Behavioral Finance

The term Behavioral Finance was coined by Daniel Kahneman who was awarded the Nobel Prize in Economics in 2002 for having: "integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty".

Behavioral Finance helps understand why under-performers inefficient behavior may lead equity markets to show pockets of anomaly. This, in turn, represents a boon to the rational active investor seeking to outperform its peers.


EQUITY GPS expert-system aims at identifying objectively when and to which extent structural underperformers drive stock prices to anomalous levels that create buy or sell opportunities. 

  • Valuation: Benjamin Graham seminal intuitions that value investing delivers performance over the medium term, while obviously correct, did not go as far as to explain why that is the case. To him, “Mr Market” sometimes offers fantastic buy or sell opportunies to rational investors. Behavioral Finance identified 50 years later why and how gregarious instincts litterally force underperforming market participants into behaving like "Mr Market".
  • Outlook Dynamics: academic and empirical research suggest that outlook dynamics is important in assessing the future performance potential of a stock, and many “momentum” investors do use this pattern in managing their portfolio. This actually works because many inefficient market participants tend to be subject to selective hearing and selective memory. So they will not change their minds quickly enough about a specific situation even if new information would reckon that. This is further accentuated when decision making involves a group of persons : even rational people working together can take irrational decision-making paths, and delay proper action. Their lagged buying and selling activity provide much seeked-alpha to more agile players who have realized sooner that something was happening and acted ahead of the less efficient crowd.
  • Familiarity bias causes structural underperformance by limiting one’s universe of choice, thus reducing the probability, the number, as well as the attractiveness of potentially interesting findings. Behavioral Finance has shown that investors tend to shy away from situations they feel uncomfortable with, and over-represent in a portfolio stocks which they can relate with (country, sector, or just "having met with the firm" ...) . Although explicit specialisation on a narrow universe of stocks can provide an edge in terms of know-how, the involuntary restriction on the “usual suspects” in terms of stock selection is a cause for structural underperformance especially, after adjusting for risk. 
  • Regret aversion is another root cause for structural underperformance. It describes the aversion, for instance, to sell a “loser” in a portfolio, for all kinds of bad pretexts. As Behavioral Finance suggested, this aversion comes from the fact negating oneself provokes a very uneasy feeling if not controlled. Portfolio management is not a science. The most successful investors do accept with no hurt feelings that they are necessarily often wrong, while the structural underperformers tend to succumb to regret aversion. A sports comparison comes to mind: the very top professional tennis players, hugely successful in their careers in systematically outperforming their peers, have won a considerable 85% of all their matches since they turned pro. To achieve this kind of dominance, they "only" have won 53% of all points involved in any given match, and they have been "wrong" or "were beaten" ... 47% of the cases.
Last update : 08/05/2019