How Practical Is Behavioural Finance?

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Behavioural Finance

How Practical Is Behavioural Finance?

In my recent editorials, I discussed the market efficiency (or lack of it). I discussed the various hypotheses that academics teach their students.  The Global Financial Crisis created doubts in what the theories and hypotheses claimed for decades. We now enter an era of doubt on what makes the market move up or down in a rational (or irrational) way.

We can ask ourselves if there is anything that can help investors beat the market. If we can determine what rational shortcomings of some traders and investors may lead to, and act in the opposite direction, could we make more money ahead of those who follow the herd mentality?

Behavioural finance ought to provide plenty of profitable opportunities for wise investors. In practice, however, few if any value investors are deploying behavioural principles to sort out which cheap stocks actually offer returns that can be taken to the bank. The impact of behavioural finance research still remains greater in academia than in practical money management.

While it points to numerous rational shortcomings, the field offers little in the way of solutions that make money from market manias. Robert Shiller, author of “Irrational Exuberance” (2000), showed that in the late 1990s, the market was in the thick of a bubble, but he could not say when it would pop.

Similarly, today’s behaviourists can’t tell us when the market has hit bottom. They can however, describe what it might look like.

The behaviourists have yet to come up with a coherent model that actually predicts the future rather than merely explains, with the benefit of hindsight, what the market did in the past. The big lesson is that theory doesn’t tell people how to beat the market. Instead, it tells us that psychology causes market prices and fundamental values to diverge for a long time.

Behavioural finance offers no investment miracles, but perhaps it can help investors train themselves how to be watchful of their behaviour and, in turn, avoid mistakes that will decrease their personal wealth.  (source: Investopedia)