Behavioral Finance and Its Practical Implications

for Investment Professionals

Thesis

By

Denisa Valsová

Submitted in Partial fulfillment

Of the Requirements for the degree of

Bachelor of Arts

In

Business Administration

And

International Economic Relations

State University of New York

Empire State College

2016

Reader: Tanweer Ali

controlling yourself at your own game.”

- Jason Zweig
 Acknowledgment

My greatest thanks go to my beloved family, who have not stopped loving me,

caring for me, feeding me and tolerating me, even at those points when I

would only talk to them about the number of characters I still had to write to

finish my thesis, and of course to my inspiring and ever-supportive mentor,

Mr. Tanweer Ali, who has probably contributed to my learning and personal

development throughout my Bachelor studies more than anybody else.

I. Introduction ................................................................................................................................. 6
II. Origins of behavioral finance .................................................................................................. 8
A. Traditional finance .................................................................................................................. 9
1. Development of modern finance and financial markets...................................................... 9
2. Theory of modern finance and the Efficient Markets Hypothesis ...................................... 14
B. Behavioral sciences ................................................................................................................ 18
1. Cognitive psychology .......................................................................................................... 19
2. Behavioral economics......................................................................................................... 19
3. Evolutionary biology and neuroscience ............................................................................. 20
III. Theory behind Behavioral Finance........................................................................................ 22
A. Background and evolution .................................................................................................... 22
1. Kahneman and Tversky ..................................................................................................... 22
2. Prospect Theory ................................................................................................................ 24
3. Other significant work in the field ..................................................................................... 26
B. Heuristics – mental shortcuts and their role..........................................................................27
1. Role of heuristics in decision making .................................................................................27
2. Key individual heuristics ................................................................................................... 28
C. Behavioral biases ................................................................................................................... 30
1. Significance of behavioral biases ....................................................................................... 30
2. Key individual biases .......................................................................................................... 31
IV. Practical Applications of Behavioral Finance in Professional Investing ............................... 38
A. Addressing loss aversion ....................................................................................................... 40
B. Overcoming investor paralysis ............................................................................................... 41
C. Addressing mental accounting .............................................................................................. 44
D. Fighting biases and heuristics in retirement savings behavior ............................................. 46
V. Herding, Bubbles, and Overconfidence: A Behavioral Study of the Stock Market ................ 50
A. Creating value in stock trading using behavioral finance findings ........................................ 52
B. The behavioral perspective on bubbles ................................................................................. 53
C. Equity premium puzzle ..........................................................................................................55
VI. Conclusion ............................................................................................................................. 58
VII. Works cited ........................................................................................................................... 60
VIII. Bibliography .......................................................................................................................... 64
 Abstract

Behavioral finance is a relatively novel field of finance that originates from behavioral

economics, conventional finance and psychology. Its aim is to identify the biases,

irrationalities and flaws in human decision-making related to financial questions, and suggest

ways to deal with these to achieve better decision making. This thesis examines the field of

behavioral finance and its origins and seeks to answer the question of whether behavioral

finance can indeed offer practical solutions and be applied by finance professionals to achieve

improved financial decisions for themselves and their clients.

The work first examines the origins of behavioral finance and the impact of other fields of

science on it, most importantly behavioral economics, psychology, neuroscience and also

conventional modern finance and behavioral science in general. Then it outlines the key

findings and theory behind behavioral finance including a detailed explanation of individual

biases and irrational behaviors that have been identified, their causes and their implications

for financial markets and their participants. Behaviors discussed include for example mental

accounting, loss aversion or overconfidence bias.

The theoretical part is followed by the core section of this work and the key result of its

research and analysis – the explanation of some practical implications of the findings for

investment professionals and of specific ways how the professionals can apply these findings

in their everyday work to both make better, more rational decisions themselves and empower

their clients to do so as well. The practical manifestations and applications are then studied

on the example of stock markets.

is indeed a powerful tool not only in understanding the deeper intuitive causes of some of

our behaviors related to financial decision making, but also, and most importantly, in

addressing these effectively on a daily basis. It empowers investment professionals to gain a

deeper understanding of the drivers of their decisions and those of their clients. A key finding

of my research is the fact that even merely being aware of the existence of the cognitive

biases and weaknesses in our decision making makes us much better at avoiding them, and

actively addressing them yields even better results. A crucial conclusion of my thesis is that

a wider application of the findings of behavioral science has the potential to not only improve

outcomes of finance related actions of individuals but also to achieve better systemic results

in financial markets, ie. in reducing their tendency to create bubbles.

The era that we live in is called the ‘information age’ – and for a good reason. Never before

have people had such instantaneous, easy access to so much information. The abundance of

information might seem to be beneficial to us in getting informed and making good decisions,

but the availability of so much information does not necessarily make us knowledgeable; in

fact, it might actually be overwhelming and hamper decision making. Judgmental heuristics,

or mental shortcuts, are thus a natural reaction that allows us to process complex information

and arrive to conclusions more rapidly. However, not only are these conclusions often faulty,

we may even believe we have gained substantial levels of knowledge when viewing the

conclusions as correct. An investment professional that is able to systematically recognize

and address incorrect uses of heuristics in financial decision making is much better equipped

not only to improve his or her own decisions but also, crucially, to help clients achieve their

goals (Moisand, 2000, p. 130).

So far, traditional approach to finance and investment has mostly worked with financial

markets and financial decision making under the elementary economic assumption of

rationality and efficiency of markets and their participants, and it has been able to explain

some of the behaviors in this way. However, more and more inconsistencies appear that the

traditional finance paradigms are unable to either predict or explain, and even the initial

assumptions of these theories are problematic – the assumption of rationality, while useful

for simplifying the situation and making it easier to analyze and understand, is just not there

in real life. As Kunte puts it, “the mechanism of incentive and fear makes investing an

inherently emotional process” (2016, n.p.). In the last years, though, finance has seen an

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emergence of a new way of thinking about financial decision making that takes into account

the psychology of the investor – heuristics, biases, emotions, fears, fallacies – to make sense

of investor decision making. Behavioral finance is a relatively new field that enters the

discussion as an alternative approach working with emotion and decision-making flaws to

see how these prevent us from achieving optimal results in investing and how they can be

worked with to optimize the results.

The aim of this work is to analyze the current traditional finance paradigm and evaluate

behavioral finance as a plausible alternative approach to the big financial debate. It shall look

at the issues that behavioral finance addresses and their relation to the predominant traditional

views of modern finance. It will further outline some specific steps that investment

professionals can take to make better financial decisions themselves and to be better suited

to advise their clients.

Behavioral finance is a powerful tool not only in understanding the deeper intuitive causes

of some of our behaviors related to financial decision making, but also, and most importantly,

in addressing these effectively on a daily basis, as it empowers investment professionals to

gain a deeper understanding of the drivers of their decisions and those of their clients, and to

apply this knowledge in their professional practice to achieve better, more rational decisions;

for this reason behavioral finance should see a broader application in everyday practice of

finance professionals in order for the industry to generate more positive outcomes.

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 II. Origins of behavioral finance

In order to understand behavioral finance, the role that it plays on modern financial markets

and its possible application by professionals active on these markets, we must first understand

where behavioral finance comes from. The aim of this chapter is to explain what was the

situation that created the impulse for the emergence and development of behavioral finance,

how it has developed since and how has it been formed and influenced by other disciplines

of both natural and social sciences. It pays special attention to the Efficient Market

Hypothesis, the central paradigm of today in finance academia, whose shortcomings in

explaining the behavior of the financial markets have been the key reason for the emergence

of behavioral finance.

Behavioral finance has entered the field of finance as an alternative theory in the debate, not

as a dominant force as of yet (but it has the potential to become one). The debate that

behavioral finance has entered is one of the biggest debates in economics in the last 50 years,

and is about whether stock prices and prices of other assets (such as bonds or even property)

reflect all the information available, or in other words, “whether prices reflect the wisdom of

crowds, or the madness of crowds,” and, by extension, whether people always (or at all) act

rationally and based on all available information when making financial decisions (Holden,

2015). So far, the rationality side of the debate is the dominant one in both modern economics

and modern finance, but it is increasingly evident that market participants are not always as

rational and well-informed as scholars would like to think, which is evidenced by numerous

anomalies that appear in the application of models based on such assumptions. This is where

behavioral finance comes in, attempting to explain the causes of these anomalies related to

8
irrational behaviors and manage them. Let us now look at the development of modern finance

(sometimes called also traditional finance, these terms are used interchangeably throughout

this work) and behavioral finance within it to understand the impact of one on the other.

A. Traditional finance

1. Development of modern finance and financial markets

The story of modern finance the way we know it is one of liberalization and deregulation and

of growing complexity, sophistication and risk. It all started in 1971 with the collapse of the

Bretton-Woods system and freely floating currencies, when Richard Nixon decided to tackle

a crisis caused by a growing trade deficit and an expensive war in Vietnam by suspending

the convertibility of the US dollar into gold. This move effectively ended the Bretton-Woods

system of currencies being pegged to the US dollar in fixed exchange rates, and with the

disappearance of exchange controls capital could suddenly move freely from one country to

another (Link by Link, 2008). This dramatically changed the world of business, trade and

finance. With floating currencies, companies operating in multiple currencies started needing

to hedge exchange rate risk. This lead to a creation of currency futures when a former lawyer

Leo Melamed introduced currency futures on the Chicago Mercantile Exchange, leading to

the eventual emergence of the complex derivatives of today (commodity futures, however,

had been a common tool for farmers to insure against falling crop prices for over a century

then) (Link by Link, 2008).

