November 22, 2017
Part One
Q. Why pay attention to an academic topic like behavioral finance?
A. One reason is that it can help you determine your own tendencies and biases in making investment decisions. There is, in fact, much research behind what your portfolio manager may have been advising you on over the years. Making better decisions at any pursuit, especially one involving investments, can add up over time.
Q. So how does the research help professional managers make better decisions for my portfolio?
A. It helps to have some historical context first. For decades, investment professionals and investors have been trained in university-level finance classes and professional accreditation programs on “Modern Portfolio Theory.” This approach is considered the foundation of sound investment principles, the bible for the investment community.
Modern Portfolio Theory (MPT) was developed by American economist Dr. Harry Markowitz in 1952, but it did not start gaining traction with mainstream investment advisors until the 1980s. Today, its principles are used by professional money managers worldwide to help investors assess the risks and rewards in portfolio management. Markowitz’s work eventually led to a Nobel Prize in 1980.
Q. What is so special about modern portfolio theory?
A. Modern Portfolio Theory (MPT) is a predictive model that can help investors build portfolios to maximize expected return based on a given level of market risk. According to the theory, it’s possible to build an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk. Given that no two people are alike, the level of risk people are willing to take is variable. Just like forecasters have weather models, financial advisors have their own financial models as well to build portfolios and help predict portfolio risk and returns.
Q. How has this helped investors?
A. Adhering to MPT principles can help investors, for example, from selling too late in a downward trending market, which is a typical textbook mistake investors make over time. Or following a herd mentality when the market is trending upward. Or holding losing positions to avoid the mental pain associated with admitting they made a bad decision.
Q. Why do investors make those kinds of mistakes?
A. As an evolutionary quirk, human beings have learned to take mental shortcuts toward an answer when overwhelmed by a lot of data or choices in a short time frame. It’s a trait that has served all of us well in many situations. That’s why “rules of thumb” are so beneficial when trying to sift through complicated situations quickly. However, investing is not one of these situations where shortcuts work over time.
Q. Should investors rely mostly on fundamentals, facts and figures when investing?
A. If the market was only populated with rational investors who are always willing to accept a higher degree of risk for a potential higher return, one could say yes. These are some of the tenets of Traditional Finance. Behavioral Finance, however, assumes that investors do not always act based on raw facts and analysis alone. Moreover, based on studies conducted in the late 1970s, researchers found that people normally feel losses twice as bad as they feel the joy of gains. Therefore Behavioral Finance argues that investors are irrational and do not always choose or make an optimal decision when given the information due to either an information processing issue or certain biases they possess.
Q. Why is it important to understand the difference?
A. Well, since 2008/2009, we have experienced one of the most extended bull market equity cycles (now 90 months) ever. It is important to revisit how most investors normally tend to react, not only in different market conditions and phases of their lives, but also according to their different behavioral biases. This should help investors not to repeat some costly mistakes, especially if they are in, or close to entering, the retirement phase. If one recognizes bias, investors can try to accommodate for it.
The second part of this series will cover the four types of behavioral investors, and how these four categories are prone to view their investment world.
Part One
Q. Why pay attention to an academic topic like behavioral finance?
A. One reason is that it can help you determine your own tendencies and biases in making investment decisions. There is, in fact, much research behind what your portfolio manager may have been advising you on over the years. Making better decisions at any pursuit, especially one involving investments, can add up over time.
Q. So how does the research help professional managers make better decisions for my portfolio?
A. It helps to have some historical context first. For decades, investment professionals and investors have been trained in university-level finance classes and professional accreditation programs on “Modern Portfolio Theory.” This approach is considered the foundation of sound investment principles, the bible for the investment community.
Modern Portfolio Theory (MPT) was developed by American economist Dr. Harry Markowitz in 1952, but it did not start gaining traction with mainstream investment advisors until the 1980s. Today, its principles are used by professional money managers worldwide to help investors assess the risks and rewards in portfolio management. Markowitz’s work eventually led to a Nobel Prize in 1980.
