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10
BEHAVIORAL FINANCE
Behavioral finance is not a branch of standard finance: it is its
replacement with a better model of humanity.
—Meir Statman
Thus far I have described stock-market theories and
techniques based on the premise that investors are
completely rational. They make decisions with the objective
of maximizing their wealth and are constrained only by their
tolerance for bearing risk. Not so, declares a new school of
financial economists who came to prominence in the early
part of the twenty-first century. Behavioralists believe that
many (perhaps even most) stock-market investors are far
from fully rational. After all, think of the behavior of your
friends and acquaintances, your fellow workers and your
supervisors, your parents and (dare I say) spouse (children,
of course, are another matter). Do any of these people act
rationally? If your answer is “no” or even “sometimes no,”
you will enjoy this journey down the less than rational
byways of behavioral finance.
Efficient-market theory, modern portfolio theory, and
various asset-pricing relationships between risk and return all
are built on the premise that stock-market investors are
rational. As a whole, they make reasonable estimates of the
present value of stocks, and their buying and selling ensures
that the prices of stocks fairly represent their future
prospects.
By now, it should be obvious that the phrase “as a whole”
represents the economists’ escape hatch. That means they
can admit that some individual market participants may be
less than rational. But they quickly wriggle out by declaring
that the trades of irrational investors will be random and
therefore cancel each other out without affecting prices. And
even if investors are irrational in a similar way, efficient-
market theory believers assert that smart rational traders will
correct any mispricings that might arise from the presence of
irrational traders.
Psychologists will have none of this economic claptrap.
Two in particular—Daniel Kahneman and Amos Tversky—
blasted economists’ views about how investors behave and in
the process are credited with fathering a whole new economic
discipline, called behavioral finance.
The two argued quite simply that people are not as
rational as economic models assume. Although this argument
is obvious to the general public and non-economists, it took
over twenty years for it to become widely accepted in
academia. Tversky died in 1996, just as it was gaining
increased credibility. Six years later, Kahneman won the
Nobel Memorial Prize in Economic Sciences for the work.
The award was particularly notable in that it was not given to
an economist. Upon hearing the news, Kahneman
commented, “The prize…is quite explicitly for joint work,
but unfortunately there is no posthumous prize.”
Though the insights expounded by Kahneman and
Tversky affected all social sciences dealing with the process
of decision making, they had a particularly strong impact on
economics departments and business schools across the
country. Imagine—a whole new field in which to publish
papers, give lectures for hefty fees, and write graduate theses.
While that may be all well and good for the professors and
the students, what about the rest of the world that wants to
invest in stocks. How can behavioral finance help them?
More to the point, what’s in it for you? Actually, quite a bit.
Behavioralists believe that market prices are highly
imprecise. Moreover, people deviate in systematic ways
from rationality, and the irrational trades of investors tend to
be correlated. Behavioral finance then takes that statement
further by asserting that it is possible to quantify or classify
such irrational behavior. Basically, there are four factors that
create irrational market behavior: overconfidence, biased
judgments, herd mentality, and loss aversion.
Well, yes, believers in efficient markets say. But—and we
believers always have a but—the distortions caused by such
factors are countered by the work of arbitrageurs. This last is
the fancy word used to describe people who profit from any
deviation of market prices from their rational value.
In a strict sense, the word “arbitrage” means profiting from
prices of the same good that differ in two markets. Suppose
in New York you can buy or sell British pounds for $1.50,
while in London you can trade dollars for pounds at a $2.00
exchange rate. The arbitrageur would then take $1.50 in New
York and buy a pound and simultaneously sell it in London
for $2.00, making a 50¢ profit. Similarly, if a common stock
sold at different prices in New York and London, it would be
justifiable to buy it in the cheap market and sell it in the
expensive one. The term “arbitrage” is generally extended to
situations where two very similar stocks sell at different
valuations or where one stock is expected to be exchanged for
another stock at a higher price if a planned merger between
the two companies is approved. In the loosest sense of the
term, “arbitrage” is used to describe the buying of stocks that
appear “undervalued” and the selling of those that have
gotten “too high.” In so doing, hardworking arbitrageurs can
smooth out irrational fluctuations in stock prices and create
an efficiently priced market.
On the other hand, behavioralists believe there are
substantial barriers to efficient arbitrage. We cannot count on
arbitrage to bring prices in line with rational valuation.
Market prices can be expected to deviate substantially from
those that could be expected in an efficient market.
The remainder of this chapter explores the key arguments
of behavioral finance in explaining why markets are not
efficient and why there is no such thing as a random walk
down Wall Street. I’ll also explain how an understanding of
this work can help protect individual investors from some
systematic errors that investors are prone to.
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