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"When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there's chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And ever it will be so." – Howard Marks, Oaktree Capital Management
The Emotional Ambivalence of Theory and Application
Howard Marks is a successful investor, a thoughtful writer and an inspiration to the investment team at Oxford. In my experience, the sentiments he expresses in the quote above are dead-on as a generalized description of investor behavior. And yet, they seem at odds with the tenets of traditional finance theory and, I dare say, the way most investors would characterize their own decisions and actions.
As an investment professional, I have long been interested in the development of various theories of finance as ways of explaining the behavior of investors and capital markets. My interest in these theories (which I describe in detail below) is far from academic, as an understanding of them is necessary for any professional in our industry. Indeed, for anyone hoping to succeed with a complex investment program.
All too often these theories are viewed as competing with each other, as if one is correct and another is false. The financial media even likes to hype the conflict to a personal level, pitting various theorists against each other in a type of Nobel Prize winning cage-match. "Bill Sharpe and Eugene Fama vs. Amos Tversky and Robert Shiller." Who wouldn't pay money to see that?!
Far from being mutually exclusive, however, an open mind and professional observation suggests these theories work side-by-side and, together, provide a robust description of the way investors and markets actually operate. The following provides thumbnail sketches of the major theories of finance and commentary on their application from the perspective of an industry practitioner.
This theory assumes that markets are generally efficient, that investors are rational and well informed processors of information, operating in what they believe to be their own self-interest. The concepts of "risk" and "uncertainty" are boiled down to statistical functions of volatility and co-variance. Perceived inefficiencies in market pricing are the result of the "limits to arbitrage," and markets naturally tend toward a state of equilibrium. Decisions by individual investors (rational or not) are never large enough to have an impact on the market as a whole. A steady progression of research led to the development of Modern Portfolio Theory, the Capital Asset Pricing Model, the Arbitrage Pricing Theory and the Efficient Market Hypothesis.
Taken as a body of work, Traditional Finance is an elegant theoretical construct and a tremendously valuable contribution to the understanding of the way markets work. And yet, it falls well short of explaining individual investor behavior. In fact, the roots of behavior and preference (biological, psychological, moral and ethical) – the very elements that make us human – are assumed to be fixed and are intentionally left out of the model. Even at the aggregate level, Traditional Finance has no explanation for market anomalies like "momentum," much less asset price bubbles (e.g., the Dot-com mania) or sharp breaks in the normal functioning of markets (e.g., events surrounding the sub-prime mortgage crisis).
This theory focuses more on decision making by investors. It assumes that investors are subject to heuristics (mental shortcuts), cognitive biases and “bounded rationality” – defined by incomplete information, uncertainty regarding the future, cognitive limitations and the finite time available in which to make decisions.
Several implications of Behavioral Finance are at odds with Traditional Finance, including:
By explaining how decisions by individuals are scaled up to affect markets as a whole, this model provides deep insight into the formation of market anomalies and price bubbles like the Tulip Bulb and Dot-com manias. While much of the original research on Behavioral Finance was conducted by psychologists and decision theorists, the model itself does not truly speak to whether heuristics, biases and cognitive limitations are rooted in psychology or neurology.
This question has given rise to an offshoot of research into Neuro Finance, using brain scanning technology such as functional MRI and PET scans. Recent research suggests the decision making process is greatly affected by the underlying neurological structure of the brain. As an extreme example, subjects known to have lesions on certain parts of the brain respond to concepts of "risk" and “uncertainty” differently than subjects without those lesions and, as a group, score consistently higher on certain controlled experimental “games.” The implication is that our decision making processes are effectively "hard-wired." Some of the neurological structures affecting decision making processes can change over time, based on experience and feedback – a type of physical training or learning. But the processes themselves, to some extent at least, are a function of structure.
This theory goes yet a step further. Feelings?! Really... must we talk about this? Indeed, a psychoanalytic contribution to finance theory greatly augments the understanding of decision making processes put forth using traditional and behavioral finance models.
To quote Richard Taffler, "Investment market outcomes are inherently unpredictable and such uncertainty leads to emotional responses of both neurological and psychological nature.1 Emotional finance directly explores how unconscious processes help drive investor and market behavior."
Investment decisions create emotional ambivalence, the unconscious conflict between the pleasure principle (e.g., excitement) and the reality principle (e.g., anxiety). In managing ambivalence, people operate in either an integrated state of mind (accepting both the good and the bad) or a divided state of mind (avoiding emotional pain).
In a divided state, investors often employ certain avoidance strategies to block out unpleasant thoughts from conscious awareness, leaving only the pleasant ones. These strategies include:
Moreover, Emotional Finance views markets as being subject to the same sense of ambivalence, taking on a dynamic yet unconscious “emotional” life of their own. Mainstream financial literature is replete with examples of support for this view, including concepts like:
In investment decision making, there is constant tension between judgments grounded in reality (an integrated state) and those grounded in unconscious phantasy (a divided state). This tension can lead to sub-optimal outcomes from decisions based on such familiar notions as: "this time it's different;" "that could never happen again;" "this situation cannot go on forever;" or "that strategy isn't working so we have to do something different." Perhaps most egregious are long-term decisions based on short-term factors – firing investment managers at the bottom of their cycles, or changing asset allocation in an emotionally-driven attempt to become more defensive after the market has already sold off. Unfortunately, we see this all the time.
As an analyst, it is clear to me that elements of ALL of these theories of finance affect investment decisions and capital markets. Every day. Despite the ongoing debate in the financial literature, it isn't a question of either-or, or even which combination of A-B-C-or-D. Rather it is all of the above. Anyone who questions this has only to spend time watching how decisions are actually made by high-performing investment teams, institutional investment committees or well-informed individuals. As an advisor, an understanding of these issues is critical in effectively managing investment portfolios, client relationships and even a business operating in such a dynamic industry.
Being aware of these dynamics, I try to operate with an integrated state of mind, acknowledging both the "good" and the "bad". Yet merely being aware of the interplay between various theories of finance is not enough. To maximize the chances of achieving your investment goals you must have a well-defined investment philosophy, a well-articulated statement of investment policy and a disciplined process that neutralizes – to the extent possible – the influence of myopia driven by emotional conflict, behavioral biases or blind adherence to the principles of Traditional Finance.
In the following articles this month, two of my colleagues further explore these issues with a focus on practical applications to portfolio management. In Cognitive Dissonance: 5-Irons and Chasing Performance, Jared Nishida examines one of the time tested pitfalls facing investors – evaluating future success based on past performance. There is quicksand in the hazard. In Patience is a Virtue, Cam Johnson explores the opportunities presented by Time Horizon Arbitrage as long-term investors capitalize on short-term fluctuation in market prices. As you read both of these articles, I encourage you once again to keep in mind the quote from Howard Marks above.
1Emotional Finance: Theory and Application, by Richard Taffler, Warwick Business School, University of Warwick, version: 14 October 2014
The above commentary represent the opinions of the authors as of 5.31.16 and are subject to change at any time due to market or economic conditions or other factors.