From Aristotle to active investment management
From Aristotle to active investment management
Active investment management is consistent with the tenets of behavioral finance, as well as with sound financial planning that seeks to help investors reach their long-term objectives.
Over 2,500 years ago, in what may have been one of the earliest examples of behavioral finance theory, ancient Greek philosopher Aristotle is reported to have said the following regarding the achievement of success:
To my way of thinking, this captures much of the essence of modern behavioral finance theory: helping investors define clear goals, acquire knowledge (“wisdom”) around the many investing pitfalls that can derail the best investing intentions, and pursue a well-defined process (or “means”) to keep a long-term investment portfolio on track.
Far more recently, well-known figures in the history of the financial markets have provided their own takes on the psychology of markets and their participants.
One of these was Benjamin Graham, author of classics on fundamental and value equity investing, including the renowned book, “The Intelligent Investor” in 1949. He wrote,
And, of course, Warren Buffett has offered many observations on market psychology over his long career. Although he has other far more popular quotes, this one resonates from a behavioral finance perspective:
BehavioralFinance.com provides this brief overview of the current state of behavioral finance theory:
Back in August, we published an article that noted how 2020 has been somewhat like a master class, or real-time laboratory, in illustrating some classic concepts of behavioral finance in a compressed time frame.
Although much has changed since then, the basic premise behind that article holds true, with investors still having to navigate the unprecedented COVID-19 era, market volatility at relatively high sustained levels compared to historical norms, and the upcoming prospects of one of the most contentious election seasons in decades.
A major example of 2020’s volatility has been seen in the performance of the NASDAQ 100 ETF (QQQ). This year, QQQ had a rapid decline of over 30% from February highs into March, a stunning advance of over 80% over the next five months, another loss of almost 15% in September, and then a rebound rally of about 10%. In fact, around the time of the most recent QQQ lows on Sept. 21, Business Insider noted, “Investors are fleeing technology stocks at a pace not seen since the dot-com bubble of 2000. They pulled $3.5 billion out of the popular Invesco QQQ Trust Series 1 ETF. … That marked the biggest daily outflow since October 2000.”
Sources: Market data, macrotrends.net
Against this background, financial advisors are increasingly recognizing the importance of behavioral finance theory in guiding their clients. Many are taking continuing education courses in this discipline or going one step further to earn a specialized certification. We have also seen more coaches for financial advisors making this an important facet of their coaching program, or becoming specialists in the behavioral finance area.
Not surprisingly, a recent readership survey we conducted for Proactive Advisor Magazine showed that advisors are very interested in the topic of “applied behavioral finance.” (You can find numerous articles on the topic by respected academics, financial journalists, and investment managers in Proactive Advisor Magazine.)
Think Advisor reported recently,
To this point about the value of active investment management from a behavioral finance perspective, a study from the nonprofit CFA Institute Research Foundation titled “Behavioral Finance—The Second Generation” notes,
Many active managers with a holistic portfolio management approach consider risk management at the core of their investment philosophy—seeking market opportunity but always keeping a close eye on mitigating risk.
This can result in multiple benefits to investors:
- The confidence that their portfolio is working continuously to smooth out volatility.
- The long-term compounding advantage of helping avoid deep portfolio losses.
- Access to sophisticated risk-management tools in an investment strategy that is customized to their risk tolerance.
While we may all like to be market geniuses or experts on investment theory, that is really not necessary.
What is critical, as Aristotle, Graham, and Buffett suggest, is having a disciplined process—one that helps take emotions out of the equation. This is not only consistent with the tenets of behavioral finance but also with sound financial and investment planning that seeks to help each investor reach his or her long-term objectives.
David Wismer is editor of Proactive Advisor Magazine. Mr. Wismer has deep experience in the communications field and content/editorial development. He has worked across many financial-services categories, including asset management, banking, insurance, financial media, exchange-traded products, and wealth management.
Financial advisors are increasingly recognizing the importance of applied behavioral finance theory in guiding their clients. Active investment management, with a focus on mitigating risk, fits well with the underlying philosophy of this approach.[dropcap...
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