In the academic community of the time, liberalism and a free-market economics were

dominant forces in economics. The conviction was that Keynesian economics, with its focus

9
on government intervention to compensate market failures, had failed and that markets with

their invisible forces would do a better job of allocating wealth and capital than governments

ever could. This school of thought, again centered in Chicago, came to have great influence

on key policy-makers of that time, Ronald Reagan and Margaret Thatcher in particular, who

both believed that after the “economic turmoil of the 1970s” freer markets would lead to

economic gains and increased popular support, as capital controls were not strictly necessary

anymore and liberalized markets would contribute to increased home ownership and make

housing more achievable with the abandoning of credit controls and an entry of more lenders

to the home-loan market. This lead to Britain and the USA abolishing capital controls in the

1980s (while Europe stayed careful and responded with the creation of the European

Monetary System) (Link by Link, 2008).

The recession and reforms of the 1980s and their consequences in Europe and the USA led

to further interesting developments in the world of finance with financial institutions being

able to move money across borders, the role of stockbrokers changing with commissions

being cut and foreign firms entering the markets. Over time, brokers and investment banks

started needing more capital to stay profitable, with the falling commissions, by trading on

their own account. Commercial banks developed strong balance sheets to get involved in the

underwriting of securities (by driving investment banks out of it) as the commercial lending

sector got way too competitive and expensive to run. The reaction of investment banks was

to get bigger. Overall, the era of the 1980s and 1990s was one of great expansion and

diversification, happening in an unusually favorable environment of few and short

recessions, with asset prices growing for most of the period and so trading in these assets or

lending against them was highly profitable (Link by Link, 2008).

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The broadening business in a favorable economic environment but with plentiful competition

led to one key development – a massive increase in the complexity of the business of banks

and other financial institutions. One crucial trend that was enabled by the advances of finance

theory was the concept of distinguishing multiple components of risk in investing and trading

these separately. As a theory of option pricing was developed by Fischer Black and Myron

Scholes at the University of Chicago, option contracts (that, similar to the above mentioned

commodity futures, had been known and used by traders since ancient history) experienced

an “explosion in their use” (Link by Link, 2008). The enormous rise in the popularity of

options was due to a simple fact – as opposed to a futures contract that firmly locks the

participants in no matter what the outcome for them, the option is a much safer approach to

hedging your exposure to fluctuations in prices, a form of insurance in a way, in which you

have a right to exercise the option if the price moves a certain way and you can only lose the

contract fee (called the premium) as a buyer if the price moves in the opposite direction, but

your gains are not limited. Black and Scholes developed a formula showing the dependence

of an option’s value on the volatility in price of the underlying asset (the more the price

moves, the more likely the option is to be exercised), and together with the strides in the

power of computers made the volatility much easier to calculate (Link by Link, 2008). This

improved understanding was a major contribution to the growth in popularity of options

before 2000.

Other derivatives followed the spread of options and currency futures in attempts to manage

risk on one side and to make money in a rather elegant way on the other side. Currency swaps

(swapping bonds in one currency for those in another one leading to lower interest rates for

both sides) emerged soon after options, followed by interest-rate swaps (allowing borrowers

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on a fixed rate to switch with those on a variable rate) that were meant to enable one to

manage his risk exposure but has been heavily used by speculators too. More exotic

derivatives started emerging after 2000, with growing complexity, trouble and space for

speculators. Credit-default swaps are one example of a complex derivative product growing

at an alarming rate and allowing an investor to “separate the risk of interest-rate movements

from the risk that a borrower will not repay” making it an insurance against default (Link by

Link, 2008).

Derivatives have become a major topic in modern finance for two simple reasons. One, “a

small initial position can lead to a much larger exposure” – if the price changes or a borrower

defaults on a loan, someone will have to cover the losses (Link by Link, 2008). In other

words, the potential for disaster is massive – derivatives can get dangerous. Given that many

newly created derivatives are complex, non-transparently engineered tools, many of them

can be worked with as off-balance sheet items, it is very difficult for regulators to keep track

of a company’s exposure to risk. State authorities sometimes also get involved in using

opaquely structured derivatives they do not understand and get into trouble, such as Orange

County in California in the 1990s or Greece’s attempts to get its debt off its balance sheet

resulting in Goldman Sachs designing a catastrophic derivative that enabled the country to

mislead EU authorities at the time but caught up with it very painfully years later. The second

reason why derivatives and modern financial instruments in general have become such a

major topic is the low level of regulation of the market. Deregulation has been a trend for

decades. While countries and local authorities understand that derivatives bring risk, they

also see that they bring trade and money when it is made easy for them, and enable investors

and companies to spread their risk, which is beneficial both for the markets and the

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economies as a whole. This, together with powerful lobbying, has created a strong driving

force to liberalize the markets and reduce government control over them. However, they also

bring their own form of risk and can promote destructive behaviors, such as in the case of

credit-default swaps that basically allow banks to insure against the damage their products

cause to others. Selling a car with faulty brakes and taking life insurance on the driver’s life

is obviously both wrong and illegal, yet the financial equivalent of this is possible in the

deregulated market of today.

Another case of growing complexity on the financial markets is the concept of securitization,

developed in the 1970s but growing massively since then to lead to the 2008 crisis.

Securitization is the practice of bundling loans, most typically mortgages, into packages that

are then sold on to outside investors. These asset-based instruments grew more and more

sophisticated and are also connected to another big 2008 troublemaker, collateralized debt

obligations, opaque and sophisticated bundles of bonds selected according to the investor’s

preferred risk profile (Link by Link). Commercial banks engaged in trading with these non-

transparent instruments with misrepresented risk thanks to securitization that allowed them

to borrow money in the markets in the years leading to 2008. And after that, you know the

rest of the story.

Overall, we can see when looking at the developments of financial markets since the collapse

of the Bretton Woods system the major trends that are shaping the industry – growing

sophistication and complexity on the background of a weak regulatory environment and the

markets showing various behaviors not quite foreseen by the academic and professional

community, such as the “dot com” bubble or the 2008 subprime lending crisis. Traditional

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finance theories have been successful to a certain extent to describe and predict the normal

developments but generally less so when working with these and other anomalies. We shall

next have a look at the theory of modern finance and the dominant market behavior theory

of today – the Efficient Markets Hypothesis, to see how well it manages to explain,

understand and predict behaviors of the markets and their participants.

2. Theory of modern finance and the Efficient Markets Hypothesis

Let us now explore the academic and theoretical aspects of the development of modern

finance since the 1970s that were the crucial elements forming the background of the events

on the markets. Finance as such can broadly be defined as “the study of how scarce resources

are allocated by humans, and how these resources are managed, acquired and invested over

time” (Subash, 2012, p. 5). Olsen (2001) has argued that traditional or modern finance is

based on six core themes:

1) All cause and effect can be known and understood, at least in theory;

2) Over time, negative feedback dominates and leads to market

equilibrium;

3) The human mind learns to solve problems in a structured way and so

can be trained to make decisions focused on optimization in a formally

logical manner;

4) It is possible to achieve complete objectivity as observers can stand

outside the system they observe;

5) Emotion negatively influences decision making

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 6) Humans have a natural tendency to decide in their individual best

interest (p. 102).

While there of course is a wide range of opinions on such a definition among finance scholars,

just from looking at these six points that traditional finance is consistent with at least to an

extent, we can spot multiple issues. It is true that to devise a model that actually manages to

give some insights, it is necessary to simplify the situation at least to a point, but some of the

assumptions, such as relying on objectivity in humans or generalizing emotion as negative

for decision making, are a rather fat stretch of reality, posing the question of how much of

the findings of traditional finance is reliable when based on assumptions that cannot be true

even most of the time, let alone all the time.

The key elements shaping the debate that are important for our analysis include the Efficient

Markets Hypothesis (EMH) and the Capital Asset Pricing Model (discussed in detail,

together with a behavioral perspective on it, in chapter III). The Efficient Markets

Hypothesis, formulated by Eugene Fama, emerged in 1969, became the leading theory

preferred by the academic community during the 1970s and has been the central paradigm of

modern finance ever since. The Efficient Markets Hypothesis states that asset prices (such as

stocks, bonds or property) completely reflect all available relevant information

instantaneously and completely. The model can be described in the following way: the price

of a share or a portfolio representing an index equals “the mathematical expectation,

conditional on all information available at the time, of the present value of actual subsequent

dividends accruing to that share or portfolio”, or in other words, that “price equals the optimal

forecast of it” (Schiller, 2005, p. 85). The practical meaning of the theory is that it is

impossible to “beat the market” consistently and over the long term, because asset prices only

15
react to new information from news, which are in their nature random. Stocks thus always

trade at their fair value, which makes it impossible for investors to buy undervalued or

overvalued stocks and outperform the market based on selecting the right stocks or going in

in the right time – there is no “free lunch”. The only way one can hence achieve a higher

return is by selecting riskier investments (Schiller, 2005, p. 85). Therefore, no investment

strategy exists which can consistently earn excess returns once these are risk-adjusted

(Subash, 2012, p. 5). According to the Efficient Markets Hypothesis, this is true for

speculative investments as well, since the speculative price already always includes the

impact of the best information regarding economic fundamentals and the price only changes

based on “good, sensible information”, including insider information.

The theory rests on certain assumptions, the key ones being the assumption that market

participants have rational expectations and value securities rationally based on these, that the

population reacts adequately on average (note that, however, they do not need to be rational

per se, no one person needs to be rational, it is only important that the population as a whole

is, with a normal distribution of reactions to new information from under-reaction through

adequate reaction to overreaction – the irrational trades cancel each other out without having

an effect on prices), and lastly that when new information appears, the market participants

adjust their expectations accordingly and adequately (Schiller, 2005, p. 83). In short, the

EMH assumes that since people value wealth, their behavior in making financial decisions is

rational - but it still does not manage to answer some key questions in financial decision

making, such as for instance why do investors trade or why do returns differ across stocks

apart from risk reasons (Subash, 2012, p. 5).

