Investors are rational beings who behave in a manner as to maximize their utility.
Investors have access to information and take into account all relevant information before making a decision
It is not difficult to see why portfolio theory goes for a toss once in a while, these harmless and logical assumptions about people and their behavior do not hold up.
Keen observers of behavior will notice that
- Investors and people in general are rationalizing beings, they aren’t rational beings
- Investors aren’t clear about what kind of information is relevant, leave alone getting access to it. Most investors cannot discern the signal from the noise
- Most people are innumerate when it comes to decision making, their utility functions are poorly constructed
Which is why most investment outcomes are sub optimal. Even when investors work with qualified financial advisers, the agency problem exists due to poorly aligned incentive structures; leading to poor outcomes yet again.
Behavioral sciences do not start with assumptions about how the world is. They start with how the world is and then attempt to make sense of why things are the way there are. A model should explain actual behavior, there is limited practical appeal to a model that uses assumptions to force fit the real world to an academic construct. Inferring people’s needs and their true motivations through their behavior can get us much further in the real world than can lofty ideals and morals. Wonder why sharply lower stock prices send investors running for the exit door when they might be better off buying? The answer is found in understanding human nature and collective behavior, not in estimating what the economy is going to do over the next twelve months.
Behavioral finance is an offshoot of the broader discipline of behavioral sciences. If you find behavioral finance interesting, you will find the broader subject equally interesting.
Wonder why relationship counselling does not work as expected? Our instincts are evolved enough to see through the charade that these counsellors peddle. Meaningful relationships can only be built based on genuine interest, not on a framework of negotiation. You cannot increase the interest level of your spouse by doing the dishes or by doing more chores around the house. You cannot logically convince someone into being interested in you.
Too many people get into relationships because they want to get the monkey off their back (peer pressure, running out of time and options) and not because they genuinely want to. No relationship counsellor can fix such fundamental problems.
“Faisla hamesha chunav se hona chahiye, dabav se nahin”
Wonder why body language is so important? Our evolutionary instincts know very well that our true nature manifests itself through our posture, body language & more importantly our actions. If there is no congruence across these, we intuitively deduce that someone is not genuine. And we would be right most of the time. There is a reason why genuineness and authenticity are given so much importance, they are rare. In my opinion it is one of the reasons the 2016 US Presidential Elections did not go as projected. You can tell authenticity when you see it, even if you do not like the person.
Observe how attraction works. If I were to ask you to list out your criteria for what makes someone physically attractive, you would have a tough time describing it in precise terms. But you can tell an attractive person from an average person in no time when you see it. Your instincts make that decision well before the logical mind can say “Now let me see what do we have here”
Problems occur when we end up using instinct when we should be using reason and the other way around. Behavioral sciences also give you some pointers on when to rely on instincts (system 1) and when to rely on deliberate thought (system 2).
Intuition is misunderstood for the most part, when Roger Federer intuitively knows the best shot to hit from a defensive position well behind the baseline, it is coming from a place of pattern recognition that is built over a decade of being in similar situations. When good stock pickers find a story interesting within the first 30 minutes of starting to read up on the business, they are tapping into a decade of having done the hard work and looking for good patterns. This is different from the system 1 instinctive reaction that uses shortcuts to come up with preferences that may not be suited for the situation at hand.
Being aware of how system 1 functions and the reasons for the same can help us avoid some pitfalls in investing, relationships and life in general.
Know thyself – Ancient Greek wisdom