiller, author of Irrational Exuberance (2000), discusses irrationality in the stock market and housing market. He points out that, while psychology is very important, it alone does not cause bubbles. Rather, bubbles result from a series elements including: participating factors, amplification factors, cultural factors, and not least, psychological factors.

Lessons from Neuro-Economics
Steven Sapra and Paul Zak

Steven Sapra and Paul Zak are Professors at the University of Southern California and Claremont Graduate University, respectively. In this chapter, they prescribe lessons for money managers. Neuro-economics, the study of brain regions involved in making decisions, permits the explanation of behavioural anomalies. One lesson from this excellent chapter concerns “anticipation of rewards.” In it, we learn that the brain (in different places) encodes reward data, motivates effort to seek rewards, and engages emotions for positive results in a rush of the sort typically associated with drug use. The lesson to investors is to be aware of how our brains influence our actions. Without discussing all the lessons contained in the chapter, suffice it to say that even a brief understanding of the operation of the brain would very likely improve our investment decisions.

The Sociology of Markets
Michael Mauboussin

Michael Mauboussin’s article is about the sociology of markets—who invests and what they invest in. It cites examples that explain how sociological factors have caused large-scale anomalies in market performance:

¾    The significant outperformance of U.S. small caps over large caps from 1926 to 1979, followed by the opposite in the 1980s and 1990s,

¾    The resumption of the small-cap outperformance pattern due to the growth in hedge funds from 2000 to the present, with their propensity (vs. that of mutual funds) for small- and mid-cap stocks, and

¾    The Alan Greenspan fixed-income “conundrum” in 2003–2004, during which Fed tightening strangely led to a fall in long rates.

The article concludes that financial institutions and agents matter a lot in asset pricing.