Behavioral finance looks to predict investor action.

    Do investors in general act rationally? The question is being hotly debated by practitioners and academics alike. The answer may well lead to an understanding of individual investor behavior, and explain why markets occasionally seem to overreact on both the upside and downside.
    Underlying the growing interest in behavioral finance is the notion that investors are not always rational, but sometimes act irrationally or emotionally when faced with difficult decisions.
    Researchers site numerous examples of individuals displaying irrational behavior, being inconsistent and making errors in judgment and incompetent decisions when faced with uncertainty.
    In an interview last year, Nobel laureate Daniel Kahneman (Financial Advisor, June 2004) discussed the principles underlying behavioral finance, which offers financial advisors the promise of helping clients avoid common errors they are prone to make. Behavioral finance departs from classical financial theory by dropping the basic assumption that investors are rational and substituting the notion that they act emotionally and are therefore prone to making mistakes.
    One such common mistake is called "narrow framing"-looking at investments in isolation from their entire portfolio. Most financial advisors usually recognize clients prone to this problem during their initial meeting, and attempt to solve it by having the client provide a list their assets and allocation. How can advisors otherwise help design complete investment programs most likely to meet clients' financial goals?
    Another common mistake individual investors make is called the "disposition effect"-the reluctance of some investors to sell a stock that has lost money. They avoid taking losses in order to avoid confirmation of the fact that they made a mistake. A reverse consequence of the disposition effect is their tendency to take gains, thereby rewarding themselves for being right. Here again, the trained financial advisor can reduce or eliminate these tendencies by dispassionately recognizing that the value of an investment is based on its future, and not its past, prospects, and by being willing to sell an investment unlikely to recover and to hold investments yet to achieve their full potential.
    Financial advisors are interested in the lessons behavioral finance teaches because they strongly imply that individual investors need professional guidance to avoid the mistakes their natural tendencies will cause them to make. These mistakes are avoided when advisors follow a series of steps in designing investment programs, which typically include defining a client's financial goals, assessing their risk tolerance, doing a complete audit of their assets and allocation, estimating their current and future income, the number of working years left, their annual savings and the length of their retirement.
    Nevertheless, there are limits to what behavioral finance can do.  Some proponents of behavioral finance argue that, if a plausible theory of investor irrationality can be found, it can be used to predict and control aberrant behavior and profitably exploit market inefficiencies arising from it. At market bottoms, some investors are observed to become overly risk averse, while rational investors search for undervalued investments. At market tops emotional investors may become "irrationally exuberant," while rational investors consider market values to be overextended and busy themselves taking profits.
    Much of the enthusiasm for developing a behavioral theory of finance is based on the observation that extreme market movements occasionally deviate from "fair values," and that such deviations are the result of some investors, not all, making irrational choices. Recall that there are two sides to a trade; at times the buyer might be right, at others, the seller. If the causes of irrational behavior can be identified, it should be possible to anticipate and time extreme market moves.
    This view, however, oversimplifies a more complex process. By their very nature, quantitative models used to estimate the "fair value" of investments must simplify real-world processes. The usefulness of a model depends upon its simplicity-identifying the main factors that influence a phenomena while omitting those that are difficult, if not impossible, to predict in terms of their timing and magnitude of influence.
    The terrorist attacks on the World Trade Center and the Pentagon on 9/11 caused the stock markets to close, and investors to become uncertain about the long-term economic, military, political and social consequences. This uncertainty increased investors' perception of risk, resulting in a wave of selling that plunged market values. Should those extraordinary adjustments in valuations be characterized as irrational, or as an appropriate response to investors' perception of increased risk?
    A statistician would classify the event as a "four or five sigma event," meaning that the plunging market values associated with those events were well beyond those that would be defined by a normal distribution, in which 99.7% of all observations are contained in a range between plus or minus three standard deviations of the mean value of the distribution. (A standard deviation is statistically described by the Greek letter "sigma.")  A four or five sigma event is therefore inconsistent with a model that uses only endogenous factors in the context of a stable, normal, bell-shaped distribution.
