Behavioral Sciences, as applied to humans, focus on the systematic analysis of the psychology of judgement and decision-making. Behavioral Economics, as applied to “the economic man” or ‘Econs’ examine how investors may diverge from being consistently rational and self-interestedagents, in an attempt to derive the greatest value possible from the least amount of money.
The 2002 and 2017 Nobel Memorial Prize in Economic Sciences were awarded to Professor Daniel Kahneman (Princeton University) and Professor Richard Thaler (University of Chicago), respectively. Both recipients earned the prize for their seminal work on Behavioral Economics and the far-reaching implications that their discoveries had in traditional’ economics, which assume that the average Econ consistently acts with rationality and self-interest.
Why has a relatively ‘new’ subfield of Economics which openly defies fundamental assumptions and beliefs,about ‘mainline’ economic theory, gained so much recognition?
Without addressing the scientific base of Behavioral Economics in this brief article, we just note that the field considers how Econs allow their behavioral biases to affect their investment decision making.
Investors not only often appear to not be rational, but they are predictably irrational!
We have all experienced, mostly without realizing it, hence the term ‘bias’, the so-called ‘Confirmatory Bias’, the process of looking for the evidence that agrees with our existing perceptions. Not only we often fail to look for the alternative views, but we are ‘coded’ in a way that we would rather prefer to distort new evidence to suit our preferences. We are influenced by our own preferences. Another behavioral bias that the Econ consistently faces is ‘Loss Aversion’: Investors tend to dislike losses much more than they appreciate gains.
For a moment, turn-off your sophisticated fundamental and technical analysis tools and think: What is the biggest source of risk in my portfolio?
Behavioral Economics provides a worrying answer: Yourself!
Investors cannot always encapsulate the latest scientific advances into their investment management practices. What they can do, however, is to use a sophisticated risk management system for establishing a process that will govern the way they make decisions, thus protecting them from their own biases. We cannot predict the size and timing of the next market downturn or the next crisis, only attempt to mitigate the main risks via educated and open-minded considerations.
Investors should embrace a systematic investment approach which will allow them to protect their portfolios from downside risks whilst partly participating in the market upside.
KlarityRisk is an award-winning software provider, specializing in Market Risk Analytics and Compliance Reporting solutions and services for the buy-side sector, as an SS&C Advent Partner. Their Advent-focused solutions are integrated with Advent Geneva, APX and AXYS. Guest author, Makis Ioannou, is the CEO of KlarityRisk; the views and opinions expressed in this blog post are those of the author and do not necessarily reflect those of SS&C Advent.
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