In the past, we have discussed how successful investing involves identifying, measuring and managing risk. Moreover, we believe the best investment decisions require a healthy degree of objectivity, much like a doctor diagnosing a patient. In the field of medicine, there is no room for emotions when evaluating and making critical healthcare decisions. For this reason, it is unusual for a doctor to perform a risky or complex medical surgery on a close family member due to the emotional ramifications that might be involved. However, as investors, we are often faced with making critical investment decisions that are impacted by our emotions and psychological biases. Whether we are willing to admit it or not, it is likely that we are less objective in our investment decisions than we may think. In recent years, the study of these biases in investment decisions has led to the field of behavioral finance. While academia has written a great deal on the subject of behavioral finance, this paper will discuss a practitioner’s view on how professional money managers address these biases in daily decision making.

Behavioral Finance

While traditional finance in the context of modern portfolio theory explains the actions of investors based on rational mathematical risk models, the reality is that investors are human, and are far from being rational creatures. As a result, modern portfolio theory has failed to explain inefficiencies and anomalies that occur in the capital markets. This has fueled recent growth in the field of behavioral finance, which is the study of how human psychology influences financial decisions and explains market anomalies. While behavioral finance is still relatively new as an academic field of study, the basic human behaviors that are exhibited are ancient and relate closely to the most primitive predispositions of mankind.

The overall impact that psychological influences have on portfolio returns are often difficult to measure. However, a study published in the October 2011 Journal of Financial Economics found that more than 75% of the variances in the returns of individual stock investing were explained by five of the most common factors addressed in behavioral finance. This study also found that sophisticated investors, who are better informed and more experienced, wisely used mutual funds to achieve good relative returns and to avoid behavioral biases that are common in individual stock investing.