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The Efficient Markets Hypothesis comes in three forms: weak (stock prices cannot be

forecasted based on past prices, fundamental analysis might provide above-average returns),

semi-strong (stock prices react to new publicly available information very quickly, neither

technical nor fundamental analysis can be relied upon to produce above-average returns in

the long term) and strong form efficiency (stock prices react very quickly to all new

information, both public and private, it is not possible for anyone to earn above-average

returns in the long term, even if they have insider information) (Schiller, 2005, p. 88). Since

the strong form is difficult to accept, mainly because of available evidence suggesting that

insiders in fact do achieve above-average returns even if trading legally, most of the

evaluations of the EMH have worked with the weak or semi-strong forms of efficiency

(Subash, 2012, p. 7).

The Efficient Market Hypothesis was at the top of its popularity in academic circles in the

1970s, but remains a dominant theory even now. The fact that the EMH assumes rationality

but is not purely based on it, as it predicts efficiency even in markets where some irrationality

exists, gives the theory a lot of credibility (Subash, 2012, p. 7). However, while there are

many studies and empirical evidence supporting the theory, there are challenges to its

validity, both empirical and theoretical. Numerous anomalies have surfaced over the years

that challenge the key principles of the hypothesis. While some of the anomalies are only

minor and the theory does work quite well with a normal distribution of population, thus

allowing for a few outliers in either direction, the challenges bring valid points and generally

do not speak in favor of the stronger forms of the theory. Some notable challenges include

the existence of a number of highly successful investors such as Warren Buffet or the

existence of market bubbles, which are obvious and major anomalies and do not fit with the

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underlying assumptions of the theory. Grossman and Stiglitz, as cited by Subash (2012)

argued that the existence of efficient markets was impossible since information had a cost

associated with it and so prices would not reflect available information perfectly, as if they

did, the investors would have no incentive to spend resources to obtain the information (p.

8). The growing number of the anomalies and inaccuracies in the Efficient Markets Theory

was one of the main reasons for the emergence of behavioral finance, which proposes valid

reasons to believe that financial markets are in fact not efficient, and it seeks to explain these

anomalies by the irrational aspect of human behavior, impact of biases, flaws in reasoning

etc. As Subash (2012) explains, while the EMH was taking over the world of finance,

researchers in psychology were discovering that people often make financial decisions in

strange, seemingly irrational ways, so the findings of psychology started being applied to

widely used finance paradigms to make sense of these deviations from the presumed

rationality of market participants (p. 5). Therefore, behavioral finance is in fact a stretch of

traditional finance to a place where it meets with natural and cognitive sciences to see what

they can offer to the effort of explaining the anomalies found in traditional finance theory

and using these to enable investment professionals to make better decisions in their everyday

practice.

B. Behavioral sciences

Behavioral finance is a relatively new discipline that has emerged from traditional finance,

applying to it the findings of other disciplines of both social and natural sciences – cognitive

psychology, behavioral economics, neuroscience and evolutionary biology and, some argue,

18
even physics – to aid standard theories of finance in explaining financial decision making by

introducing behavioral aspects to the process.

1. Cognitive psychology

Traditional finance is very strongly focused on the concept of risk. However, what it does is

it attempts to quantify and analyze only the risk itself on an ad hoc basis using sophisticated

tools such as variance of return or Beta. In traditional finance, risk is a mathematical

phenomenon. What it does not take into account is the investor as the perceiver of the risk

from the psychological point of view and the unique context of his situation and experiences

– it treats risk as something external when in fact it is a concept that helps people understand

and deal with the uncertainties and dangers of life and each person sees it differently. Thanks

to the findings of cognitive psychology, behavioral finance is able to see risk a multi-factor

phenomenon with various dimensions including the probability and size of a loss, perception

of fairness, trust or fear (Olsen, 2001, p. 109). Insights on cognitive dissonance, time

preference and other behavior patterns have been very valuable to behavioral finance

research.

2. Behavioral economics

Behavioral economics has been a crucial building block of behavioral finance as it identifies

inconsistencies in human behavior and the classical economic theory on utility and rational

analysis of available alternatives. It discovered some elementary behavior patterns applicable

in financial decision making such as the anchoring effect or some substantial anomalies such

as hyperbolic discounting, discounting inconsistent in anticipated gains and anticipated

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losses as well as in smaller versus larger outcomes, projection bias and many other patterns.

These pose a valuable challenge to traditional finance that strongly emphasizes time and

future and have potential to contribute to creating and testing of models that forecast prices,

earnings, cash flows or dividends while taking into account how the temporal aspect is

evaluated and how choices are being made in this regard. Behavioral economics very clearly

shows that people are certainly not and even cannot be “logic machines” (Olsen, 2001, p.

120).

3. Evolutionary biology and neuroscience

Neuroscience and evolutionary biology examine the human brain and how it has changed

throughout the development of mankind. The most crucial and valuable contribution of

neuroscience and evolutionary biology to the development of behavioral science in general

and behavioral finance in particular is in the understanding it brings to the “connection and

interplay between emotions and cognition” (Olsen, 2010, p. 102). As mentioned above,

traditional finance sees emotion as contributing to poor decisions, suggesting that extracting

emotion from the decision making process should lead to better decisions – using rational,

structured logic should bring a better result. As Olsen (2001) puts it, “the idealized economic

man is a person who has deep and intimate familiarity with his environment, a well-ordered

set of preferences and a numerical ability to evaluate different alternatives and optimize his

choices” (p. 103). It is most certainly true that sometimes emotion does lead to poor decision

in finance and elsewhere, and that is also one of the focuses of behavioral finance. Modern

decision theories tend to emphasize the frontal cortex of the brain (the “executive function”)

as the dominant one in decision making. Nevertheless, neuroscience examines the brain as a

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highly complex biological system in which all parts operate together and support the

functions of one another. Its key finding is that emotion typically plays a lead role in decision

making with cognition being the supportive function – this is the basis for caring as emotion

in inseparable from other functions and thus “reason is impotent without emotion”. Emotion

is dominant in the perception process and creates the context for experiences which are

necessary for reason to operate and help it categorize and simplify the world (Olsen, 2001,

p. 103). These findings of neuroscience are of utmost significance to behavioral scientists as

they show that neither the classic idea of the “economic man” nor its more modern versions

is the correct interpretation of the human mind and decision making process, and thus show

the need for theories that encompass these key discoveries to make sense of human decisions

within finance.

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III. Theory behind Behavioral Finance

Having established how and why behavioral finance originated, let us now look in more detail

on what exactly it is, what concepts it works with and what methods it uses. Behavioral

finance is the study of the influence of psychology, emotion and mental shortcuts and biases

on the behavior of financial market participants, and the subsequent effect on markets

(Sewell, 2007, p. 1). Behavioral finance research includes both observation and analysis of

the behavior of financial markets and their participants in real environments and the

observation in experimental settings.

A. Background and evolution

The behavioral finance paradigm has developed as a response to the problems faced by the

traditional paradigm. In its core, it claims that investment choices are not always made fully

rationally, and so it attempts to make sense of those investment market phenomena that fall

out of the understanding of the traditional paradigm by relaxing two traditional assumptions

about rationality: agents actually sometimes fail to update their beliefs correctly and there is

a “systematic deviation from the normative process in making investment choices” (Subash,

2012, p. 9).

1. Kahneman and Tversky

Daniel Kahneman and Amos Tversky are often recognized as the fathers or founders of

behavioral finance. Daniel Kahneman is a Nobel prize-winning psychologist focused on

psychology of judgement and decision making and on behavioral sciences; Amos Tversky

(who passed away in 1996) was a cognitive and mathematical psychologist focused on

22
systematic cognitive biases and the handling of risk. While originally focused on different

research topics, they started to work together in the 1970s and laid the grounds of the field.

Their first steps were to adapt psychological experiments in decision theory to real financial

scenarios and contrast normative solutions to problems with subjective answers to these

problems they collected through experiments (Subash, 2012, p. 11).

Kahneman and Tversky authored together a number of papers that came to form solid

grounds to the field, especially in the 1970s and early 1980s. Their first paper, “Belief in the

Law of Small Numbers”, published in 1971, discussed the faulty beliefs people hold about

probabilities and the representativeness of statistics, such as the belief that a random sample

of a population is in fact representative of the given population (Kahneman and Tversky,

1971). Two subsequent works, “Subjective Probability: A Judgement of Representativeness”

and “On the Psychology of Prediction”, expanded on the topic of representativeness and

examine the powerful role of the representativeness bias in the creation of intuitive

predictions (Kahneman and Tversky, 1972, 1973). The two most important works followed

in 1974 and 1979, respectively: “Judgment under Uncertainty: Heuristics and Biases”

identified three fundamental heuristics used by humans to make sense of complex uncertain

situations – Representativeness, Availability and Anchoring; “Prospect Theory: An Analysis

of Decision under Risk” developed a new model for decision making under risk that was to

serve as an alternative to the expected utility theory (Kahneman and Tversky, 1974, 1979).

His work on Prospect Theory was what earned Kahneman the Nobel Prize in Economic

Sciences in 2002 together with Vernon L. Smith (and would almost certainly have included

Amos Tversky as well had he not untimely passes several years earlier). In the 1981 paper

titled “The Framing of Decisions and the Psychology of Choice”, the duo then introduced a

23
phenomenon known as Framing, meaning that framing a certain problem in different ways

to an individual influences the perceptions, decisions, evaluation of options and probabilities

and thus also the outcomes of the individual’s dealing with that problem (Kahneman and

Tversky, 1981). Sewell (2007) points out that when Framing and Prospect Theory are taken

into account, “the rational theory of choice does not provide an adequate foundation for a

descriptive theory of decision making” (p. 3).

