Rational Economic Man versus Behaviorally Biased Man

• Stemming from neoclassical economics, Homo economicus is a simple model of human economic
behavior, which assumes that principles of perfect self-interest, perfect rationality, and perfect
information govern economic decisions by individuals.
• Homo economicus is a tenet that economists uphold with varying degrees of stringency. Some
have adopted it in a semistrong form; this version does not see rational economic behavior as
perfectly predominant but still assumes an abnormally high occurrence of rational economic
traits. Other economists support a weak form of Homo economicus, in which the corresponding
traits exist but are not strong. All of these versions share the core assumption that humans are
“rational maximizers” who are purely self-interested and make perfectly rational economic
decisions.
• Economists like to use the concept of rational economic man for two primary reasons:
(1) Homo economicus makes economic analysis relatively simple.
(2) Homo economicus allows economists to quantify their findings, making their work more
elegant and easier to digest. If humans are perfectly rational, possessing perfect information and
perfect selfinterest, then perhaps their behavior can be quantified.
• Most criticisms of Homo economicus proceed by challenging the bases for these three underlying
assumptions—perfect rationality, perfect self-interest, and perfect information.
1. Perfect Rationality. When humans are rational, they have the ability to reason and to make
beneficial judgments. However, rationality is not the sole driver of human behavior. In fact,
it may not even be the primary driver, as many psychologists believe that the human
intellect is actually subservient to human emotion. They contend, therefore, that human
behavior is less the product of logic than of subjective impulses, such as fear, love, hate,
pleasure, and pain. Humans use their intellect only to achieve or to avoid these emotional
outcomes.
2. Perfect Self-Interest. Many studies have shown that people are not perfectly self-interested.
If they were, philanthropy would not exist. Religions prizing selflessness, sacrifice, and
kindness to strangers would also be unlikely to prevail as they have over centuries. Perfect
self-interest would preclude people from performing such unselfish deeds as volunteering,
helping the needy, or serving in the military. It would also rule out self-destructive behavior,
such as suicide, alcoholism, and substance abuse.
3. Perfect Information. Some people may possess perfect or near-perfect information on
certain subjects; a doctor or a dentist, one would hope, is impeccably versed in his or her
field. It is impossible, however, for every person to enjoy perfect knowledge of every
subject. In the world of investing, there is nearly an infinite amount to know and learn; and
even the most successful investors don’t master all disciplines. Many economic decisions
are made in the absence of perfect information.

THE ROLE OF BEHAVIORAL FINANCE WITH PRIVATE CLIENTS

Private clients can greatly benefit from the application of behavioral finance to their unique situations.
Because behavioral finance is a relatively new concept in application to individual investors, investment
advisors may feel reluctant to accept its validity. Moreover, advisors may not feel comfortable asking their
clients psychological or behavioral questions to ascertain biases, especially at the beginning of the
advisory relationship.

HOW PRACTICAL APPLICATION OF BEHAVIORAL FINANCE CAN CREATE A

SUCCESSFUL ADVISORY RELATIONSHIP
Wealth management practitioners have different ways of measuring the success of an advisory
relationship. Few could argue that every successful relationship shares some fundamental
characteristics:
■ The advisor understands the client’s financial goals.
■ The advisor maintains a systematic (consistent) approach to advising the client.
■ The advisor delivers what the client expects.
■ The relationship benefits both client and advisor.

So, how can behavioral finance help?

Formulating Financial Goals

Experienced financial advisors know that defining financial goals is critical to creating an investment
program appropriate for the client. To best define financial goals, it is helpful to understand the
psychology and the emotions underlying the decisions behind creating the goals.

Maintaining a Consistent Approach

Most successful advisors exercise a consistent approach to delivering wealth management services.
Incorporating the benefits of behavioral finance can become part of that discipline and would not
mandate largescale changes in the advisor’s methods. Behavioral finance can also add more
professionalism and structure to the relationship because advisors can use it in the process for getting
to know the client, which precedes the delivery of any actual investment advice. This step will be
appreciated by clients, and it will make the relationship more successful.

Delivering What the Client Expects

Perhaps there is no other aspect of the advisory relationship that could benefit more from behavioral
finance. Addressing client expectations is essential to a successful relationship; in many unfortunate
instances, the advisor doesn’t deliver the client’s expectations because the advisor doesn’t understand
the needs of the client. Behavioral finance provides a context in which the advisor can take a step back
and attempt to really understand the motivations of the client. Having gotten to the root of the client’s
expectations, the advisor is then more equipped to help realize them.

Ensuring Mutual Benefits

There is no question that measures taken that result in happier, more satisfied clients will also improve
the advisor’s practice and work life. Incorporating insights from behavioral finance into the advisory
relationship will enhance that relationship, and it will lead to more fruitful results.
It is well known by those in the individual investor advisory business that investment results are not the
primary reason that a client seeks a new advisor. The number-one reason that practitioners lose clients
is that clients do not feel as though their advisors understand, or attempt to understand, the clients’
financial objectives—resulting in poor relationships.

The primary benefit that behavioral finance offers is the ability to develop a strong bond between client
and advisor. By getting inside the head of the client and developing a comprehensive grasp of his or her
motives and fears, the advisor can help the client to better understand why a portfolio is designed the
way it is and why it is the “right” portfolio for him or her—regardless of what happens from day to day
in the markets.

