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.

But how can a portfolio be customized without understanding the client's behavioral biases? Customization is the hallmark of a separately managed account, says Boulder, Colo.-based veteran wealth management and SMA consultant Curtis Greenlaw. "Careful analysis emanating from client fears and expectations-in addition to their biases-is crucial," he says. "These biases shouldn't overwhelm the portfolio management process, but acknowledging and understanding them should be useful to advisors and managers in addressing important issues of suitability, as well as more effectively managing client expectations."

But are these behavioral technologies, often described as cutting edge, helping managers in their quest for better investor understanding and communication and more skilled portfolio management? Perhaps, says Scott MacKillop, co-founder and president of Trivcon Consulting based in Evergreen, Colo. "In some sense, these are really not cutting-edge strategies at all. Many traditional value investors look at the world very much like the behaviorists. They believe that investors overreact to events and behave in other nonrational ways with the result that securities are mispriced, if only temporarily."

Such strategies have been around for many years, says MacKillop. "Firms like Fuller & Thaler are trying to directly apply the teachings of behavioral finance to investing in ways that could be characterized as cutting edge. They apparently have had some success, although I don't think they have discovered the Holy Grail yet. Once they do, everyone will copy their approach, and they will have to move on to discover new ways to exploit investor nonrational behavior. Based on their track record, it looks like investing a portion of a client's assets in their funds would have resulted in a pretty decent return."

Lambert doesn't mince words about the exploitation of BFT. "This goes to the heart of the issue of active versus passive," he says. "For active managers this is another tool in decision-making. For the passive adherents, it is just another heresy."

Consultant Curt Greenlaw believes behavioral finance merely incorporates another variable to assess an investor's visceral attitudes and response to risk. "Describing it as cutting edge is ironic," he says. "It is inane to believe that any mathematical 'model' or cursory questionnaire can adequately measure risk. So, it would be worthwhile and prudent to entrust a portion of a portfolio to a separate account manager who truly seeks to better understand their clients' motivations, fears and biases."

James N. Whiddon, a CFP licensee and CEO of JWA Financial Group Inc. in Dallas, offers a slightly acerbic viewpoint. "The behavioral insights [strategies] that money managers are using may be cutting edge, but the clients are the ones who eventually may bleed," he says.

He adds that a concept still taught in business classes continues to ring true: "The market can remain irrational longer than investors can remain solvent." Whiddon believes that some money managers create 'products' that are seemingly based on valid academic research such as behavioral economics. "But in truth, they are often cleverly disguised marketing approaches," he says. His bottom-line approach is a "long-term adherence to MPT (modern portfolio theory) with deep and broad diversification across multiple asset classes. It is still the best way to invest."

Although cynics still abound-primarily among the more traditional guardians of efficient-market theory-the beliefs presented by behavioral theorists are increasingly gaining acceptance in the economic and financial communities. However, University of Chicago finance professor Eugene Fama, a widely respected efficient-markets theorist, criticizes behavioral finance theory. In a 1998 essay in the Journal of Financial Economics, Fama rebuts the view that behavioral finance might replace efficient-markets theory. The field tends to attract people who are not very good statisticians, says Fama in the article, and he argues that behavioral finance hasn't shown that the cumulative tendencies of individuals have an impact on world prices. Fama continues to argue that "data-mining techniques make it possible to locate patterns whose significance is nonetheless questionable, if not irrelevant."

But some remain unconvinced. "Perhaps this is true, but how does he explain the week or ten-day lag in market pricing of a stock after the announcement of a particular news event?" asks Kathleen Gurney, Ph.D., and CEO at Financialpsychology.com. She also is founder of the Center for Family Finance, in association with the University of South Florida in Sarasota.

The debate about MPT and BFT continues to stir controversy as industry scholars question and/or disagree. Even some true behavioral finance believers have some doubt as to the consistencies of the psychological studies supporting the ideology, not to mention the validity of its benefits for separate account holders as mentioned in the MMI paper. SMA specialist MacKillop says he admires MMI's efforts to enlist the behaviorists in the cause of promoting separate accounts, but he feels they may be "stretching the teachings of BF a bit in the process."

