Commentary: The Rich Potential of Behavioral Finance

Abstract

uch of themost important research in the economics and investing arenas over the past half-century has been in the realm of behavioral finance. In contrast with classical economics, which posits that people will maximize their financial self-interest at all times, behavioral finance acknowledges that we are all just human at the end of the day. We are motivated by rational thought and advancing our own financial well-being, of course, but we also draw upon our personal experiences and emotions when we’re making financial choices. That helps explain why we buy lottery tickets even when we know the odds of winning are infinitesimal (dreaming feels good) or why we pull money out of the market when stocks are down (losing money feels terrible). To date, much of the analysis and energy around the rational/irrational world of financial decisionmaking has centered around investment choices. How investors’ pain in seeing their account values fall affects their subsequent investment selections. How having toomany choices on the 401(k) menu can breed decision paralysis and inertia. How frothy market environments encourage risk taking. And so on. It’s probably only natural that investment decision making hogs the spotlight when the conversation turns to how people behave with their money. After all, it is not hard to demonstrate that emotion-fueled decisionmaking about investment choices does undermine financial well-being. For example, in its 2022 “Mind the Gap” study (Arnott et al. 2022), Morningstar researchers found that the typical mutual fund investor earned 1.7 percentage points less than funds’ published total returns over the previous decade. That seems like a head-scratcher: How could investors earn so much less than the products they invest in? The difference, it turns out, relates to investors’ timing decisions and, specifically, their ongoing tendency to buy high and sell