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The Promise of Behavioral Finance

A practitioner’s view of the history of behavioral finance

Steve 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. While behavioral finance as a distinct approach is alive and well, his vision of integration and of wide application within the industry is increasingly coming true.

Thaler was awarded the Nobel Memorial Prize in Economic Sciences on Monday for his contributions to behavioral economics. And we thought we’d 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 that deviate from ideal economic outcomes. This work has challenged the once common view in economics (and finance) that individuals are narrowly selfish and rational, and use all available information to maximize their expected utility.

For example, investors often have different preferences based on how a set of options are described: A serious medical procedure with a 90% survival rate elicits a very different response than one presented as having a 10% mortality rate. This observation builds on the work of two 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 one 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 myopic loss aversion (frequent checking of one's portfolio exacerbates investor biases and distorts trading behavior — one of Richard Thaler and Shlomo Benartzi's early findings), illusory superiority (the vast majority of investors think they are better than average), overconfidence (believing one's skills and likelihood of success are more than they really are), and recency bias (believing that past performance predicts future performance).

Behavioral research like this has come to broad public awareness in books such as Richard Thaler and Cass Sunstein’s Nudge (2008), Dan Ariely’s Predictably Irrational (2008), and Daniel Kahneman’s best-selling book Thinking, Fast and Slow (2011).

Behavioral finance in the finance industry

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 said in phone interview on April 28. “I was often faced with reactions between skepticism and indifference.”

Now, behavioral finance is well known, and the interest is palpable.

Our path at Morningstar

Where is Morningstar in all of this? We see behavioral finance as a tool to support our mission of helping investors reach their financial goals. Morningstar has long provided unbiased and accurate information, which is essential for investors. However, we recognize that information alone can sometimes be insufficient—and additional tools may be needed to support investor success.

Building on early work we conducted with pioneers such as Shlomo Benartzi and Richard Thaler, we ramped up our efforts two years ago and established Morningstar’s Behavioral Insights Team. I have the honor of leading that team of Ph.D. researchers and practitioners who develop behavioral tools to help investors in an increasingly complicated market. As behavioralists, we study the quirks of the mind, such as why people say they want to do something (like invest for the long term) but actually do something else (chase short-term returns), and how to help investors align their action with their intentions. 

Behavioral finance is also increasingly infused throughout the product development process at Morningstar, from new financial planning software to interventions to help investors save for the future via our Retirement Management software.

Celebrating Richard Thaler’s achievement

At Morningstar, we are thankful for the tremendous contributions Richard Thaler has made to the field and congratulate him on being awarded the Nobel Prize in economics. We look forward to the further development of the field he helped found, for the benefit of investors worldwide.

This blog post is adapted from an article that originally appeared in the June/July 2017 issue of Morningstar magazine.  Read the full article or subscribe to the magazine .

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