Today, some funds are beginning to integrate psychological and neuroscientific knowledge with economics, creating a system known as behavioral finance.
While few would dispute the assertion that investors don’t always make rational decisions, most of us like to think that we’re better than that. Michael Ervolini, the co-founder of Boston-based Cabot Research—a firm that’s using the latest behavioral finance research to advise portfolio managers—says that’s exactly the type of problem behavioral finance can help solve.
“People may have a suspicion that they aren’t perfect, but they view behavioral tendencies as happening to someone else.”
One of Cabot’s clients, Principle Global Equities, has been rolling out a system to leverage market volatility using behavioral finance insights. According to Jeff Schwarte, a portfolio manager at Principle, “Volatility can be an entry point, but if a portfolio manager is worried about the next quarter, for instance, that volatility will make them question their investment savvy.”
This is only one example of the uses of behavioral finance, but it’s easy to see the promise of it. If investors can be made aware of their own biases and potential for irrational decision-making, poor and ill-considered choices could be made far less often.
Yet if behavioral finance is to make a significant impact in the investing and financial world, it needs to go beyond portfolio managers just trying to remind themselves to be more rational.
J.P. Morgan Asset Management has funds that are based entirely around behavioral finance insights, and one of their primary concerns is formalizing and institutionalizing the decision-making process. A good example they note is always recording the rationale for an investment choice, as well as the conditions under which it should be sold.
Another example, this one going back to Principle, is to ask “portfolio managers if they would buy an existing holding today.” Naturally, if they determine that they would not, they encouraged to quickly move the money elsewhere. This might seem like an obvious technique, but we know from psychology that we are disposed to a powerful bias for the status quo.
It’s doubtless too early to make sweeping pronouncements about the impact of behavioral finance on investing and the financial industry at large, but it is an interesting topic to speculate.