How Advisors Can Apply Behavioral Finance

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Indeed, we have to distance ourselves from the presumption that financial markets always work well and that price changes always reflect genuine information…The challenge for economists is to make this reality a better part of their models.

Robert Shiller, “From Efficient Markets Theory to Behavioral Finance”

Professor Shiller wrote those words in 2003. Ten years later he received the 2013 Nobel Prize in Economics for his pioneering behavioral finance research, sharing the prize with Lars Peter Hansen and Eugene Fama. Naming Fama as co-recipient created a Machiavellian buzz in anticipation of the award ceremony, as Shiller had described Fama’s efficient market hypothesis (EMH) as “the most remarkable error in the history of economic thought.”

Who says the Nobel committee didn’t have a twisted sense of humor?

The shift to behavioral finance received a further boost in 2017 when the Nobel Prize in Economics was awarded to Richard Thaler of the University of Chicago, also home to Fama. Throughout his career, Thaler focused on the cognitive errors made by individuals and how government and business policy can be revised in order to “nudge” people to make better decisions. Thaler and Fama are good friends and regularly play golf together. Most likely the EMH joins religion and politics as taboo topics while enjoying a friendly round!

Today, behavioral finance appears everywhere in the financial services industry. Advisors are warming to the notion that behavioral coaching is important for the successful execution of a client’s financial plan. Many are concluding such coaching should represent a significant portion of time spent with clients.

The 15 years since Shiller’s statement above has seen an avalanche of new academically verified pricing anomalies, further challenging the notion “that price changes always reflect genuine information.” This has gotten to the point that we have to wonder if collective cognitive errors are the primary drivers of investment returns, displacing new information as the most important driver.