Morningstar Magazine - June/July 2017 - 41

The Promise of Behavioral Finance
By learning to overcome their
biases, investors gain a vital tool to help
them reach their financial goals.

BEHAVIOR

Stephen Wendel

Nearly 18 years ago, pioneer behavioral scientist
Richard Thaler called for the "end of behavioral
finance" as a separate discipline-because all of
finance would soon be behavioral (Thaler 1999).
Behavioral finance as a distinct approach is
very much alive and well, and it is being applied in
a variety of contexts within the industry. In this
article, let's take a brief tour through the history
of behavioral finance-from a practitioner's
perspective-and see where things might take us
over the next 10 years.
Where It All Started

Over the past three decades, researchers in
economics and psychology have cataloged dozens
of different biases that affect how investors make
choices and cause them to deviate from
their ideal economic outcome. This work has
challenged the once common view in economics
(and finance) that individuals are narrowly selfish
and rational, using all available information to
maximize their expected utility.

trailblazers in the field, psychologists Daniel
Kahneman and Amos Tversky, who began their
work on what is known as Prospect Theory
in the 1970s. Their insights, and those of other
behavioral researchers, had broad implications
for understanding human decision-making,
and its consequences for finance became clear
right away. In a sample study, researchers found
that a related bias causes investors to hold on to
losing stocks far longer than they should, to avoid
realizing a loss (aka the disposition effect).
Researchers discovered numerous other
biases that specifically affect financial behavior
as well, such as illusory superiority (the vast
majority of investors think they are better than
average), overconfidence (beliefs about
oneself outpacing the reality), and recency bias
(believing that past performance predicts
future performance). Behavioral research like this
has come to broad public awareness in books such
as Thaler and Cass Sunstein's Nudge (2008),
Dan Ariely's Predictably Irrational (2008), and
Kahneman's best-selling book Thinking, Fast and
Slow (2011).
Behavioral Finance in the Finance Industry

For example, investors often have different risk
preferences based on how options are
described: A serious medical procedure with
a 90% survival rate elicits a very different response
than one presented having a 10% mortality
rate. This observation builds on the work of two

For practitioners in finance, the wealth of research
from the 1970s to today has increasingly
seeped into practical work, especially recently.
Ten years ago, at Barclays, Greg Davies set up one
of the first applied behavioral science teams in
finance. "I had to start every single meeting with,

'Has anyone heard of behavioral finance?'" he says.
"I was often faced with reactions between
skepticism and indifference" (Davies 2017). Now,
behavioral finance is well known, and the interest
is palpable. Michael Liersch, Merrill Lynch's
head of behavioral finance and goals-based
consulting, says, "I get so many calls a day from
advisors who are eager and excited...about
behavioral finance" (Liersch 2017).
The intersection between behavioral finance
and practice can been seen in terms of
four distinct themes: cataloging investor biases,
arbitraging market anomalies, developing
tools to avoid and overcome these biases, and
exploiting people's biases for profit.
Much of the early work in the field-and a
significant portion of the materials that
practitioners develop and promulgate today-
focuses on cataloging and educating
investors about their numerous biases. The implicit
or explicit assumption is that savvy investors,
properly informed and educated about these
biases, can overcome them. In reality, the
effectiveness of this approach has been difficult
to establish in the field.1
Side by side with the study of individual
biases, researchers and practitioners have
investigated how investment mistakes
might aggregate up into market anomalies such
as asset-price bubbles and crashes, the equity
premium, and the small-cap premium.
Significant debate occurred, and continues to
occur, about whether and how behavioral
anomalies could persist over time (Sornette et al.,
2016), with some researchers arguing that
limits to arbitrage, including trading costs
and industry incentives, allow them to persist
(for example, Barberis and Thaler 2003). The
implication of this work is a potential for profit:
If arbitrage is possible, well-informed,
behaviorally savvy investors might exploit these
predictable irrationalities.
The third theme has only emerged in force over
the past few years and focuses on developing

1 With a few exceptions, like Kaustia and Perttula (2012).

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