×

2020 Curriculum CFA Program Level III Portfolio Management and Wealth Planning

The Behavioral Finance Perspective

Download the full reading (PDF)

Available to members

Introduction

Behavioral finance attempts to understand and explain observed investor and market behaviors. This differs from traditional (standard) finance, which is based on hypotheses about how investors and markets should behave. In other words, behavioral finance differs from traditional finance in that it focuses on how investors and markets behave in practice rather than in theory. By focusing on actual behavior, behavioral researchers have observed that individuals make investment decisions in ways and with outcomes that differ from the approaches and outcomes of traditional finance. As Meir Statman so succinctly puts it, “Standard finance people are modeled as “rational,” whereas behavioral finance people are modeled as “normal.” Normal people behave in a manner and with outcomes that may appear irrational or suboptimal from a traditional finance perspective. As a result of identified divergence between observed and theoretically optimal decision making, the global investment community has begun to realize that it cannot rely entirely on scientific, mathematical, or economic models to explain individual investor and market behavior.

As behavioral finance gains acceptance, efforts to understand what drives individual investor and market behavior will increase. Complete understanding will never be possible, however, because human behavior cannot be predicted with scientific precision or fully explained by a simple “unifying theory.” In fact, trying to predict economic behavior, and by extension market behavior, has been likened to trying to predict the weather.


"Like weather forecasters, economic forecasters must deal with a system that is extraordinarily complex, that is subject to random shocks, and about which our data and understanding will always be imperfect. In some ways, predicting the economy is even more difficult than forecasting the weather, because the economy is not made up of molecules whose behavior is subject to the laws of physics, but rather of human beings who are themselves thinking about the future and whose behavior may be influenced by the forecasts that they or others make. To be sure, historical relationships and regularities can help economists, as well as weather forecasters, gain some insight into the future, but these must be used with considerable caution and healthy skepticism."

– US Federal Reserve Chairman Ben Bernanke


At its core, behavioral finance is about understanding how people make decisions, both individually and collectively. By understanding how investors and markets behave, it may be possible to modify or adapt to their behaviors in order to improve economic outcomes. In many instances, this may entail identifying a behavior and then modifying the behavior so it more closely matches that assumed under the traditional finance models. In other instances, it may be necessary to adapt to an identified behavior and to make decisions that adjust for the behavior. The integration of behavioral and traditional finance has the potential to produce a superior economic outcome; the resulting financial decision may produce an economic outcome closer to the optimal outcome of traditional finance, while being easier for an investor to adhere to in practice.

To provide a framework for understanding the implications of the decision-making process for financial market practitioners, throughout this reading we will use an approach developed by decision theorist, Howard Raiffa. Raiffa (1997) discusses three approaches to the analysis of decisions that provide a more accurate view of a “real” person’s thought process. He uses the terms normative analysis, descriptive analysis, and prescriptive analysis. Normative analysis is concerned with the rational solution to the problem at hand. It defines an ideal that actual decisions should strive to approximate. Descriptive analysis is concerned with the manner in which real people actually make decisions. Prescriptive analysis is concerned with practical advice and tools that might help people achieve results more closely approximating those of normative analysis. We can think of the traditional finance assumptions about behavior as normative, behavioral finance explanations of behaviors as descriptive, and efforts to use behavioral finance in practice as prescriptive.

In order to use behavioral finance in practice, it is important to understand how behavioral finance differs from traditional finance and some of the theoretical perspectives that are relevant to the understanding of the differences. Section 2 compares and contrasts behavioral and traditional perspectives of investor behaviors. Section 3 discusses theories that relax the assumptions about investor behavior that are inherent in traditional finance. Section 4 compares and contrasts traditional and behavioral finance perspectives of market behaviors and portfolio construction. A summary and practice problems conclude the reading.

Learning Outcomes

The member should be able to:

  • contrast traditional and behavioral finance perspectives on investor decision making;
  • contrast expected utility and prospect theories of investment decision making;

  • discuss the effect that cognitive limitations and bounded rationality may have on investment decision making;

  • compare traditional and behavioral finance perspectives on portfolio construction and the behavior of capital markets. 

Summary

With its simplifying assumption of rational investors and efficient markets, traditional finance has gained wide acceptance among academics and investment professionals as a guide to financial decision making. Over time, however, the limitations of traditional finance have become increasingly apparent. Individual decision making is not nearly as objective and intellectually rigorous, and financial markets are not always as rational and efficiently priced as traditional finance assumes. To bridge this gap between theory and practice, behavioral finance approaches decision making from an empirical perspective. It identifies patterns of individual behavior without trying to justify or rationalize them.

A practical integration of behavioral and traditional finance may lead to a better outcome than either approach used in isolation. By knowing how investors should behave and how investors are likely to behave, it may be possible to construct investment solutions that are both more rational from a traditional perspective and, because of adjustments reflecting behavioral insights, easier to accept and remain committed to. Although these behavioral insights will not lead easily or automatically to superior results, it is hoped that they will help many improve their investment approach and enhance risk management.

Among the points made in this reading are the following:

  • Traditional finance assumes that investors are rational: Investors are risk-averse, self-interested utility-maximizers who process available information in an unbiased way.

  • Traditional finance assumes that investors construct and hold optimal portfolios; optimal portfolios are mean–variance efficient.

  • Traditional finance hypothesizes that markets are efficient: Market prices incorporate and reflect all available and relevant information.

  • Behavioral finance makes different (non-normative) assumptions about investor and market behaviors.

  • Behavioral finance attempts to understand and explain observed investor and market behaviors; observed behaviors often differ from the idealized behaviors assumed under traditional finance.

  • Behavioral biases are observed to affect the financial decisions of individuals.

  • Bounded rationality is proposed as an alternative to assuming perfect information and perfect rationality on the part of individuals: Individuals are acknowledged to have informational, intellectual, and computational limitations and as a result may satisfice rather than optimize when making decisions.

  • Prospect theory is proposed as an alternative to expected utility theory. Within prospect theory, loss aversion is proposed as an alternative to risk aversion. 

  • Markets are not always observed to be efficient; anomalous markets are observed.

  • Theories and models based on behavioral perspectives have been advanced to explain observed market behavior and portfolio construction.

  • One behavioral approach to asset pricing suggests that the discount rate used to value an asset should include a sentiment risk premium.

  • Behavioral portfolio theory suggests that portfolios are constructed in layers to satisfy investor goals rather than to be mean–variance efficient.

  • The behavioral life-cycle hypothesis suggests that people classify their assets into non-fungible mental accounts and develop spending (current consumption) and savings (future consumption) plans that, although not optimal, achieve some balance between short-term gratification and long-term goals.

  • The adaptive markets hypothesis, based on some principles of evolutionary biology, suggests that the degree of market efficiency is related to environmental factors characterizing market ecology. These factors include the number of competitors in the market, the magnitude of profit opportunities available, and the adaptability of the market participants.

  • By understanding investor behavior, it may be possible to construct investment solutions that will be closer to the rational solution of traditional finance and, because of adjustments reflecting behavioral insights, easier to accept and remain committed to. 

We’re using cookies, but you can turn them off in Privacy Settings. If you use the site without changing settings, you are agreeing to our use of cookies. Learn more in our Privacy Policy.