Introduction to Behavioral Finance and Investor Personality

“We have met the enemy, and he is us”

Walt Kelly, Author of Pogo

Two Facts of Life as a Human Being

1. Humans are very emotional. Even the most analytical of us tend to fall back on our emotions for final decisions.   And then we subconsciously select data and use analysis that supports our emotions.   Matters of money and finance tend to hold extra emotional significance for many people, possibly because of the effort and sacrifice experienced to acquire money.  Often the emotional significance is because of the importance of money to our survival, family, goals, dreams, and aspirations.

2. Decision making can be overwhelming. As humans in a modern, capitalist, free-enterprise society, we are faced with an enormous number of decisions.   Some of them are basic enough that they are almost instinctive, but still, they are decisions to be made.   Other decisions have enough of an impact on our lives that we perform considerable analysis of them.  The cumulative and compounding effects of a life with almost continuous decision making can be overwhelming and stressful.  The tendency to put our emotions first combined with the overwhelm of constant decision making makes the human being poorly suited for investment decisions, so we need to develop a better decision making framework and process.

Two Facts of Investing and Business

1. Emotion. The price movements of markets represent the sum-total of all emotionally influenced decisions of all buyers and sellers.   Buyers and sellers are not rational and therefore the markets are often not rational or efficient.  Instead, the markets are a chaotic, complex system.

2. Logic. The world of business management and valuation is one of math, statistics, financial logic, and probability.  Businesses are managed based on logical mathematical measures such as sales revenue, costs, margins, and earnings.   The process of projecting these measures into the future to estimate future values and investment returns requires application of statistics and probabilities.

The Investing Solution

1. Behavioral Finance to understand market psychology and statistical analysis of prices to capitalize on emotionally induced market inefficiencies and extremes (technical analysis).   

2. Computational Finance of company and market data to discover the logical insights hidden below the noise of the emotions (quantitative analysis).

The Financial Media; Adding Fuel to the Emotional Fire

The financial media that we are bombarded with is rife with emotions and heuristics.   Emotions sell advertising, and that is how the media makes money.  Heuristics (rules of thumb and mental shortcuts we make up) make financial reporting easier, more understandable, and therefore more appealing to a broader audience, which leads to more advertising.  

Good examples are:

  • Your equity allocation should be your age subtracted from 100
  • Sell in May and stay away
  • The market is up because oil is up, the market is down because oil is up

Media infused emotions and heuristics often lead to irrational, poor investment decisions because many investors believe that the media and their “experts” know what is right. 

Also, the media tends to get their ideas and information from sources with biases and conflicts of interest; the big financial firms that make substantial profits by getting people to invest with certain beliefs and behaviors.  And most experts have their own motive for media participation, free advertising for their investment product or service.

People have a tremendous appetite for stories to explain what is often not really explainable or doesn’t need explaining.   This is called the narrative fallacy.   People flock to media stories that are emotionally charged and often exaggerated in order to maximize the audience.   Maximizing readership and viewership is essential to achieving their main objective; to maximize profits from advertising revenue.

The over-emotionalized narrative fallacies only add to the irrational inefficiencies of the markets.  In fact, we believe that the main creator of and contributor to market irrationality and chaos is the media.

The Mirador Process

Investment Approach

Mirador is completely independent.  We only work for our clients.  Based on the above explanation of the investment industry’s challenges based on behavioral finance research, at Mirador, we avoid the financial media and most external, third-party research. Instead, we rely on data modeling and analysis.

1. Behavioral Finance to understand market psychology and statistical analysis of prices to capitalize on emotionally induced market inefficiencies and extremes (technical analysis).   

Client Approach

Mirador’s clientele come from a wide variety of backgrounds, and they represent diverse personalities and investment needs.  We strive to avoid profiling and stereotyping people.   Instead, we provide a highly personalized and sophisticated service.  Our clients do not hire us to follow the media or apply rules of thumb and rhymes to their portfolio management.  Our service goal for clients is to:

  • Develop effective portfolio solutions using behavioral finance concepts.
  • Manage the portfolios with expertise in behavioral and computational finance.
  • Educate people about the importance of behavioral finance and the computational finance solutions so they see through the emotional market chaos.
  • Facilitate people throughout their investment lifecycle by monitoring the changes in their investment personality, financial needs, and market psychology.

Knowing our clients well is the most crucial aspect to accomplishing the above.  We strive to understand our clients from the industry standard Know Your client parameters such as age, occupation, income, and net worth, but we also try to know them from more of a behavioral finance perspective.

The Mirador IPPRD

For investors interested in taking this to the next level, we have developed what we call the Investor Personality and Portfolio Requirements Discovery (“IPPRD”) document.  This has been designed over several years as a way to achieve excellence in knowing our clients and providing more personalized service.   The IPPRD has four sections:

Section one is for thinking or meditating about the meaning and purpose of wealth, money, and portfolio management.   Although this is not quantifiable, we are very interested in what you write. 

Section two is to discover your investor personality and is based on:

  • The Nobel Prize winning work of Kahneman and Tversky on prospect theory.
  • The application of their work by Pompian in his book “Behavioral Finance and Wealth Management”
  • Many financial planning surveys I have collected over the years.

The questions are designed to uncover the three elements of your investment personality:

  1. Risk Willingness versus Ability
  2. Heuristic and Bias levels
  3. Reasonable Return Expectations

When possible, we extend our study to non-clients and use the combined results to further our research in behavioral and computational finance.   This will provide valuable input for the future of Mirador and your portfolio management.

Our comparison of spousal results might help us to identify differences that might need to be addressed (carefully) and this may be very helpful for you, your portfolio management and maybe your relationship!

Section Three is for Portfolio Requirements.  These questions are more common, and they help uncover specific financial needs and wants and volatility tolerance.   This section should also be completed independently, although there are some questions with answers that should be the same for each partner.

The fourth section is a form taken from our financial projection software.  This form provides us with the details of your current financial positions and some other information we need to do a good job for you.

Conclusion

This is a complex subject with three main categories of heuristics covering 20 biases plus other risk and return topics and know-your client financial details.  So yes, this is a lengthy process and I know it’s not for everyone.  The survey approach of the one section is essential to maintain the unbiased quantitative approach and obtain the complete information we need.

With the IPPRD, you might be entertained, amused, your curiosity aroused, and you should learn something new – perhaps about yourself!  But most importantly, this work might be important to guide us with the future management of your portfolio and our investment service offering.  There might be future projects to update and monitor changes in psychology that will have direct input to our portfolio management process.  All information is kept strictly confidential, as is always the case at Mirador.

This survey completes the circle that links behavioral finance with the computational portfolio management we have implemented for so long. It is most sensible for Mirador to have consistency between our client advisory approach and our computational finance approach.

This study provides that consistency. This study improves our portfolio management, strengthens client relationships, and positions us at the highest level of integrity for depth of research and implementation in the fields of applied behavioral and computational finance.