2. Prospect Theory

The Nobel prize-winning Prospect Theory, created in 1979 by Kahneman and Tversky,

aims to explain how people deal with risk and uncertainty and why there is a clear

irregularity in human behavior when assessing this risk under uncertainty. It claims that

“people are not consistently risk-averse; rather they are risk-averse in gains but risk-takers

in losses” and that they “place much more weight on outcomes that are perceived more

certain than that are considered mere probable”, which is known as the Certainty effect

(Subash, 2012, p. 12). The assessment and choice process has two phases under the theory:

the early phase of framing and the following phase of evaluation. Apart from the Certainty

effect, the choice is also influenced by the above mentioned Framing effect, which has

been evidenced to systematically reverse the preferences of decision-makers when the

same problem was presented to them (framed) in different ways (Kahneman and Tversky,

1981, p. 274).

The Prospect Theory deals with the idea of value maximization in a different way than

traditional finance, which typically works with the Modern Portfolio Theory. The value

24
(or wealth) maximization functions for the two are different. Where the final wealth

position is the basis for value maximization for the Modern Portfolio Theory, the Prospect

Theory works with gains and losses on the rationale that people may opt for different

choices in situations with identical final wealth levels. This is because people typically

perceive outcomes more in terms of gains and losses (measures as relative changes against

some neutral reference point) rather than in terms of final states of wealth (measured in

absolute terms) which is an important characteristic of the framing process (Subash, 2012,

p. 12). When it comes to stock investments, people tend to perceive the purchase price as

the natural reference point, but might be affected by additional reference points in their

decisions and perceptions – recent maximum stock prices, for instance, have been found

to impact the investors’ decisions on trading individual stocks (Subash, 2012, p. 13). The

value maximization function of the Prospect Theory can be graphically expressed as an

S-shaped curve as shown in the graph below:

Figure 2.1: Prospect Theory Value Function, source: Kahneman and Tversky (1979)

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 The shape of the function reflects the fact that it is defined in terms of changes in wealth

rather than in terms of the final wealth level. It shows the risk aversion in gains (by being

concave in that sector) and risk seeking in losses (by being convex in that sector). The

practical meaning of the function is that the same change in gains or losses will be more

significant to the investor if it is closer to the reference point and less significant when it

is further away – the same gain or loss in absolute term will mean much less for you if the

stock price has already grown or fallen a lot. This idea is connected to the concept of

prospective utility – investors select a portfolio allocation based on the potential gains and

losses of each individual investment, and then opt for the allocation which offers the

highest prospective utility (Subash, 2012, p. 13).

3. Other significant work in the field

Kahneman and Tversky are not the only scholars to have formed the basis of behavioral

finance. Mark Schindler, as cited by Subash (2012), is another author in the field worth

mentioning, and he sees three key cornerstones in behavioral finance research: limits to

arbitrage, psychology and sociology. Limits to arbitrage mean that it might be problematic

for the rational traders to eliminate or outweigh the dislocations caused by the less rational

ones, meaning there exist arbitrage opportunities that enable investor irrationality to have

long-term impact on asset prices. Psychology comes into play as the research and

experimental findings in this area, particularly in cognitive psychology, evidence certain

biases that people systematically show when creating their beliefs and preferences that then

have influence on their decision making. Sociology is crucial in that it shows the fact that a

26
substantial number of finance-related decisions are made as a result of social interaction

instead of being contemplated rationally in isolation, shattering the assumption that financial

decisions are made by individuals without external influences (p. 10).

B. Heuristics – mental shortcuts and their role

Heuristics are a key feature of human decision making. Kahneman defines them as “simple,

efficient rules of thumb which have been proposed to explain how people make decisions,

come to judgements and solve problems, typically when facing complex problems or

incomplete information” (Parikh, 2011, p. 45). In other words, heuristics are quick, functional

“survival tools” that help us deal with complex, uncertain situations that we face every day

that it would be too difficult or time consuming to solve individually every single time – they

allow us to make sense of and cope with the complex, ever-changing world that surrounds

us. They evolved over time to let us survive and succeed. They tend to work quite well (which

is why we all use them) under most circumstances, but there are situations in which they can

and often do lead to systematic cognitive biases with the way they influence our decision

making and thus may lead to sub-optimal decision making.

1. Role of heuristics in decision making

Kahneman and Tversky defined heuristics (also called “mental shortcuts” or “rules of

thumb”) as a strategy that can be used to deal with a wide range of issues to reduce them

from complex issues requiring advanced problem solving to more simple judgmental

operations. These strategies usually offer a correct solution, but not always, which is what

makes their use problematic. Heuristics are experience-based – they develop when humans

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try to process all the information needed to solve issues, see how something works and arrive

at solutions (often through trial and error) and later, when they encounter a similar situation,

the previously proved solutions are applied to these new situations (Subash, 2012, p.14). The

use of heuristic simplification may lead people to make predictable, sub-optimal choices

when dealing with difficult and uncertain situations. The reason heuristics are relevant to the

study of behavioral finance is simple – modern trading and financial markets are increasingly

fast-paced, complex and opaque, there is many times more information available than we can

process and speed of reaction has become a crucial element of successful trading. This being

the case, heuristics are important for quick decision making but need to be studied and

worked with carefully to prevent biases and resulting sub-optimal outcomes. Also, very

interestingly, traditional finance assumes financial decisions are made on the basis of rational

data analysis with the help of statistical and mathematical tools and therefore do not consider

the use of heuristics in the investors’ decision making. However, evidence suggests that this

assumption is often faulty, which is why heuristics need to be studied and understood to both

understand the decision making processes of other actors on the markets but also, most

crucially, to optimize one’s own decision making.

2. Key individual heuristics

As stated earlier, in 1974 Kahneman and Tversky identified three fundamental, basic

heuristics – representativeness, availability and anchoring in their work “Judgment under

Uncertainty: Heuristics and Biases” (Kahneman and Tversky, 1974, p. 1128). In Heuristics

and Biases: The Psychology of Intuitive Judgment (2002), Gilovich, Griffn and Kahneman

identifed six “general purpose” heuristics (affect, availability, causality, fluency, similarity

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and surprise) and six “special purpose heuristics” (attribution, substitution, outrage,

prototype, recognition, choosing by liking and choosing by default). The three heuristics

previously identified by Kahneman and Tversky – representativeness, availability and

anchoring – were replaced by the new ones, with attribution-substitution replacing

representativeness and affect replacing anchoring and adjustment (with the replaced names

for heuristics sometimes being used for biases instead – see section C) (Sewell, 2007, p. 7).

Out of this number, Sewell considers affect, availability and similarity to be the most

important:

Affect – this heuristic deals with “goodness” or “badness” of something; the affective

reaction to a stimulus is rapid and automatic (as when you very quickly sense the feeling

associated with words like “treasure” or “hate”) (Sewell, 2007, p. 8).

Availability – a cognitive heuristic where the decision maker uses or relies on readily

available knowledge to make the decision instead of examining other alternatives or

approaches (Sewell, 2007, p. 8).

Similarity – a heuristic that makes us believe that “like causes like” and “appearance equals

reality”; it is used to explain how people arrive at judgements based on the similarity of the

assessed situation to other situations or prototypes of such situations (Sewell, 2007, p. 8).

Heuristics, as has been mentioned above, are an important survival tool, however, it is easy

to see how they can mislead us and result in sub-optimal choices. Chapter 3 will examine

some methods to cope with both our natural tendency to resort to heuristics in problem

solving and with the influence of biases on our perception and decision making.

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 C. Behavioral biases

1. Significance of behavioral biases

Behavioral finance offers explanations of anomalies on the financial markets using well-

identified psychological biases, as investors may often have the tendency to incline towards

certain types of behaviors, leading them to cognitive errors. According to Barber and Odean,

as quoted by Subash (2012), behavioral finance “relaxes the traditional assumptions of

financial economics by incorporating these observable, systematic, and very human

departures from rationality into standard models of financial markets”. They believe that

investors face two key biases – the tendency of humans to be overconfident in themselves,

and their desire to avoid regret (p. 9).

Overconfidence and regret aversion are not the only important and present biases by far.

Psychological and behavioral research distinguishes a broad range of specific biases and

recent works and studies in behavioral finance have applied over fifty of these to individual

investor behavior in various situations and contexts. Some scholars do not distinguish

between biases and heuristics and use the terms interchangeably, some do distinguish and

call biases “beliefs, judgements, or preferences”, and yet others attempt to meaningfully

categorize biases into a framework, for instance along cognitive or emotional lines (Subash,

2012, p. 15). Pompian (2006) argues that while such taxonomy might be useful, no unified

underlying theory of why our behavior is often subject to biases has been created. Therefore,

instead of a single universal theory of investor decision making and behavior, the research in

behavioral finance has to rely on a wide collection of empirical evidence showing the

“ineffectiveness of human decision making in various economic decision-making

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circumstances” (p. 32). Nevertheless, despite the lack of a universal theory explaining why

we operate under bias, the mere awareness that we may tend to do so and how is a significant

step towards coping with these natural but sometimes harmful tendencies. Let us thus

examine the most significant biases in more detail.