He goes on to say, "Certainly, the perspective and experience of a professional money manager can be of great value to an investor. But I believe the behaviorists have made the point quite convincingly that professionals and non-professionals alike can exhibit nonrational behavior in making investment decisions. The MMI's statement seems to suggest that somehow 'careful analysis' is an antidote to nonrational behavior. This implies that nonrational behavior is the same thing as emotional behavior and that it can be reined in by the application of intellect and critical thinking."

MacKillop says there may be some truth to that, but also believes one of the great insights of behavioral finance is that "critical thinking" and "careful analysis" can be very much affected by nonrational thought processes, too. "In other words, professionals must grapple with their behavioral issues just like the rest of the investing public," says MacKillop. "There are certainly many good reasons to use separate accounts, but I'm not sure that behavioral finance is one of them."

Separate accounts aside, how can advisors apply the understanding of investor behavior to create portfolios for clients? First and foremost, BFT puts the notion of risk back into investing, according to wealth manager Martim de Arantes-Oliveira, a principal at H&S Financial Advisory LLC in Menlo, Calif. "Portfolios must be a reflection of process and discipline," he says. "Risk management is the primary function of portfolios. For all parties concerned, it emphasizes the need for that discipline and process in asset management as a way to mitigate-not eliminate-the innate irrationality and inconsistencies present in human decision-making, i.e., it revives the idea of uncertainty of outcome."

Lambert says his firm does not use BFT to outwit the market. "Instead, behavioral finance helps us create portfolios that clients will be satisfied with in good times and bad, and in keeping clients in the parts of the market that are appropriate for them," he explains. "It sometimes requires an advisor to be more flexible in portfolio construction, or to turn away a potential client because there is a mismatch in philosophies."

Financial psychologist Gurney says that she has observed a relationship between investment preferences and the "money personality styles" of clients. Her Moneymax Profiling System was developed to help investors (and advisors) become aware of, and take responsibility for, the money personalities and traits that drive their behavior. Says Gurney, "Often advisors find out what they need to know [about investor behavior] after the fact rather than during the investment process."

Some suggest that many advisors and money managers themselves are the obstacles to putting BFT into practice on any level, because they sometimes fall into the traps of "I know all the answers" or "I don't have time to spend on all this psychology." Invesco's Paul Power says we all can be our own worst enemy. "As professional money managers, one way we avoid that trap is to have multiple portfolio managers look at stocks to buy AND sell. For example, if a particular stock was suggested for purchase by portfolio manager A, and it isn't performing well, it is helpful to have portfolio manager B review the security with a fresh perspective," he explains. "This helps remove emotion from the decision-making process."

Investor psychology is a complex business-difficult to define and even harder to understand, concludes the MMI paper. The first step toward avoiding behavioral errors is understanding the behavioral influences that can cause them. And since most investors find it difficult to identify-much less correct-their own strengths and weaknesses, advisors and managers can create value for clients, thus reinforcing the important role that advisors and managers play in an effective overall wealth management strategy.

MacKillop perhaps says it best: "Behavioral finance is in its early stages. I do not think that even its most ardent supporters would claim that it perfectly explains market behavior or that it can be widely employed by the typical investor to gain a consistent investment advantage or beat the market. However, behavioral finance can certainly make advisors and money managers better investment counselors. By understanding nonrational behavior and working to help clients overcome it, advisors and managers can do a great service to their clients and increase their chances of reaching their long-term objectives. Anything that can contribute to that effort should be widely embraced by the investment community."

The Prospect Theory

Kahneman and Tversky presented groups of subjects with a number of problems.

One group of subjects was presented with the following dilemma:

In addition to whatever you own, you have been given $1,000. You are asked to choose between:

A. A sure gain of $500.

B. A 50% chance to gain $1,000 and a 50% chance to gain nothing.

Another group of subjects was presented with a different problem:

In addition to whatever you own, you have been given $2,000. You are asked to

choose between:

A. A sure loss of $500.

B. A 50% chance to lose $1,000 and a 50% chance to lose nothing.

In the first group, 84% chose A. In the second group 69% chose B. The two problems are identical in terms of net cash to the subject, however the phrasing of the question causes the problems to be interpreted differently.

Source: Daniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision Making Under Risk," Econometrica, 1979.