Q. What is so special about modern portfolio theory?
A. Modern Portfolio Theory (MPT) is a predictive model that can help investors build portfolios to maximize expected return based on a given level of market risk. According to the theory, it’s possible to build an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk. Given that no two people are alike, the level of risk people are willing to take is variable. Just like forecasters have weather models, financial advisors have their own financial models as well to build portfolios and help predict portfolio risk and returns.
Q. How has this helped investors?
A. Adhering to MPT principles can help investors, for example, from selling too late in a downward trending market, which is a typical textbook mistake investors make over time. Or following a herd mentality when the market is trending upward. Or holding losing positions to avoid the mental pain associated with admitting they made a bad decision.
Q. Why do investors make those kinds of mistakes?
A. As an evolutionary quirk, human beings have learned to take mental shortcuts toward an answer when overwhelmed by a lot of data or choices in a short time frame. It’s a trait that has served all of us well in many situations. That’s why “rules of thumb” are so beneficial when trying to sift through complicated situations quickly. However, investing is not one of these situations where shortcuts work over time.
Q. Should investors rely mostly on fundamentals, facts and figures when investing?
A. If the market was only populated with rational investors who are always willing to accept a higher degree of risk for a potential higher return, one could say yes. These are some of the tenets of Traditional Finance. Behavioral Finance, however, assumes that investors do not always act based on raw facts and analysis alone. Moreover, based on studies conducted in the late 1970s, researchers found that people normally feel losses twice as bad as they feel the joy of gains. Therefore Behavioral Finance argues that investors are irrational and do not always choose or make an optimal decision when given the information due to either an information processing issue or certain biases they possess.
Q. Why is it important to understand the difference?
A. Well, since 2008/2009, we have experienced one of the most extended bull market equity cycles (now 90 months) ever. It is important to revisit how most investors normally tend to react, not only in different market conditions and phases of their lives, but also according to their different behavioral biases. This should help investors not to repeat some costly mistakes, especially if they are in, or close to entering, the retirement phase. If one recognizes bias, investors can try to accommodate for it.
The second part of this series will cover the four types of behavioral investors, and how these four categories are prone to view their investment world.
References:
-The Investment Advisor Body of Knowledge Readings for the CIMA® Certification, 1st Edition, by IMCA®.
-Behavioral Finance and Wealth Management: How to Build Optimal Portfolios That Account for Investor Biases, by Michael M. Pompian, CFA, CFP®.
-Behavioral finance in Asset Management, A Primer, by Marcus Schulmerich, PhD, CFA, FRM.
-Samuelson, William and Richard Zeckhauser, “Status Quo Bias in Decision Making” Journal of Risk and Uncertainty.
Disclosures:
*Always consult with your CPA and professional advisor on matters involving income taxes.
Past performance is no guarantee of future results, and the opinions and other information in the commentary are as of November 14, 2017. This summary is intended to provide general information only and is reflective of the opinions of Commerce Trust.
This material is not a recommendation of any particular security, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional. Diversification does not guarantee a profit or protect against all risk.
Commerce does not provide tax advice or legal advice to customers. Consult a tax specialist regarding tax implications related to any product and specific financial situation.
Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Commerce Trust is a division of Commerce Bank.
-The Investment Advisor Body of Knowledge Readings for the CIMA® Certification, 1st Edition, by IMCA®.
-Behavioral Finance and Wealth Management: How to Build Optimal Portfolios That Account for Investor Biases, by Michael M. Pompian, CFA, CFP®.
-Behavioral finance in Asset Management, A Primer, by Marcus Schulmerich, PhD, CFA, FRM.
-Samuelson, William and Richard Zeckhauser, “Status Quo Bias in Decision Making” Journal of Risk and Uncertainty.
Disclosures:
*Always consult with your CPA and professional advisor on matters involving income taxes.
Past performance is no guarantee of future results, and the opinions and other information in the commentary are as of November 14, 2017. This summary is intended to provide general information only and is reflective of the opinions of Commerce Trust.
This material is not a recommendation of any particular security, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional. Diversification does not guarantee a profit or protect against all risk.
Commerce does not provide tax advice or legal advice to customers. Consult a tax specialist regarding tax implications related to any product and specific financial situation.
Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Commerce Trust is a division of Commerce Bank.