2. Key individual biases

A wide range of biases that have been empirically proven to occur in humans is recognized

by behavioral scholars, with some of them holding particular significance for the discipline:

Overconfidence bias – a bias that involves the overestimation of one’s knowledge,

skills and capability to control a situation and the underestimation of risks of that

situation; Pompain describes it as “unwarranted faith in one’s intuitive reasoning,

judgements, and cognitive abilities” – research shows that people are generally poor

at estimating probabilities, fail to understand their own abilities and the limits of their

knowledge, and tent to think they are smarter and better informed than they actually

are, leading to actions based on faulty assumptions (2006, p. 84). A general

overconfidence of their own ability is a common trait for investors when picking

investments and deciding to enter or exit a position; specific security selection seems

to exhibit the greatest overconfidence in investors (Subash, 2012, p. 16). Research

also suggests that men are more overconfident than women. In a study of investor

behavior in relation to gender between 1991 and 1997, Barber and Odean (2001)

tested the hypothesis that more overconfident investors trade excessively (and should

exhibit worse results) and found that men traded 45% more than women, and that

while women’s returns were cut by 1.72% during that period, men’s were cut by

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2.5%, confirming a correlation of overconfidence, excessive trading and worsened

results (p. 272).

Representativeness bias – representativeness can be defined as an “assessment of

the degree of correspondence between a sample and a population” (Gilovich et al,

1983, p. 57), and deals with determining conditional probabilities, i.e. judging

whether an object or event A belongs to a class of process B; it is thus used when

making judgements under uncertainty to determine the probability that A belongs to

B (Subash, 2012, p. 17). Sherfin (2000), as quoted by Subash (2012), explains

representativeness as a “judgement based on overreliance stereotypes” with investors

expecting their recent successes to extend into the future as well (p. 17). Ritter (2001)

also connects representativeness to the apparent long-term underperformance of IPOs

which he linked to the prevalence of short-term orientation of investors (p. 14). An

example of representativeness would be the investors’ tendency to assume that

positive characteristics of a company can be directly attributed to its stock – evidence

shows such investments tend to be poor the majority of the time (Subash, 2012, p.

17).

Herding bias – herding, in the context of finance, happens when participants in

financial markets imitate the behavior of each other or of a larger group regardless of

whether they would make the same decision individually, resulting in converging

action. The classic case of herding in finance is the tendency of individual investors

to follow the investment decisions of the majority instead of carefully and rationally

assessing the decision on their own independently from the popular opinion. A key

element of herding is the concept of peer pressure – both the concern of an investor

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about how others will perceive his or her decision and the feeling or concern that if

everybody is going in a certain direction, they must have a solid reason for doing so,

or have some important knowledge pointing them in that direction. In other words,

the idea that the majority must know best/cannot be wrong. Not surprisingly,

individual private investors tend to be influenced in their decision making by

professional financial analysts. What is very interesting and alarming though, as

Welch (2000) discovered in his study, these professional analysts can fall victim to

herding behavior as well, especially when revising their recommendations – the

tendency to follow the market’s consensus was quite noticeable (p. 8). The reason

herding behavior is an issue is very clear – herding is one of the main drivers of the

creation of market bubbles that bring a host of negative consequences for both

individual investors and the markets as whole. A study of herd behavior in extreme

market conditions by Econonou, Kostakis and Philippas (2010) in years 1998-2008

showed that herding behavior was stronger during periods of rising, or bull, markets

in the examined stock markets (Greece, Italy, Spain and Portugal) (p. 42). This result

is troubling as it shows the tendency of bubbles of reinforcing themselves until their

eventual burst.

Anchoring bias – refers to the human habit of making estimates by starting at a

certain initial value – the anchor - and then adjusting it according to additional

information to arrive at the final answer. The issue with anchoring is that the

adjustments to the initial value tend to be insufficient in factoring in the new

information, so the final answers heavily depend on the initial value estimate. The

initial value estimate, however, can in turn be easily influenced or manipulated as the

33
tendency to create anchors is very strong with most people, especially in situations

where they have little prior experience to use as a basis for defining the anchor value.

The core issue with this is that anchoring works even if the anchor is entirely arbitrary,

so for instance a price that an investor is willing to pay for an asset, especially one he

or she is not particularly familiar with in terms of fair prices, can be influenced by

almost any random number if it is encountered in a ‘correct’ setting. Ariely (2008)

proves this in a rather fascinating experiment in which 55 marketing students at the

Sloan School of Management, MIT, were asked to write the last two digits of their

social security number in the corner of a paper and later were asked to indicate

maximum prices they would be willing to pay for items that were new to them and

whose fair pricing was difficult for them to determine, such as archive wines or high-

tech gadgets. The students were asked to write their number next to each item on the

list in the form of a price (if they number was 23, for instance, they would write $23

next to each item on the list). Then, the students were asked to indicate whether they

would be willing to pay that price for each items and also write next to the items the

maximum price they would bid for the given item. While the students were convinced

that their social security number had no impact on how they would bid for the items,

the experiment clearly showed that the social security numbers worked as price

anchors for them – the people with lower numbers placed on average lower bids than

those with high numbers. Overall, the bids in the highest-number group (80-99) were

an incredible 216-346% higher than the bids in the lowest-number group (0-19) (p.

21). This is an alarming result as it shows that any number, no matter how arbitrary,

can serve as a price anchor depending on the setting in which it is encountered.

Historical stock prices or professional analyst target price recommendations serve as

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some natural anchors for investors, who might then fail to assess the fair value of a

stock independently and adjust the initial anchor price sufficiently, leading to under-

or overestimates of fair price.

Cognitive Dissonance bias – the mental conflict or a feeling of unease, stress or

discomfort that people experience when they are faced with new evidence or

information suggesting that a belief or an assumption they hold is wrong, when they

act against their values or when they hold two or more beliefs or values that are

conflicting. Pompian (2006) distinguishes two aspects of cognitive dissonance related

to investor decision making: selective perception and selective decision making.

Selective perception refers to only registering information that confirms or

strengthens an existing belief (in order to avoid cognitive dissonance), distorting the

real picture and preventing rational, reasonable adjustment. Selective decision

making is the fact that investors tend to reinforce or replicate earlier decisions even

when evidence might suggest these decisions were sub-optimal, thus leading to a

repetition of the sub-optimal decisions. Investors try to rationalize and justify their

previous actions to allow them to stick to their original decisions, again in order to

avoid the cognitive dissonance caused by them challenging their own past steps (p.

54). The desire to avoid cognitive dissonance can thus lead to a repetition of mistakes

and decisions that were bad in the first place.

Regret Aversion bias – a psychological error that is caused by an excessive focus on

feelings of regret that an investor will experience if he or she makes a decision that

turns out to be poor; the idea is closely connected to risk aversion. In plain words, an

investor is typically afraid he or she will make the wrong decision and will regret it

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in the future. However, an excessive focus on these potential feelings can cripple

decision making as the investor might fail to carry out objective, rational, rigorous

analysis of the asset in the light of this bias. Regret aversion is present in two main

types – errors of commission and errors of omission. Errors of commission occur as

a result of misguided action (for instance, buying a wrong stock or some other

investment and regretting it in hindsight), while errors of omission occur as a result

of a lack of positive action (for instance, not going ahead and buying a stock or some

other investment and then again regretting it in hindsight) (Subash, 2012, p. 21).

Loss Aversion bias – this bias refers to a natural human tendency to have a strong

preference for avoiding losses over obtaining gains, as to a human mind, “losses loom

larger than gains” (Benartzi and Payne, 2015, p. 2). Kahneman and Tversky, who

were the first to document loss aversion, have estimated that the average loss aversion

coefficient is about 2-2.5, meaning that losses loom two to two and a half times larger

than gains. The practical meaning of this finding is that if the upside of a bet is only

twice as large as the downside, many people, being affected by the loss aversion bias,

will decline the bet. Being loss-averse is natural and there is nothing inherently wrong

with it in principle, but it is necessary to understand how our asymmetric perception

of losses might impact our decisions (Benartzi and Payne, 2015, p. 2). Loss aversion

is also documented to have impact on financial decisions – Benartzi and Payne (2015)

demonstrated in an experiment on 401 participants that was concerned with picking

preferred choices and indicating perceived risk in a series of gambles that people tend

to make choices based on the desire to avoid the psychological pain of losing money

instead of being guided by rational theoretical measures of risk like expected returns

36
 or variance – because most people do not define risk in standard deviation terms but

instead see it in terms of “losing”.

As stated above, the range of examined and recorded biases is very broad. Other often

encountered biases include for instance the Gambler’s Fallacy bias, the Mental

Accounting bias or the Hindsight bias, closely connected to the Risk Aversion bias. The

following chapter will, among other things, examine some methods investment

professionals can employ in dealing with their own biases and those of their clients.

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IV. Practical Applications of Behavioral Finance in Professional Investing

Let us now finally look at the fundamental question that we asked in the beginning of this

work - is there some practical use or value in the study of behavioral finance, and can it help

us fix any of the issues it so readily helps to identify? The short answer is yes, there is, and

yes, it can indeed. But it all depends on how you work with it. As discussed in the previous

chapters, behavioral finance has not been able thus far to produce a single, all-encompassing

theory of human decision making, in relation to market behavior, to investment decisions or

in relation to decision making in general, that would work as one unified, elegant and concise

explanation of everything, in a way that the Efficient Market Hypothesis has aimed to.

Instead, behavioral finance works more on a case-by-case, empirical basis, offering separate

explanations of individual irrationalities present in our behavior, which are all connected by

the single unifying “umbrella” idea – people do not decide rationally, at least not all the time

anyway.

While behavioral finance has no single theory that would fix all the issues yet, it offers a

wide range of applications for use in individual problems, be it for the use of the investor

him- or herself in their investment activities or in day-to-day work with clients. These

methods are usually fairly straightforward to apply; all they typically require is the

willingness to identify and admit an issue or an irrationality, and consistency and a structured,

honest-with-oneself approach to addressing it. Given we often cannot get rid of our emotion,

intuition or reflex driven approaches to decision making, we have to learn to work with them

effectively and efficiently.

