Winning at Active Management

Chapter 5 A More Human Description of Investors and Markets: Behavioral Finance

Behavioral finance, emerging in the 1990s as a counterpoint to Modern Portfolio Theory (MPT), pictures a world in which investing decisions are far more complex than cold trade-offs weighing only numerical measures of risk and return. “Theoretical models of efficient financial markets that represent everyone as rational optimizers can be no more than metaphors for the world around us. Nothing could be more absurd than to claim that everyone knows how to solve complex stochastic optimization models,” wrote Robert Shiller (emphasis in the original).¹

“. . . [A]lthough to err is indeed human, financial practitioners of all types, from portfolio managers to corporate executives, make the same mistakes repeatedly,” wrote Professor Hersh Shefrin of Santa Clara University in 2002. Behavioral finance recognizes the influence that human emotions and reactions—hopes of earning great profits, fear of difficult choices, and inconsistent reasoning about money—exert in economic and investing decisions.² Accordingly, behavioral finance has grown into a rich and diverse body of knowledge, earning Nobel prizes for its researchers. We limit our discussion to a few representative aspects.

Loss Aversion

MPT dictates that all investors make identical, dispassionate evaluations of investments based solely on expected return and volatility, but this assumption ignores the impact of a phenomenon known as loss aversion. ...