Behavioral finance theory is gaining ground in investment strategies.

The tendency to gamble and assume unnecessary risks is a basic human trait, according to many human behavior researchers. We are inclined to remember our successes, and forget our failures, they say, which artificially boosts our confidence. As John Allen Paulos states in his book, Innumeracy, "There is a strong general tendency to filter out the bad and the failed, and to focus on the good and the successful."

These tendencies are never more apparent than in the ways we invest, say industry sources. Princeton University's Daniel Kahneman, the 2002 Nobel Prize winner in economics, spent years studying the mental processes investors use to make financial decisions. His theories, as well as those of an increasing number of scholars-including University of Chicago professor and pioneer in behavioral finance Richard A. Thaler-stem from the early 1970s, another dreary era for investments, and are quickly coming back into vogue. The late Amos Tversky, Kahneman's long-time friend and collaborator and a Stanford behavioral finance professor, is frequently cited as the forefather of behavioral finance theory (BFT). He co-authored with Kahneman the famous Prospect Theory: An Analysis of Decision under Risk [Econometrica, 1979. See sidebar], which kicked off a wave of behavioral trend research.

A recent white paper by The Money Management Institute (MMI) is becoming a new focal point in the ongoing debate over behavioral financial theory. This research attempts to better understand and explain how emotions and cognitive errors influence investors and their decision-making process. Many BFT researchers believe that by studying human psychology and other social sciences, we can better answer questions about the efficiency of our markets as well as its anomalies, bubbles and crashes. But critics say that BFT doesn't provide enough hard evidence to disprove or cast doubt on efficient market theories, and that the underlying methods of research for BFT are questionable.

Academic research and real-world observation suggest that investors are often their own worst enemies, reports The Money Management Institute in a Summer 2003 white paper titled Behavioral Finance and the Individual Investor. Too often, they fall prey to certain mental quirks, or habits of thought, that can lead them to overestimate their own investment management skills and underestimate the complexity of making sound investment decisions. The insights garnered through BFT research have begun to challenge many previous assumptions about the nature of the financial markets.

The MMI research also suggests that investors who have a clearer understanding of the investment process may be less likely to be misguided by their own psychological blind spots. This, in turn, highlights the important role that financial advisors and professional money managers can play in an effective investment program. Says Paul Power, national sales director for Invesco, "Without a doubt, having a second set of eyes can help the individual investor set up an effective investment program and stay with that program. I think that is a key benefit of working with a financial advisor. This is also true when selecting a professional money manager. If the individual investor understands, and is comfortable with, the money manager's investment discipline, the odds of long-term success are greater."

This belief extends specifically to the management of separate accounts, according to MMI, which is seen in a small but growing number of professional managers who are incorporating behavioral insights into their investment strategies. Thaler, a principal at the San Mateo, Calif.-based money management firm Fuller & Thaler Asset Management in addition to his position at the University of Chicago, uses behavioral finance concepts to invest in U.S. equities. His firm manages approximately $1.8 billion in separate accounts. Other recognizable names using BFT include well-known contrarian manager David Dreman, LSV Asset Management, Fisher Investments and Martingale Asset Management.

As growing numbers of managers and advisors join the ranks of behavioral finance supporters, the investor is the ultimate benefactor, particularly if they choose separate accounts, suggests MMI in its white paper. Choosing experienced, qualified portfolio managers increases the likelihood that investors' strategies will be shaped by careful analysis, rather than behavioral biases, the paper says.

Veteran advisor J. Jeffrey Lambert, a CFP licensee at Lighthouse Financial Planning in Sacramento, Calif., agrees, but also believes the MMI statement could very well be making a case more for advisors than separate account management.

"When the separate account manager's style is out of favor," asks Lambert, "how is that manager going to help the client from bailing on their strategy if they are reacting to other behavioral biases?" Lambert submits that regardless of whether or not a client has a separate account, it's the advisor or manager who focuses strictly on the client who will provide "the crucial value of assisting the client to stick to their investment policy."

Jim Ware, a CFA and managing director of The Focus Consulting Group in Glenview, Ill., and author of The Psychology of Money and Investment Leadership, agrees with Lambert and says it takes an unusual person, free of personal fears and corporate bureaucracy, to invest with very little bias. "Most firms will continue to show bias in their investing, thus allowing the exceptional individuals to prosper," Ware comments.