Michael O. AdairManaging Director, Senior Investment Consultant | 2018

Introduction

Although behavioral finance is a much younger field than economics, significant research has been conducted to develop behavioral finance since its inception in the late 1970s.

Behavioral finance has come under the spotlight recently after Richard Thaler was awarded the Nobel Prize in Economics.1 Although behavioral finance is a much younger field than economics, significant research has been conducted to develop behavioral finance since its inception in the late 1970s. The discipline demonstrates the pitfalls of economic theory that result from the assumption of rationality and self-interest. To account for the deviations from rationality, economic issues are looked at through a psychological lens that more accurately predicts and explains human behavior. In fact, many of the findings appear intuitive, but only with the emergence of behavioral finance did data and experimentation give credence to these ideas.

Thaler was recognized in 2017 for his research illustrating that individuals depart from rationality systematically. In other words, when people behave “irrationally”—in an economic sense—they do so consistently, meaning this behavior can be categorized and modeled.1 He outlines how choice architecture can influence decisions and claims that a libertarian paternalistic approach should be established to increase overall welfare in society.2

Libertarian paternalism refers to the idea that organizations, both public and private, should have the right to influence behavior while still retaining people’s freedom of choice. Thaler asserts that small nudges in both the public and private sector can benefit those who are prone to making these systematic errors at little to no cost to the more sophisticated decision-makers. In other words, libertarian paternalism is a compromise between paternalism and autonomy in the market and attempts to appease both ends of the spectrum.

Investment managers are not spared from the biases described by behavioral finance. The literature indicates that even experts in their respective fields fall prey to cognitive biases.4,5,6 It is important for advisors and wealth managers to be aware of biases and mental shortcuts that can impact their decisions. By learning about the nuances of observed behavior in the market, people can learn to mitigate and prevent future errors. The tenets of behavioral finance outlined below demonstrate the pitfalls of standard economic theory and illustrate how to reduce the various biases.

Although behavioral finance is a much younger field than economics, significant research has been conducted to develop behavioral finance since its inception in the late 1970s.

Sources

1Appelbaum, B. (2017, October 9). Nobel in Economics Is Awarded to Richard Thaler. The New York Times. Retrieved from https://www.nytimes.com/2017/10/09/business/nobel-economics-richard-thaler.html
2 Thaler, R. H., & Sunstein, C. R. (2009). Nudge: Improving Decisions About Health, Wealth, and Happiness. New York: Penguin Books.
3 Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263-291.
4 Tversky, A., & Kahneman, D. (1983). Extensional Versus Intuitive Reasoning: The Conjunction Fallacy In Probability Judgment. Psychological Review, 90 (4), 293-315.
5 Northcraft, G.B. and M.A. Neale, 1987, “Experts, Amateurs, and Real Estate: An Anchoring-and-Adjustment Perspective on Property Pricing Decisions,” Organizational Behavior and Human Decision Processes 39, 228–241.
6 Englich, B., T. Mussweiler, and F. Strack, 2006, “Playing Dice with Criminal Sentences: The Influence of Irrelevant Anchors on Experts’ Judicial Decision Making,” Personality and Social Psychology Bulletin 32, 188–200.
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10 Odean, T. (1998). Are Investors Reluctant To Realize Their Losses?. The Journal Of Finance, 53 (5), 1775-1798.
11 Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263-291.
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Important Disclosures

Investment management services provided by City National Bank through its wholly owned subsidiary City National Rochdale, LLC, a registered investment advisor.

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Returns include the reinvestment of interest and dividends. Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk.

Past performance is no guarantee of future performance.

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