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Perception Versus Reality

Mark Paccione, CFA, CFP® Director, CAPTRUST Investment Research, R. Michael Gray, CPA, PFS Senior Vice President, CAPTRUST Financial Advisor

As active participants in the capital markets, we at CAPTRUST are well aware that economic theory and reality are often two very different things. Traditional economic theory assumes that humans are rational wealth maximizers who make logical decisions with their capital. However, basic life experience tells us this is not always the case. Experiments have shown, for example, that individuals will drive farther to save $5 on a $15 item than a $100 item.1 Theory would dictate that a rational individual would drive the same amount of time regardless of the price. However, humans don’t always act rationally when it comes to money, and our behavioral quirks create risks, challenges, and opportunities for us as investors.

Enter behavioral finance, a discipline that tries to bridge this gap between theory and reality. Behavioral finance studies the effect of social, cognitive, and emotional forces on economic and investment decisions made by individuals — and how those decisions often contradict the rational behavior assumed by classical economic models. It is an exciting and relatively new field of study based on the work of three key figures: Amos Tversky, Daniel Kahneman, and Richard Thaler. Starting in the 1960s, cognitive psychologists Kahneman and Tversky researched and published many of the psychological concepts that behavioral finance explores, including popular works on prospect theory and loss aversion which investigate an individual’s tendency to view gains differently from losses. Research has shown that individuals prefer avoiding losses much more than experiencing gains. In 2002, Kahneman received the Nobel Prize in economics for his groundbreaking work with Tversky.
 
The third major figure in behavioral finance is Richard Thaler, a professor at the University of Chicago. Building on the work of Tversky and Kahneman, he published a paper titled “Mental Accounting Matters” in 1999. Mental accounting, which was discussed in our first quarter Strategic Research Report, is a concept that explores how individuals perceive and experience financial outcomes, how decisions are made and subsequently evaluated, and how financial activities are assigned to specific accounts or “buckets.” Anyone who has ever set aside money for a specific purpose—such as saving for a child’s college tuition, creating a vacation fund, or socking money away for an engagement ring—has employed mental accounting.
 
Three themes central to behavioral finance are: heuristics, framing, and market inefficiencies. Heuristics refers to the use of “rules of thumb” in decision making in situations when detailed analysis and exhaustive searches are not practical. One common heuristic is anchoring and adjustment, where estimates are based on an adjustment from an implicit reference point (or anchor). For example, if you ask a general question such as “What will the S&P 500 return next year?” you will get a wide range of answers. If you ask, “How much higher or lower than +10% will the S&P 500 return next year?,” the range of estimates will be in a band that clusters around +10%. That’s a heuristic at work. Changing the way a choice is presented can impact what choice is eventually made. This phenomenon is referred to as framing. For example, when asked if they prefer meat that is 90% lean or 10% fat, most people will say they prefer the former— even though they’re exactly the same thing. Finally, market inefficiencies refer to anomalies that exist due to the behavioral biases of market participants. Many biases have been uncovered and examined. A few of them are: status quo bias (sticking with what you know), recency bias (assigning a heavier weight to events that just occurred in decision making), fear of losses, and confirmation bias (the tendency to accept data that confirms existing beliefs while rejecting data that contradicts them).
 
While studying the quirks of human behavior may sound interesting, readers may question the relevance of such information. Knowledge of behavioral finance is important to CAPTRUST and our clients as it enables us tomake better financial decisions. By understanding natural mental processes and human decision-making tendencies, we can avoid common mistakes, set up portfolios that are more congruent with how an individual thinks, and make investment decisions that help generate higher returns over the long run. In short, understanding behavioral fi nance theory increases our chances of success for achieving our main mission, meeting our clients’ financial goals.