What Is a Behaviorist?
A behaviorist is an adherent of the theories of behavioral economics and finance, which hold that investors and other market participants neither behave in a rational manner nor in their own best interests. Investing decisions, like all human activity, are subject to a complicated mix of emotion, environment, and bias. The failure to follow pure reason leads to market inefficiencies and profit opportunities for informed investors. Behavioral economics stands in opposition to the traditional rational choice model and the efficient markets hypothesis, both of which assume perfectly rational investor behavior based on available information.
- Behaviorists favor the theories of behavior economics and behavior finance, which highlight economic behaviors that appear to violate traditional rational choice theory.
- Behaviorists believe that emotional, psychological, and environmental influences are as strong as or stronger than purely rational consideration of costs and benefits in economic decision making.
- Behaviorists point to a wide range of cognitive biases that have been described by researchers to explain various market imperfections and deviations from the predictions of economic models based on rational choice theory.
The behaviorist theory of investing incorporates elements of psychology to explain market imperfections that the efficient market hypothesis (EMH) fails to address. The behaviorist sees inefficiencies, such as spikes in volatility, erratic price movements, and superstar traders who consistently beat the market, as evidence that the EMH's presumption of perfectly rational markets does not explain real-world investor behavior.
Behaviorism begins with the notion that investors are humans and are therefore neither perfect nor identical. We are each unique in our cognitive abilities and backgrounds. Behavioral inconsistencies from one individual to the next can be partially explained by the physiology of the human brain. Research has shown that the brain is made up of sections with distinct and often competing priorities. Any human decision-making process, such as the selection of an optimal investment, involves a resolution of these competing priorities. Toward this end, the brain engages in psychological tics that behaviorists have identified as biases.
Critics of behavioral economics and behavioral finance point out that, for the most part, rational choice theory and the models derived from it, such as the laws of supply and demand and the vast majority of economic models, do indeed do a pretty good job of explaining and predicting observed behavior of investors and other participants in the economy. Most economic behavior does appear to be rational. Others argue that the cognitive biases that behaviorists highlight to explain allegedly irrational behavioral, while they may narrowly violate the assumptions of rational choice theory, are actually rational in some broader sense. For example, irrational overconfidence may lead some individuals to make irrational economic decisions for themselves, but from an evolutionary perspective the presence of some irrationally overconfident individuals might confer some real advantage to the overall population in organizing behavior, perhaps by serving as entrepreneurs or other leaders.
Biases as the Foundation of Behaviorism
Biases are often cited by behaviorists to explain recurring errors in human judgment. Common imperfections in our decision-making process include:
- Hindsight bias, the belief that past events were predictable and this should inform future decision-making.
- Gambler's fallacy, which refers to the probability that the result of a coin flip is somehow contingent on previous flips. In fact, each coin flip is a distinct and unrelated event with a 50% probability of heads or tails.
- Confirmation bias, or the tendency to believe that future or present results support one's existing theory or explanation.
- Overconfidence, the universal belief that we are smarter than we really are.
This is a small sampling of a long list of behavioral biases that can help explain inefficiencies in our markets. In response to these imperfections, the behaviorist portfolio theory recommends layers of investments tailored to distinct and well-defined objectives as opposed to the EMH approach, which endorses passively managed index funds.