My Behavioral Economics Elevator Pitch

Greetings All,

This week we’re discussing our brief (elevator pitch) interpretation of behavioral economics. I’ve been in the investment business all my life so the conversation will revolve around behavioral theory and the financial markets for me personally.

I suppose traditional market theory (as well as economics) has always had a very mathematical feel to it. Theories were expressed in terms that was easily packaged into explainable, broad-based assumptions that seemed to fit the profile of a rational investor. The Efficient Market Hypothesis, the Efficient Frontier and the Capital Asset Pricing Model (CAPM) were still very highly considered back in the late 80’s into early 90’s. What bothered me about these theories were the anomalies that just couldn’t be explained away by even the most ardent of traditionalists.

Behavioral Economics/Finance introduces the variable that humans are not always rational – in fact I’d venture to say that it’s in our DNA to be consistently irrational. So, events such as the January Effect and post-earnings announcement drift should have been statistically impossible under traditional market theory, yet they occurred. If equity prices were truly random as traditional market theory dictates, then stock price movement would be equally distributed and yet there are many instances of fat tails that translated into trends. Technical analysis would be non-existent and yet it is a thriving field of study.

One assumption under the Efficient Market Hypothesis is that prices reflect all available public information. That statement itself seems to me a contradiction. If all prices reflected all available public information, then there would be zero incentive for analysts to do research. This would create an information vacuum. It never made sense to me.

I’ll sum it up by saying the most appealing part of behavioral economics/finance for me is its precise way of dealing with the explainable.

To measure what traditional economists equated to an error function. The most important part of behavioral economics (and I speak through personal experience) is understanding and embracing my emotional nuances to become more efficient in my career and to be a better person in general.

What areas of behavioral economics am I drawn to? Most definitely it would be human behavior under extremely stressful circumstances. Understanding how a hostile environment alters the decision-making process. There are some behavioral biases that are cognitive in nature and one could possibly learn to behave a certain way in certain situations. But there are emotional biases that we will never “learn-away” in my opinion. We just need to find the best way of coping with something innate in our DNA. To learn to deal with both the psychological pressures of the moment but also the physical effects as well (if anyone wants to read a great book on the physical toll read The Hour Between Dog and Wolf: How Risk Taking Transforms Us, Body and Mind by John Coates).

I will be taking my platform that I use for investing and finding ways to quantify the creation of anxiety-adjusted market returns as a compliment to risk adjusted returns. Take the last week for instance, where the market has been in a free-fall. The conversations that I have with my clients and within my own investment committee have shifted. The conversation in many cases have turned 180 degrees from “potential returns” to a much more urgent “what are we at risk of losing”. Loss aversion has kicked in as we travel down and left in the value function (Kahneman & Tversky, 1979).

Reason will prevail. And while I can’t guarantee that the portfolio will not lose money, I can assure that we won’t lose money by making dumb decisions. It has worked in the past and keeping a clear mind has actually increased the alpha in the portfolio. The most comfortable (stress-free) return on investment is something the industry is overlooking right now and there is an opportunity there. One thing I picked up from our reading, “although irrationality is commonplace, it does not necessarily mean that we are helpless (Ariely, 2009, p.244)” I really would like to expand on that concept.

Joseph S. Kalinowski, CFA

References

Angner, E. & Loewenstein, G., Behavioral Economics (2012). Handbook of the philosophy of science: Philosophy of Economic, 641-690, Uskali Mäki ed., Amsterdam: Elsevier.

Ariely, D. (2009). Predictably Irrational: The Hidden Forces that Shape our Decisions. New York, N.Y.: Harper Perennial Modern Classics.

Coates, J. M. (2013). The hour between dog and wolf: how risk-taking transforms us, body and mind. Toronto: Vintage Canada.

Kahneman, Daniel and Amos Tversky, “Prospect Theory: An Analysis of Decision under Risk,” Econometrica 47 (1979): 263– 291.

Kahneman, D. (2011). Thinking, fast and slow (1st ed.). New York: Farrar, Straus and Giroux.

Pugno, M. (2014). Scitovsky, Behavioural Economics, and Beyond. Economics: The Open-Access, Open-Assessment E-Journal, 8(2014-24), 1. doi: 10.5018/economics-ejournal.ja.2014-24