For investors to be able to fully profit from an event, they must have two pieces of information: the magnitude of the event's impact on an investment, and its timing. By their very nature, exogenous events are not predictable with regards to magnitude or timing. The possibility that an exogenous event might occur can be surmised, but the degree to which it will impact an investment, or its timing, can not.   
    Few, if any, financial advisors could have predicted the heights to which the bubble would rise, and the timing of the bust, or the extent to which Enron's hidden losses, or WorldCom's bankruptcy, would undermine stock market values. Yet those events had an unmistakable effect on the investing public's assessment of risk and stock market values. How, then, could an investor have accurately determined the timing and magnitude of their influence on the overall market or specific segments of it? The simple answer is that he or she could not.
    It is perhaps more productive to maintain the assumption of rationality in trying to understand investor behavior, and use it to determine the likely choices a rational investor might make under extraordinarily difficult circumstances.
    A half century ago Nobel-prize winning economist Milton Friedman and Leonard Savage, in Foundations for Financial Analysis, observed that most rational investors had diminishing marginal utility for wealth, coveting their first dollar more than their second. Friedman and Savage also observed that some investors seemed to have less utility for their first dollar than their next, being willing to accept disproportionately greater risk to acquire wealth. This apparent paradox confused some economists, who considered such behavior irrational. Instead, Friedman and Savage maintained that investors living at one socio-economic level, who aspired to another, higher level, would rationally gamble the security of the lesser level for the possibility of achieving the higher one. In other words, seemingly irrational behavior can have a rational explanation.
    The tendency for speculative price changes to follow a distribution which has more observations at the tails than a normal distribution is well documented. Benoit Mandelbrot concluded that changes in speculative prices follow a "stable Paretian" distribution, which has denser tails than a normal distribution, but did not offer an explanation of why investor behavior would cause those extreme changes. Another Nobel-prize winning economist, Eugene Fama, subsequently confirmed that stock price changes also had denser tails than might be expected, but offered no explanation based on investor behavior.
    However, S. James Press, a University of Chicago doctoral student, departed from these earlier researchers by offering a theory as to why there are more extreme values in actual stock price movements than are possible if they were normally distributed. Simply stated, he argued that stock price returns are normally distributed, but the mean of the distribution is unstable and exogenous shocks cause it to move up and down, thereby creating more observations in the tails of the distribution.
    In recalling the events of 9/11, Press' explanation offers a plausible explanation of the stock market's precipitous decline. On the day before the attack, investors held one assessment of risk and made decisions based on information known on that date. On 9/11, after the terrorist attacks, with the World Trade Center destroyed and the Pentagon badly damaged, the financial markets closed, communications impaired and fears that other attacks were imminent, caused a massive shift in investors' assessments of the risks involved in holding stocks. Was the flight to the safety of cash irrational, an error in judgment, or incompetence? Probably not, because investors had another set of facts with which to assess the risk of holding stocks, and the increased risk required a higher rate at which to discount future earnings-which meant that stocks had diminished in value in a single day.
    This is not to say that speculative bubbles do not contain elements of irrationality or bad judgment. Evidence of large numbers of investors acting irrationally and even stupidly is well-documented in Charles McKay's On Popular Delusions and the Madness of Crowds, in his descriptions of the South Sea, Bubble, Tulipmania and others. Yet, it seems unlikely that investors, either individually or collectively, who display irrational behavior, make errors in judgment or remain incompetent could have anything but a temporary impact on market valuations. Instead, investors displaying rational behavior, making objective and competent judgments, are more likely to consistently profit from their decisions.
    Behavioral finance may produce important insights about irrational investor behavior, but its potential should not be overestimated. A substantial body of sound economic and financial theory exists, based on the assumption that parties having access to all available information, acting in their own self-interest, will make rational and competent decisions.

C. Michael Carty is principal and chief investment officer of New Millennium Advisors LLC, a New York City-based investment advisor. He can be reached at [email protected].