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Some flaws or biases might be less problematic in their implications and impact than others

– for instance, have a look at the loss aversion bias versus the herding bias. As discussed

before, loss aversion does not have to represent an issue as such if we are aware of it and

adjust our approach accordingly. We do not like losses and wanting to protect from them can

be seen as absolutely reasonable goal to an extent. The herding bias, on the other hand, has

the potential to be quite destructive (just look at market bubbles), and seems to serve little to

no purpose in an industry where arguably your biggest competitive advantage over other

investors is knowing better. That is why you want to learn to work with some biases but with

some others, the objective is to limit their power over your choices as much as possible.

All the strategies for addressing the behavioral flaws that cloud our rational decision-making

abilities have the same starting point – creating awareness, both for oneself and for the client.

In this case, actively realizing and recognizing we might sometimes be influenced by our

emotions, fears, reflexes or simply automatic learned behaviors is the single most important

step towards more rational decision making rewarding us with optimal outcomes. For some

heuristics and biases, education and awareness creation might be enough to address them

(such as the herding behavior, for instance). We shall thus look at some other selected biases

and heuristics for which specific strategies have been devised and tested to see how

investment professionals can go further to address them for themselves and their clients. This

section will next outline some further steps we can take to achieve bias-proof investment

decision making strategies with both clients and investors benefiting. The work of Shlomo

Benartzi, a Professor at the UCLA Anderson School of Management and the Chief

Behavioral Economist at the Allianz Global Investors Center for Behavioral Finance, will be

a particularly valuable source of information to us. Dr. Benartzi is one of the leading

39
contemporary authors on practical applications of behavioral finance in the investment

profession, and focuses mainly on the ways in which investment professionals can work with

clients to overcome biases and reach optimal outcomes.

A. Addressing loss aversion

As discussed above, the loss aversion bias deals with the human tendency to perceive gains

and losses asymmetrically that is not covered by standard measures of risk like variance or

standard deviation, and can have a significant impact on investment decisions as most people

will only consider a bet if the upside is at least twice the downside. Benartzi and Payne (2015)

have devised a strategy to deal with loss aversion when working with clients that is based on

taking into consideration our asymmetric sensitivity to gains and losses and understanding

how these might affect our decisions. They claim we should not aim to rewire our brain to

get rid of loss aversion (if only for the mere fact that we do not know how to do that) as there

is nothing fundamentally wrong about being loss-averse. Instead, we should make sure that

our selected investment strategy fits our approach to and feeling about losses (p. 5). To help

client-facing investment professionals, such as financial advisors, pension consultants or plan

sponsors incorporate the loss aversion-coping strategies into their day-to-day activities and

work with clients, Benartzi and Payne (2015) have devised four key questions for investment

professionals to ask themselves:

1. How do the limitations of standard measures of risk and volatility, such as standard

deviation and Sharpe rations, factor into your chosen strategy? We know that these

measures consider good and bad surprises equal, but people do not. Are you aware of

this fact and are you working with it?

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 2. To what extent is your strategy able to balance loss aversion and gain seeking? We

know that losses feel greater to us than equivalent gains but investment does not end

with preventing losses – our approach needs to focus on achieving gains as well.

3. Are you sufficiently assessing the magnitude and probability of potential losses?

Possible losses should be evaluated prior to making the investments so that the risk is

always known and duly considered before the actual loss can occur.

4. To what extent does your approach change when working with individuals with

different levels of sensitivity to losses? While the median individual is indeed loss-

averse with an aversion coefficient of about 2-2.5, there are vast differences among

people, with some not being loss-averse at all in fact and some being extremely loss-

averse, on the other hand. Are you responding to the needs of all these types of

clients? (p. 6)

Overall, decades of research indicate that people are not scared by the volatile growth on the

financial markets but by the steep falls, but, as Benartzi and Payne state, “what goes up must

come down”, therefore we need to make our typically loss-averse characters think about the

concept of losses before they occur and how we manage risk and these losses, especially with

them looming larger than gains (p. 6).

B. Overcoming investor paralysis

The 2008 financial crisis and the economic recession that followed it created an environment

characteristic with investor paralysis – a phenomenon, stronger at some times than at others,

of investors feeling insecure about their decision making abilities and never being quite

satisfied with what they know, and resulting with investors’ hesitation and ultimately an

41
inability to make timely decisions. In the fear that a bear market is not over yet or that they

will miss the best time to get in a bull one, investors weigh the risk of being wrong against

the probability of being right, which can lead to a decision-making paralysis (Benartzi, 2011,

p. 8). Such paralysis is typical in circumstances such as the post-2008 period, with large

amounts of cash just sitting in accounts, not being put to any use.

So when such paralysis afflicts the markets, what is the cure for it? Richard Thaler, a

University of Chicago behavioral economist, advises to “devise a plan that you will actually

be able to implement, even when confronted with the inevitable distractions and temptations”

(Benartzi, 2011, p. 8). The question that naturally follows, of course, is what would such a

plan look like? Richard Thaler and Shlomo Benartzi have devised a solution called “Invest

More Tomorrow” based on the “Save More Tomorrow” (SMarT) program. Benartzi

describes the SMarT program as a “savings enhancement plan that utilizes an understanding

of the psychological obstacles people face when trying to save more money” and argues that

some of the key psychological hurdles that people face when trying to save more also play a

role in preventing investors from getting back to the market (2011, p. 8).

The SMarT program, which has been a great success, works around three key psychological

obstacles: procrastination, loss aversion and inertia. To fight procrastination, employees are

invited to pre-commit to enhance their savings rate in the future. To avoid loss aversion, the

employees’ first rate increase coincides with their next pay rise so they do not feel a decrease

in their take-home pay, and then continues to rise automatically with each following pay rise

until it reaches a pre-determined maximum level, making inertia work in the employees’ best

42
interest. Employees may quit the plan any time but in fact rarely do, but the option to do so

makes it easier for them to get involved in the first place (Benartzi, 2011, p. 9).

As the difficulties or reluctance to enter the market are largely similar to the inability to

sufficiently contribute to savings plans, the Invest More Tomorrow system builds on existing

investment plans of financial advisors and on the SMarT program. It consists of two parts:

overcoming the fear of a portfolio value decline (loss aversion) and overcoming

procrastination. Loss aversion is the most critical psychological factor in investor paralysis

as a decline in the portfolio value intuitively causes psychological pain to the investor. This

aversion to future losses is all the stronger when investors have experienced losses recently,

as was the case for many people in the 2008 financial crisis. The experience of losses and the

related psychological pain thus significantly contributed to the investor paralysis as people

became much more reluctant to take risks (Benartzi, 2011, p. 9). So how do we address this?

Benartzi has advocates employing a method called “fuzzy mental accounting” based on the

Prospect Theory discussed in the previous chapter. It involves spreading a specific proportion

of one’s portfolio investments (such as 25%) over a longer period of time and investing in

smaller amounts of money so there is no single reference point that one could readily refer

to in order to examine how the value of his or her portfolio has changed with the moves of

the market. This lack of a clear reference point makes the pain of loss aversion much less

pronounced. As such, this investment strategy is well-known as “dollar cost averaging”. The

Invest More Tomorrow approach then combines this strategy with a strategy to fight

procrastination. This strategy mostly relies on asking the right questions to the client – first

of all, if he or she is willing to commit to come back to the market at some point in the future,

and if so, then when does he or she think the market conditions will be stable/favorable

enough to take the action. This strategy gives the client a feeling of both control and

43
commitment as no decisions are imposed on him or her. It also promotes proactive action

through the key psychological factor of pre-commitment.

C. Addressing mental accounting

To illustrate the idea behind mental accounting, Moisand (2000) brings up the fascinating

example of the TV show “Who Wants to be a Millionaire?”. What happens during the course

of the competition is that as the stakes go up from the original amount of $1,000 with each

question, the contestants become visibly more anxious, ponder on their answers longer and

are more likely to seek help. Mental accounting is a phenomenon that makes people “treat

one sum of money differently from another sum of equal amount due to where it is kept, from

where it was obtained or for what it is to be used” – it is unlikely that a contestant would

answer so quickly and confidently if the $1,000 came from his or her paycheck; the money

to be won is perceived as not truly theirs yet, meaning there is little to lose, even though

$1,000 is still the same $1,000 (p. 130). This perception shifts, however, as the stakes go

higher. This often works similarly for clients interested in investment advice – many seek out

advice despite having managed their money for their entire adult life themselves simply

because the amounts have gone higher. This can be merely a function of the size of the

portfolio but can also be related to a particular life situation the client is in – setting up a

college fund for a child or approaching retirement.

Interestingly, mental accounting can have both a beneficial and a harmful impact on decision

making. According to the very accurate saying that a bull market should not be confused with

brains, both clients and professionals can easily get fooled into thinking they have superior

44
investing skills after a short period of successes. Combined with mental accounting, this

overconfidence can end up being very costly. What happens is when investing, individuals

perceive the earnings from their previous investments as results of their skills and not ‘real’

money and so find it easily replaced through employing that investment skill further (kind of

like the psychological impact of being on a winning streak in a casino in Las Vegas). A

common outcome of this approach is a more active portfolio with inferior yields (Moisand,

2000, p. 131). In some cases, such as the college fund example, nevertheless, mental

accounting can actually be beneficial. Many clients perceive the money in a college fund as

sacred and keep a very hands-off approach to it, avoiding the too-active approach and giving

the fund more chance to perform over time. If this adherence to status quo is not too strong

and has a reasonable basis, it can actually be very beneficial.

