It seems to be human nature to be fascinated by pathology. Sigmund Freud began his study of the human psyche by outlining how it was broken (hint: your Mom) and the discipline continued down that path for over a century. It was roughly 150 years before the study of clinical psychology was offset at all by the study of what we now call “positive psychology” – the study of what makes us happy, strong and exceptional. Perhaps it is no surprise then that behavioral finance too began with the study of the anomalous and is only now coming around to a more solution-focused ideal. While a thorough review of the transition from efficient to behavioral approaches isn’t why we are here, it’s worth considering the rudiments of these ideas and how we can improve upon them.
For decades, the prevailing economic theories espoused a view of Economic Man as rational, utility maximizing and self-interested. On these simple (if unrealistic) assumptions, economists built mathematical models of exceeding elegance but limited real-world applicability. It all worked beautifully, until it didn’t. Goaded on by a belief in the predictability of Economic Man, The Smartest People in the Room picked up pennies in front of steamrollers- until they got flattened.
On the strength of hedge fund implosions, multiple manias with accompanying crashes and mounting evidence of human irrationality, Economic Man begin to give way to Behavioral Man. Behavioral proponents began to document the flaws of investors with the same righteous zeal with which proponents of market efficiency had previously defended the aggregate wisdom of the crowd. At my last count, psychologists and economists had uncovered 117 documented biases capable of obscuring lucid financial decision-making. One hundred and seventeen different ways for you to get it wrong.
But the problem with all of this Ivory Tower philosophizing is that none of it truly helps investors. For a clinical psychologist, a diagnosis is a necessary but far from sufficient part of a treatment plan. No shrink worth his $200 an hour would label you pathological and show you the door, yet that is largely what behavioral finance has given the investing public: a surfeit of pathology and a dearth of solutions.
To consider firsthand the futility of being told only what not to do, let’s try the following.
“Do not think of a pink elephant.”
What happened as you read the first sentence of this section? Odds are, you did the very thing I asked you not to do – you imagined a pink elephant. How disappointing! You could have imagined any number of things - you had infinity minus one options - and yet you still disobeyed my simple request. Sigh. Oh well, I haven’t given up on you yet, so let’s try one more time.
“Do not, whatever you do, imagine a large purple elephant with a parasol daintily tiptoeing across a highwire connecting two tall buildings in a large metropolitan area.”
You did it again didn’t you?
All feigned anger aside, what you just experienced was the very natural tendency to imagine and even ruminate on something, even when you know you oughtn’t. Consider the person on a diet who has created a lengthy list of “bad” foods. He may, for instance, repeat the mantra, “I will not eat a cookie. I will not eat a cookie. I will not eat a cookie.” any time he experiences the slightest temptation.
But what is the net effect of all of his self-flagellating rumination? Effectively he has thought about cookies all day and is likely to cave at the first sign of an Oreo. The research is unequivocal that a far more effective approach is to reorient that behavior into something desirable rather than repeat messages of self-denial that ironically keep the “evil” object top of mind. Unfortunately for investors, there are far more histrionic “Don’t do this!” messages than constructive “Do this insteads" and that is where Nocturne Capital comes in. Applied behavioral finance is all about managing your self and managing your wealth, with your advisor being your guide to the former and Nocturne Capital addressing the latter. Behavioral finance is not just a collection of interesting anecdotes about human quirks, it can provide real guidance with respect to everything from diversification to risk management to security selection and viewing it as anything else is a disservice to its lessons that have the potential to both entertain and improve outcomes.
For much, much more on applying behavioral finance to the management of both self and wealth, please check out "The Laws of Wealth" by Nocturne Capital founder, Dr. Daniel Crosby.