Behaviorist

A behaviorist is an adherent of the theory of behavioral economics, which holds that investors 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.

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.

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-percent 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.