Make Behavioral Finance Useful – Alternative Investment Application is the Next Big Thing

So behavioral finance is hot these days. Authors such as Nouriel Roubini and Malcolm Gladwell have popularized it with the Great Unwashed. And academics are starting to catch on too, so that's progress.

The problem is that for all its intellectual fecundity, behavioral finance suffers from a major problem. That is, that it hasn’t been useful from a practical perspective. Sure pioneers (!?) such as the UK government have set up their infamous Nudge Unit and it’s doing some interesting stuff. But the dirty little secret of behavioral economics and behavioral finance is that they haven’t in general made it into the real world.

Partly that’s because the academics behind these new disciplines are – you guessed it – academics. So their interest isn’t in doing something useful; it’s adding to their publications count – in which they have succeeded admirably – and getting tenure – less so here.

And yet another reason is that economists have been loath to admit that modern microeconomics generally doesn’t work especially at predicting things like company valuation. In any case people still see an economics degree from the Ivy League as being a ticket to respect even it in practice it doesn’t help you much predict what will happen (such as the Fed notably missing all of the last few recessions). So if the new economics isn’t useful, why change from the old economics which doesn’t work but which everyone knows and respects for precisely that fact?

Yet there’s still a big problem. Hedge funds don’t work and investors are leaving them. For most investors an index fund will actually do better than an investment managed by so-called experts. Private equity is often a crap-shoot although it has been doing better recently (mainly because the market has been doing better so the private equity guys have an adoring fan base of investors to sell to). So what’s a girl to do?

Actually behavioral finance provides the answer but the vast majority of financial pooh-bahs still haven’t registered this yet. It’s clear that one of the fundamental problems in modern investing is that it doesn’t take formally into account the financial behaviors of CEOs and management teams.

So while a public company for example might have financial transparency (well, maybe), it totally lacks behavioral transparency. The only thing an investor can look to is the air-brushed resumes of the top officers in a company which have been prepared to make them look like the Apostles by their IR people. So you’re not going to get any joy there.

But using behavioral finance techniques it’s possible to get this information. This means that you can plug it into your financial and risk models so that you can compute the behavioral risk of a company’s management team in terms of profitability and valuation metrics. In fact that’s what my company has been doing for several years. If you want to find out more read my book, The Three Financial Styles of very Successful Leaders for the skinny.

In fact using this model, coupled with our behavioral finance-based psychometric assessments, you can actually predict the income statement that will result from the leadership of a specific management team. We calm this product a Behavioral Proforma™. You can use this for investment purposes of for management due diligence, say for a private equity company.

My prediction is that the behavioral finance route leveraging psychometric assessments that measure financial cognitive biases is going to become a new way to approach alternative investing. It won’t replace traditional fundamental and technical analysis but it will form a new base on which to provide data which is often far more important than market metrics on their own, that base being the behavioral financial cognitive biases of the people who actually make them tick.

It’s clear that we need a revolution in investing so that we can overcome the dead-end that modern investing theory now finds itself in. Watch out for behavioral finance to become the next Big Thing in the investment world.

Is this totally new approach going to revolutionize the world of investing?