So how does an investment professional tell if a client is using mental accounting, and how

does he or she work with it? Two straightforward, simple signs of the use of mental

accounting can be easily identified. First of them is too little savings and the presence of

credit card balances – reflecting the mental assignment of too high value on savings and too

little on borrowed money (alternatively, spending might be under control for a client but they

might still struggle to save much). The second sign is an “abundance of conservative

investments within qualified retirement plans”, meaning that clients are extremely careful

when they are acutely aware they will have to live off that money at some point in their life.

This behavior occurs in financially educated people as well, suggesting that it really is a bias

at play and not merely a lack of proper education in the subject area (Moisand, 2000, p. 132).

45
As with many other heuristics, the first step in targeting mental accounting is education.

Explaining to the client clearly what the issue is and why it needs to be tackled is the first

necessary step. Helping the client slow the decision-making process down and start properly

from the beginning is the second. The client needs to define his or her goals very clearly (and

refer to them often) to help maintain focus later on. Next, the advisor might suggest that the

client views all of his or her money as if it was earned through employment (to give it the

feeling of ‘real’ money and greater value) and consider limiting or quitting the use of credit

cards as cash tends to be spent more responsibly. Lastly, think of how mental accounting can

be used to your client’s advantage instead, such as in payroll deduction savings plans – the

perception of these can be optimized by marking them as segmented for a special purpose.

The human tendency to leave things as they are then ensures little to no disruption. Trust and

awareness need to be built continuously throughout the relationship to ensure that the client

will be able to better implement a reasonable course of action (Moisand, 200, p. 133).

D. Fighting biases and heuristics in retirement savings behavior

Even in countries with government-provided pensions, and especially so in countries with no

or limited public pension system, participation in some sort of a retirement saving plan is

crucial for individual well-being in older age and, by extension, equally crucial for the

stability of the overall socio-economic environment of a country (what would you do as a

government if a quarter of your population was struggling to get by every day?). Be it a

‘defined benefit’ or a ‘defined contribution’ plan, everyone should at least seriously consider

participating in one. Retirement plans are important form the point of view of personal

finance, yet not nearly everyone saves for their retirement, or saves well.

46
Already the decision of whether to join a retirement plan or not seems to cause problems.

With tax-deductible contributions, tax-deferred accumulations and common employer

contributions, joining a plan seems like a no-brainer for most but the most liquidity-

constrained households, one would assume participation rates would be nearing 100%. In the

UK, for instance, where some defined benefit plans do not even require employees to

contribute money themselves and all one needs to do is join, only about 50% of eligible

employees join. Participation is surprisingly low even among older employees whose plan

options would represent pure profit opportunities close to their retirement (making them an

arbitrage opportunity) – only about 60% take part (Benartzi, 2007, p. 82). One way to easily

and effectively encourage participation in retirement savings schemes is to use the inertia or

status quo bias, already discussed above, that is working against people and turn it into an

advantage – by making the default option for a pension plan to be in, not to be out, meaning

one would actively have to opt out of a plan instead of having to take the action to actively

opt in. Evidence shows that very few employees then leave the plan. Another very effective

idea is to require employees to actively decide whether to join a plan, for instance by having

to tick a “yes” or “no” box in a designated form. Benartzi (2007) mentions a company that

switched to this active model from the default-option model and saw the participation

increase an impressive 25 percentage points (p. 83). A simplification of the decision making

process, such as offering a pre-defined strategy, is another effective method as it helps

overcome decision paralysis created by the need to evaluate choices (e.g. choose a savings

rate or the asset allocation mix). A wider range of options, in the other hand, can have the

exact opposite effect. Iyengar, Huberman, and Jiang as quoted by Benartzi (2007) discovered

47
a negative correlation between the number of investment options available and the rate of

participation in the program. The addition of ten funds to the choice of investment options

correlated to about 2 percentage points drop in the participation rate (p. 84).

Once the issue of enrolment is tackled, the next thing to deal with is contribution rates and

asset allocation. This work will not ambitiously aim to define what the exact number might

be that is considered “enough” but it is important to note the example of the US shows rates

are typically way too low to create a meaningful retirement income later on, and in any case,

most employees believe they should in fact save more (with 68% of participants in a 2002

survey by Choi et al. reporting they feel their savings rate is “too low”) (Benartzi, 2007, p.

84). Naïve diversification strategy heuristics are also a common culprit – investors, even

highly educated ones (such as the Nobel Prize laureate and one of the founders of modern

portfolio theory Harry Markowitz) fall victim to the idea of spreading their assets evenly

across the given number of available options without further analyzing the characteristics of

each option (e.g. going 50:50 to stocks and bonds), leading to sub-optimal diversification

(Benartzi, 2007, p. 85). So what can employers do, or what can professional advisors

recommend them to do, in order to have more employees commit to the savings plans and

select an optimal savings rate and asset allocation that allows them to create a reasonable

nest-egg for their retirement?

The interventions that employers, or plan sponsors, can take fall into two broad (and

unsurprising given the recommendations in previous sections) types of interventions:

education and plan design. However, many employers presently offer free financial

education programs to their employees to help them make better financial decisions, yet these

48
seldom seem to have the full desired effect; results are disappointing, with before and after

scores differing even by a single percentage point. Following up on courses is helpful but as

Benartzi concludes, “teaching is hard”. A more suitable alternative, and possibly even a less

costly one, thus lies in the retirement plan design created in a way that promotes long-term

saving goals. Automatic enrolment discussed above is the simplest option but it does suffer

from the severe disadvantage that savers tend to stick to the default savings rate which is

typically quite low and insufficient if not upped during the course of the plan. Here, Benartzi

advises to employ the Save More Tomorrow framework that he devised together with Thaler.

The framework, discussed in more detail in Section B, revolves around a very simple idea of

having clients/employees pre-commit to increase their savings rate in the future, with the

increases in savings rate aligned with pay rises to eliminate the blow of having less cash

available (such as a 3% increase in savings aligned with an average pay rise of 3.25-3.5%

used in one of the surveyed companies). Savings increases are automatic once someone joins

the program, having inertia work in the client’s benefit. This approach is particularly

successful when combined with automatic enrolment, achieving both high participation and

high savings. Many retirement plan administrators, such as Vanguard, T. Rowe Price, TIAA-

CREF, Fidelity or Hewitt Associates, have already adopted the idea, showing that the

application of behavioral finance can indeed be very practical and offer tangible results

(Benartzi, 2007, p. 100).

49
 V. Herding, Bubbles, and Overconfidence: A Behavioral Study of the Stock

Market

Stock markets are fascinating. They are by far the most well-known and closely followed

aspect of finance among the general public; they seem to have a life of their own and they

seem to affect everything and everyone in some way or another. They can do a whole range

of amazing things – react to news, react to one another, or create or destroy wealth within the

blink of an eye. They are even attributed personal characteristics or emotions – you have

certainly heard a phrase like ‘the markets were anxious prior to the expected announcement

of the 3Q earnings report’. Some scholars and professionals see them as highly quantitatively

analyzable and seek to understand them and predict future developments with the help of

numbers. Ultimately, however, deep down each market is just a collection of actions and

reactions of its participants (its emotional, imperfectly informed and often irrational

participants), and as such is only as good as the sum of those individual actions is. Decisions

are made based on incomplete knowledge and limited understanding, incomplete or incorrect

information and also emotion. For this reason it is extremely difficult to reduce a stock market

into some sort of a mathematical model that would enable us to fully understand what is

happening and why and what shall happen next. The aim of this chapter is thus to briefly

examine the behavioral dimension of stock markets to see what makes them tick in terms of

market participant behavior.

The volatility of stock prices is very high, not only in the short term, but also in the long. In

figure 5.1 below, showing the development of the Dow Jones Industrial Average index since

50
1985, we can clearly see a distinct upward trend; however, we can also see that this upward

development has been a very ‘bumpy’ one with noticeable ups and downs, the largest drop

occurring towards the end of 2008. There are many things that have impact on stock price

fluctuations. Sewel argues that this volatility in stock prices is way too high to only be

attributable to new information about future real dividends. Instead, he argues that the

volatility is a result of people systematically overreacting to dramatic news and unexpected

events (and underreacting to other substantial information), and that it results in significant

weak-form inefficiencies on the market (Sewell, 2007, p. 3).

Figure 5.1: Dow Jones Industrial Average since 1985, source: Yahoo Finance (2016)

In the past decades, stock markets have been mostly interpreted in light of the Efficient

Market Hypothesis discussed in detail in Chapter II. However, the evidence presented by

behavioral research suggests that investor behavior is influenced by biases, heuristics and

emotion in a way that strongly challenges the thesis that markets are efficient. Based on wide

psychological evidence, Barberis, Schleifer and Vishny, as quoted by Sewell (2007), have

51
devised a model of investor sentiment that shows that stock prices tend to overreact to series

of good or bad news while at the same time underreacting to news such as earnings reports

(p. 5). Fama, the father of the Efficient Market Hypothesis, reacts to this challenge by

claiming that these obvious instances of under-reaction and over-reaction are about

comparably common and thus cancel each other out and do not impact the efficiency of the

market. Nevertheless, this argument does not hold as under-reaction and over-reaction

typically do not appear in the same circumstances and/or time intervals. In fact, Odean found

evidence in 1998 of the so called ‘disposition effect’ - a tendency of investors to sell winning

investments too soon and to keep losing investments for too long, both preventing value

maximization (Sewell, 2007, p. 5).

