Behavioral finance is a great field, no doubt, and deserved its 2002 Nobel prize. The difficulty for practitioners is to turn its irrefutable findings into actionable recommendations. In this post we highlight a few of the challenges.
When the topic is first introduced to decision makers, the action item usually suggested is to identify and neutralize one’s own biases, thus enabling purely rational decision making. Unfortunately for us, sometimes in finance our “collected experience” or intuition or whatever-you-call-it is all we have to go on – there are too many poker games continually occurring, and a paucity of available information for all players. The strategy depends on the outcome of games, and the opponents’ anticipated responses depend on some very subjective assumptions by the analyst.
A further complication arises from the messiness of real-world decisions: focusing solely on one’s own cognitive biases may sidestep related, often intertwined, but distinct issues that may interfere with optimal decision making. The individual firm and its managers presumably respect different utility functions, and these should be aligned (the Fisher separation theory notwithstanding). Agency issues may further interfere with manager decision making, but they are an inherent facet of our condition.
Turning Theory Into Action
Let’s take as an example the question of optimal investment strategy for a firm. An overly cautious manager might make the mistake of underinvestment: hoarding cash in anticipation of extreme business downturns, imagined and improbable. Though prospect theory (including the study of cognitive biases) can be used to explain the manager’s behavior in the abstract, it is quite a leap from generalized population behaviors to firm specifics. Remember our perspective requires advising a single firm about optimal investment. Perhaps a cognitive bias has led, say, Microsoft to underinvest, and a different cognitive bias has led Larry Ellison or Richard Branson to overinvest. How do I, as adviser, determine whether my current client is in one camp or the other (or both)?
Separately, but perhaps equally as important (if not interesting as well): how do investor biases interplay with managers’? Assume for the moment our sole goal is to maximize share price, where part of the animal spirits that influence market price are due to investors’ biases. Do we think the investor biases are synergistic with or competing with managers’ biases? For example: if at a given point in time the managers are being overly cautious with investment, might this be the same time when investors are irrationally rewarding fortress balance sheets?
Once one dips a toe into the pool of behavioral finance, it may lead to a longer-than-expected swim.