Sunday, January 8, 2017

Dr. Krause's Review of Michael Lewis' The Undoing Project and Behavioral Finance

Michael Lewis' New Book on Behavioral Finance Attracts Needed Attention to the Topic in the Investments Industry

Marquette's AIM program director, Dr. David Krause, encouraged his students over the winter break to read Michael Lewis' lastest book: The Undoing Project. Here are some of his thoughts following his reading of the book.

The Undoing Project contains the history of the professional relationship between Daniel Kahneman and Amos Tversky - two renowned Israeli academicians. These psychology professors collaborated in the 1980s and 1990s to create the underpinnings of behavioral economics. The Undoing Project goes into depth about their intertwined lives - both on the battlefield and in the halls of Hebrew University. Their important academic research on the human mind and how it behaves paved the way for the emergence of behavioral economics and finance.

Image result for moneyball bookTheir research and the subsequent articles it generated, according to Michael Lewis, changed how we view the world. It has lead to increased confidence in evidence-based medicine and the use of algorithms - especially over human intuition. It challenges our beliefs in the capabilities of our political leaders and it also is finding its way into the investment industry. As Lewis pointed out, more professionals sports teams are becoming more aware of human decision-making shortcomings and are applying more analytical approaches (e.g. Moneyball).

According to traditional finance theory, investors and consumers are, for the most part, rational "wealth maximizers." However, Kahneman and Tversky (and others) have observed many instances where emotions and investor psychology adversely influence decision-making, causing investors to behave in erratic and irrational ways.

Lewis' new book seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why investors make irrational decisions. This is quite a departure from recent Lewis books (Liar's Poker, The Big Short, Flash Boys, and Moneyball).

Image result for behavioral financeWhile I found The Undoing Project to be an interesting read and I compliment Michael Lewis for taking on this challenging subject and making it interesting to the mass audience, I still remain somewhat skeptical that behavioral finance has fully arrived. To be honest, even the work of Kahneman and Tversky seem to me to be more like arm-chair science or story-telling. 

While I concede that individuals and some professionals exhibit decision biases and display irrationality at times when it comes to investing, I do not find the evidence presented by behaviorists to validate that the financial markets are inefficient in the long-term. There are short-term anomalies that cannot be completely explained by modern financial theory; however, behavioral finance hasn't yet evolved into a coherent theory to fully explain these. Many finding by behaviorists appear to contradict each other - and to me it looks like data that is in search of a theory. I don't go as far as some to suggest that behavior finance attracts those who are bad at math, but it clearly isn't as scientific-based as classical economies. 

I do believe that studying behavioral finance is important and it will be incorporated more and more into the AIM curriculum as the discipline further develops; however, I encourage students to act rationally and not abandon traditional, classical  finance and economics theory. In the AIM program we will be adding more behavioral finance especially as it applies to the decision-making of individual investors, analysts and portfolio managers. It is important for the AIM students to learn about the academic research that is evolving and that is beginning to show linkages to neuro-science and the manner in which investors think and feel - and how this can affect the way they behave when making investment decisions.

For students going into the industry as financial advisors, analysts and institutional consultants, the challenge becomes explaining ‘irrational behavior’ in a meaningful way to downstream investors and colleagues.  

Dr. David Krause, AIM director said, "I will continue to encourage my students to read books, like The Undoing Project. Providing our students with fundamental tools and an understanding of behavioral finance can help them overcome the possibility of making poor financial decisions.  For institutional managers and investors, understanding the exposure of their portfolios to the various types of behavioral risk scenarios in today’s environment becomes vital. The CFA Institute is also updating their behavioral finance curriculum, so it makes sense for the AIM program to stay ahead of the curve. I look forward to the debate that we'll likely have this spring about behavioral and modern finance theory."

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