Another common culprit of stock market investors is overconfidence. It is a well-documented

fact that men tend to be more overconfident than women; this is especially the case in such

male-dominated fields as finance. Theoretical models then predict that investor

overconfidence leads to excessive trading, and excessive trading in turn leads to reduced

returns. A study performed by Barber and Odean in 2001 showed that men traded 45% more

than women, reducing their returns compared to women due to overconfidence (Sewell,

2007, p. 5).

A. Creating value in stock trading using behavioral finance findings

Behavioral finance does not merely point out the issues in stock market behaviors not picked

upon by traditional finance theories; its findings can also be useful for succeeding in stock

trading, beating the Efficient Market Hypothesis’ claim that a market cannot be outperformed

52
by an individual investor in the long term – these strategies are based on exploiting the

suboptimal behavior patterns of typical investors with the use of improved understanding

provided by behavioral studies. One such approach exploiting the suboptimal behavior of a

typical investor is the use of ‘value strategies’. A value strategy focuses on purchasing stocks

whose prices are low relative to their measures of fundamental value, such as earnings,

dividends, book assets or other measures, and according to Lakonishok, Shleifer and Vishny,

it typically yields higher returns (Sewell, 2007, p.5). Together with Chan and Jagadeesh,

Lakonishok also discovered that price momentum and earnings momentum strategies were

profitable because the market underreacts to new information – it only responds to it

gradually over time (Sewell, 2007, p. 5).

B. The behavioral perspective on bubbles

Perhaps no occurrences on the stock markets are as strongly related to the behavioral aspects

of market participant decision making as market bubbles are. The behavioral explanation for

bubbles is fairly straightforward and intuitive – it is a theory of hype. Evidence suggests that

bubbles are in a way self-fulfilling prophecies, meaning a positive run can result in inflated

prices (investors follow others to buy winning stocks), while a negative one can push prices

down (investors follow others to dump losing stocks). Extreme positive runs can then inflate

stock prices to a point when these do not represent any increase in real value of the underlying

asset anymore. Interestingly though, this trend can reverse when runs are extended over a

longer period of time.

53
Using sequential information from the past to make decisions about the future is a very

common heuristic that allows us to cope with the presence of innumerable factors influencing

future outcomes – past information might still be a better indication of future than no

information at all, and trying to factor all the variables in is plainly impossible. It is also

commonly used in marketing communication of funds or financial products that suggest

(despite the oh-so-ironic obligatory disclaimer that “past performance is no guarantee of

future results”) that the future is likely to be at least as bright. Does this marketing strategy

work then? Research shows that do indeed tend to make decisions based on sequences of

information, leading to biases such as the gambler’s fallacy (a mistaken prediction of a

reverse in a sequence that is essentially random but happens to be showing a trend for a period

of time) or the hot hand fallacy (wrong projection about the future of a process that is in its

nature random) (Johnson and Tallis, 2005, p. 486).

Johnson and Tallis (2005) have thus devised two key hypotheses on stock purchases:

Hypothesis 1: When making purchasing decisions about a stock that has been

displaying a positive earnings run, investors’ preference for purchasing that stock will

first increase in short to medium term, but at some critical point, the run will become

too long and the preference will actually decrease in the expectation of the end of the

positive run.

Hypothesis 2: When encountering a negative earnings run, investors’ preference for

buying a stock will at first fall for a short to moderate run, but at a certain critical

point the trend will reverse and the preference for buying the stock will go up (p.

492).

Overall, in short runs, individuals tend to fall victim to the hot hand fallacy, while in long

runs they give in to the gambler’s fallacy. Another important finding is that individual

54
reactions to the length of the run actually reverse depending on whether they operate in

selling or buying mode. This individual response pattern might be able to explain market

participant behavior at the aggregate level – momentum on the market in the short run is

typically followed by a reversal in a longer run (Johnson and Tallis, 2005, p. 500). This gives

us a certain understanding of bubbles from the behavioral point of view – a set of trends or

sentiments on the market gradually initiate a positive run that becomes self-enforcing at first

(thus creating the bubble), but after reaching a critical point, the preferences inevitably have

to shift and decrease (thus making the bubble burst) – run lengths are triggering substantial

overreaction.

C. Equity premium puzzle

The equity premium puzzle is a big topic in finance and one of the most contentious one,

with no single hypothesis generally accepted as a sufficient explanation. The equity premium

puzzle refers to the empirical observation that in about the past 100 years, equities (stocks)

have consistently outperformed government bonds to a far greater extent than would be

predicted in the standard paradigm of utility maximization paradigm. In other words, stocks

offer much greater returns than bonds (surprisingly greater - typically in the range of about

3-7% in the long run) without representing a correspondingly large increase of risk. So why

is the premium so large and if it is, why does anyone actually hold bonds? Many explanations

have been offered, including the argument that the equity premium does not really exist and

is merely a statistical illusion or that it is the side effect of observing market bubbles in

creation. Nevertheless, most scholars agree on the existence of the equity premium, just not

on a clear explanation of it.

55
Behavioral finance has its own explanation to offer to the host of others. Benartzi and Thaler

identify key behavioral concepts they believe are in the core of the premium – loss aversion

(greater sensitivity to losses as opposed to comparable gains) in combination with a rigorous

tendency to monitor one’s own wealth, or mental accounting (where the length of the

evaluation period is the key aspect). Benartzi and Thaler call this combination ‘myopic loss

aversion’ and believe this is what is causing the equity premium. Myopic loss aversion can

be seen as a temporary loss of the ability to see the bigger picture and an excessive focus on

short-term developments. It manifests itself for instance as panic selling in periods of steep

market declines. Loss aversion and a short evaluation period thus make investors unwilling

to bear the risks associated with holding equities, as the more often an investor evaluates his

portfolio, (the shorter his evaluation period is), the less likely he is to find the high-mean,

high-risk investment to stocks unattractive (Benartzi and Thaler, 1995, p. 75). Working on

the basis of the Prospect Theory, Benartzi and Thaler (1995) focus on the evaluation period

in looking for a behavioral answer to the puzzle – how long would the evaluation period have

to be to make investors indifferent to whether they hold their assets in stocks or in bonds?

What combination of stocks and bonds would maximize the prospective utility for an investor

with a given evaluation period? On the basis of Prospect Theory preferences, how often

would investors have to evaluate their portfolios to explain the equity premium? Benartzi and

Thales (1995) employ historical data based simulations, working with monthly returns of

stocks, bonds and T-bills over the period of 1926-1990 to calculate prospective utilities of

each asset class for a specific holding period. While every investor uses different evaluation

periods and might use a combination of them (e.g. a brief check every quarter with an in-

depth evaluation only done annually), one year is probably the most plausible length of the

56
evaluation period for which bonds seem to have a comparative prospective utility to bonds.

As for the composition of a portfolio, portfolio mixes composed between 30% and 55% of

stocks all seem to yield about the same prospective values, which is roughly consistent with

mixes typically employed by institutional investors (p. 84).

The behavioral solution that Benartzi and Thaler (1995) offer for the equity premium puzzle

is rather simple then – combining a strong sensitivity to losses with a prudent tendency to

monitor the changes in one’s wealth often. The high sensitivity to losses “shifts the domain

of the utility function from consumption to returns” and the tendency to monitor one’s wealth

makes people require a greater premium in order to be able to accept high variability of

returns, which is very visible when one is monitoring his wealth more frequently (p. 90).

57
VI. Conclusion

Be it seen as a challenge or an addition to the paradigm of traditional finance, behavioral

finance has been becoming an increasingly significant force in the financial debate. Creating

the bridge between traditional finance and psychology, behavioral finance has been able to

explain and sometimes even correct some of the anomalies in the neoclassical finance theory,

and has been initiating a major shift of our understanding of the behavior of financial markets.

The basic application of behavioral finance findings is very straightforward for both

investment professionals making their own decisions and for those advising clients. The key

and necessary requirement for success (meaning being able to make better decisions that

offer better returns) is awareness. Realizing what the issue might be and what is the rationale

behind it is the most crucial step in addressing it – finding the answer to questions such as

why do we feel the way we feel about a decision, what elements are influencing it, what are

our real goals. The realization that we can be and often are wrong is a very powerful one.

When working with clients, good communication is a necessary additive to this. An advisor

must be able to explain why something is an issue and how to address it very clearly and

confidently, is many of these approach may feel counterintuitive. As we have seen throughout

the text, there are even ways to have our biases and decision-making flaws actually work in

our favor, such as using inertia in the increased contribution savings schemes. Many of the

behavioral solutions for individual problems fall in the ‘easy wins’ category – there is a wide

range of easy but effective practical applications available.

While behavioral finance is doing a good job in clarifying some of the aspects of human

decision making, it has still not been able to produce a single, unified, standalone theory – so

58
far, it has worked rather with separate sets of empirical evidence to address individual flaws

or anomalies. According to De Bondt, Hersh, Muradoglu and Staikouras (2008), a new

paradigm shall be created in finance academia, combining elements of both traditional, or

neoclassic as they label it, and behavioral finance. It shall replace the unrealistic, overly

simplified assumptions about rationality and optimality of individual decision making and

behavior with descriptive insights gained by empirical testing and experiments (p. 17). After

all, any system of understanding has to be continuously challenged and updated to respond

to and reflect social change. While behavioral finance alone, with its current level of

understanding, cannot address all the challenges of financial decision making research and

optimization, it is clear that the true nature of people with all its flaws, emotions and limits

to rationality has to be understood and taken into account if private investors, investment

professionals and even policy makers alike are to make well-informed decisions that lead to

the best results possible. Even with its still limited reach, behavioral finance undoubtedly has

the potential to not only improve outcomes of finance related actions of individuals but also

to achieve better systemic results in financial markets, ie. in reducing their tendency to create

bubbles, enhancing the stability of the system and overall benefit.

59
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