Two Intellectual Disciplines Emerging that Contributed to the Genesis of Behavioral Finance:

1. Cognitive Psychology - Many scholars of contemporary behavioral finance feel that the field’s
most direct roots are in cognitive psychology. Cognitive psychology is the scientific study of cognition, or
the mental processes that are believed to drive human behavior. Research in cognitive psychology
investigates a variety of topics, including memory, attention, perception, knowledge representation,
reasoning, creativity, and problem solving. Cognitive psychology is a relatively recent development in
the history of psychological research, emerging only in the late 1950s and early 1960s. The term
“cognitive psychology” was coined by Ulrich Neisser in1967, when he published a book with that title.
The cognitive approach was actually brought to prominence, however, by Donald Broadbent, who
published Perception and Communication in 1958. Broadbent promulgated the information-processing
archetype of cognition that, to this day, serves as the dominant cognitive psychological model.
Broadbent’s approach treats mental processes like software running on a computer (the brain).
Cognitive psychology commonly describes human thought in terms of input, representation,
computation or processing, and output.

Decision Making under Uncertainty

Each day, people have little difficulty making hundreds of decisions. This is because the best course of
action is often obvious and because many decisions do not determine outcomes significant enough to
merit a great deal of attention. On occasion, however, many potential decision paths emanate, and the
correct course is unclear. Sometimes, our decisions have significant consequences. These situations
demand substantial time and effort to try to devise a systematic approach to analyzing various courses
of action.
Even in a perfect world, when a decision maker must choose one among a number of possible actions,
the ultimate consequences of each, if not every, available action will depend on uncertainties to be
resolved in the future.

When deciding under uncertainty, there are generally accepted guidelines that a decision maker should
follow:
1. Take an inventory of all viable options available for obtaining information, for experimentation, and
for action.
2. List the events that may occur.
3. Arrange pertinent information and choices/assumptions.
4. Rank the consequences resulting from the various courses of action.
5. Determine the probability of an uncertain event occurring.

Unfortunately, facing uncertainty, most people cannot and do not systematically describe problems,
record all the necessary data, or synthesize information to create rules for making decisions. Instead,
most people venture down somewhat more subjective, less ideal paths of reasoning in an attempt to
determine the course of action consistent with their basic judgments and preferences.

In 1968, in Decision Analysis: Introductory Lectures on Choices under Uncertainty,9 decision theorist
Howard Raiffa introduced to the analysis of decisions three approaches that provide a more accurate
view of a “real” person’s thought process.
(1) Normative analysis is concerned with the rational solution to the problem at hand. It defines
an ideal that actual decisions should strive to approximate.
(2) Descriptive analysis is concerned with the manner in which real people actually make
decisions.
(3) Prescriptive analysis is concerned with practical advice and tools that might help people
achieve results more closely approximating those of normative analysis.

PSYCHOGRAPHIC MODELS USED IN BEHAVIORAL FINANCE

Psychographic models are designed to classify individuals according to certain characteristics,

tendencies, or behaviors. Psychographic classifications are particularly relevant with regard to
individual strategy and risk tolerance. An investor’s background and past experiences can play a
significant role in decisions made during the asset allocation process. If investors fitting specific
psychographic profiles are more likely to exhibit specific investor biases, then practitioners can attempt
to recognize the relevant telltale behavioral tendencies before investment decisions are made.
Hopefully, resulting considerations would yield better investment outcomes.

Barnewall Two-Way Model

One of the oldest and most prevalent psychographic investor models, based on the work of Marilyn
MacGruder Barnewall, was intended to help investment advisors interface with clients. Barnewall
distinguished between two relatively simple investor types: passive investors and active investors.
Barnewall noted:
“Passive investors” are defined as those investors who have become wealthy passively—for
example, by inheritance or by risking the capital of others rather than risking their own capital.
Passive investors have a greater need for security than they have tolerance for risk. Occupational groups
that tend to have passive investors include corporate executives, lawyers with large regional firms,
certified public accountants with large CPA firms medical and dental non-surgeons, individuals with
inherited wealth, small business owners who inherited the business, politicians, bankers, and
journalists. The smaller the economic resources an investor has, the more likely the person is to be a
passive investor. The lack of resources gives individuals a higher security need and a lower tolerance for
risk. Thus, a large percentage of the middle and lower socioeconomic classes are passive investors as
well.
“Active investors” are defined as those individuals who have earned their own wealth in their
lifetimes. They have been actively involved in the wealth creation, and they have risked their own capital
in achieving their wealth objectives. Active investors have a higher tolerance for risk than they have
need for security. Related to their high risk tolerance is the fact that active investors prefer to maintain
control of their own investments. If they become involved in an aggressive investment of which they are
not in control, their risk tolerance drops quickly. Their tolerance for risk is high because they believe in
themselves. They get very involved in their own investments to the point that they gather tremendous
amounts of information about the investments and tend to drive their investment managers crazy. By
their involvement and control, they feel that they reduce risk to an acceptable level.
Barnewall’s work suggests that a simple, noninvasive overview of an investor’s personal history
and career record could signal potential pitfalls to guard against in establishing an advisory relationship.
Her analysis also indicates that a quick, biographic glance at a client could provide an important context
for portfolio design.

Bailard, Biehl, and Kaiser Five-Way Model

The Bailard, Biehl, and Kaiser (BB&K) model features some principles of the Barnewall model; but by
classifying investor personalities along two axes—level of confidence and method of action—it
introduces an additional dimension of analysis. Thomas Bailard, David Biehl, and Ronald Kaiser
provided a graphic representation of their model and explain:
The first aspect of personality deals with how confidently the investor
approaches life, regardless of whether it is his approach to
his career, his health, his money. These are important emotional
choices, and they are dictated by how confident the investor is
about some things or how much he tends to worry about them.
The second element deals with whether the investor is methodical,
careful, and analytical in his approach to life or whether he is
emotional, intuitive, and impetuous. These two elements can be
thought of as two “axes” of individual psychology; one axis is
called “confident-anxious” and the other is called the “carefulimpetuous” axis.

BB&K Five Investor Personality Types