by Mark W. Riepe, CFA
Mark W. Riepe, CFA, is a senior vice president at Charles Schwab & Co. Inc. and president of Charles Schwab Investment Advisory in San Francisco, California.
When I first became acquainted with the field of behavioral finance it wasn’t even called behavioral finance. The time was 1990 or so and the course that covered this material at the University of Chicago was titled “Behavioral Decision Making.” Whatever the name, the material was exhilarating, but it felt decidedly on the fringe.
Over the next decade, the field gained steam and greater acceptance among practitioners and academics. At least for me, a certain degree of validation from the practitioner community occurred in 1998 when a paper I was fortunate to work on with future Nobel laureate Danny Kahneman was published by the Journal of Portfolio Management.1
So where does the field stand today? That’s an impossible question to answer for one short column, especially given how vibrant the field of behavioral finance has become. Nevertheless, here are a handful of musings on the field as I think about where it stands nearly 25 years after I first became aware of its existence.
Full Acceptance Is Elusive
I recall that behavioral pioneer Dick Thaler once said something to the effect that there shouldn’t be something called behavioral economics or behavioral finance. If the ideas and approaches of its adherents had merit and were fully embraced, then they would be absorbed into the mainstream of economics and become a standard part of the toolkit used by economists to explain and make predictions about the real world. The very fact that the Journal has an editorial focus on behavioral finance in this issue and the curriculums of business schools have distinct courses on the subject tells me that this field is still viewed as a separate way of looking at the world.
People Are Capable of Learning
It’s easy to get the impression from reading a bundle of literature on this topic that people are remarkably screwed up. Fair enough. Humans are, after all, humans. However, what gets far less attention are those studies that demonstrate that human fallibility isn’t constant and seems to improve as we age and/or gain experience.
Bateman et al. (2010) investigated the decision making of Australians in an experiment designed to replicate the portfolio selection process for those participating in the Australian equivalent of a defined contribution plan. When looking at the entire population of subjects, researchers found that between 14 percent and 37 percent of subjects made inconsistent choices when confronted with different methods of presenting data on the available portfolio choices. However, only 5 percent of subjects in the 55+ age group did so.
Agarwal et al. (2007) looked at a far broader set of financial decisions faced by individuals and found that in 10 realms of personal finance, individuals make better decisions as they age, with the peak prowess at about 53 years.
List (2003, 2011) has focused not on age, but experience. He’s demonstrated how individuals are subject to the endowment effect when entering a market for the first time, but through repeated exposure to the market, substantially reduce the impact of the effect as they gain experience.
Is the Glass Half Full or Half Empty?
The behavioral finance field grew up in a world where the prevailing academic assumption was that people, as a group, behave rationally. The assumption of rationality is a strong one and, over the decades, many studies have demonstrated both experimental and real-world evidence of violations of strictly rational behavior. Fair enough, people aren’t fully rational, but it’s dangerous to leap to the other extreme that people are utterly irrational. The Bateman study mentioned earlier is a relevant example. Depending on what model of rationality one uses, between 14 percent and 37 percent of people exhibited inconsistent risk preferences. However, between 63 percent and 86 percent got it right. (It didn’t escape my notice that if any reader was influenced by my switching the percentages from those who were inconsistent in their preferences to those who were consistent, that reader was falling prey to “framing”—one of the more powerful behavioral affects.)
Another example is from Barber and Odean (2004) who investigated how tax efficient individuals are when they invest. Not surprisingly, the results are a mixed bag. Investors tend to hold tax inefficient assets in tax-deferred accounts, and they practice some tax-loss harvesting. However, they aren’t perfect and could do a better job. The bottom line is that we need to move away from a discussion where people are or aren’t rational and toward the admittedly messier, but more realistic terrain where people reside somewhere on a continuum.
Is Anyone Making Money on Any of This?
Numerous money managers have created money management strategies designed to exploit various behavioral anomalies. Unfortunately, I am not aware of any database free of survivorship bias that explicitly focuses on these types of money managers. It would be interesting to see whether managers who have tried to exploit these anomalies under real-world conditions have better success than managers who employ more traditional techniques. More importantly, even if these managers are identifying exploitable efficiencies, are they able to exploit these inefficiencies in a cost-effective fashion that leaves something on the table for their shareholders?
Where Do We Go from Here?
The future is bright for behavioral finance. Simply too many instances exist in which a behavioral perspective on economics and finance is providing important insights. As a result, Dick Thaler will one day get his wish and the field will be fully integrated into the mainstream.
As for readers of the Journal, there’s no need to wait for academic debates to be concluded. That process can take generations. I encourage every practitioner to get up to speed on the literature right now, as I believe there are numerous findings you can use to improve the outcomes of your clients.
- Kahneman, Daniel, and Mark W. Riepe. 1998. “Aspects of Investor Psychology.” Journal of Portfolio Management 24 (4): 52–65.
Agarwal, Sumit, et al. 2007. “The Age of Reason: Financial Decisions Over the Life Cycle.” National Bureau of Economic Research working paper no. 13191 (June).
Barber, Brad M., and Terrance Odean. 2004. “Are Individual Investors Tax Savvy? Evidence from Retail and Discount Brokerage Accounts.” Journal of Public Economics 88 (1): 419–442.
Bateman, Hazel, et al. 2010. “Economic Rationality, Risk Presentation, and Retirement Portfolio Choice.” UNSW Australian School of Business research paper No. 2011ACTL02 (December).
List, John A. 2003. “Does Market Experience Eliminate Market Anomalies?” Quarterly Journal of Economics 118 (1): 41–71.
List, John A. 2011. “Does Market Experience Eliminate Market Anomalies? The Case of Exogenous Market Experience.” National Bureau of Economic Research working paper no. w16908 (March).