Behavioral finance is for individuals, not markets

Warning: this post is idealistic and potentially naive.


I believe, and would like to convince more people, that it’s more profitable to help people make better decisions, than to take advantage of how they mis-make decisions.

Proving what everyone already knew

Despite what some may say, traditional economics doesn’t say everyone is a perfectly rational consumer. It just says that in equilibrium (after learning and costs like information gathering are accounted for), markets are pretty darn efficient and on average, consumers are rational.  

So historically the main challenge to behavioral economics was “are these biases persistent” and “does this matter for markets”? Individuals might be irrational, and for short periods, but are they over time, and in aggregate? Richard Thaler ‘anomalies’ series forced the economic establishment to concede that yes, perhaps there is something significant (at a societal level) about these annoying ‘behavioral economists’.

The turnaround is impressive. Today if you ask a finance person why a persistent premia like value or momentum exists, the answer will generally either be ‘market structure’ or ‘behavioral’. Structural, like the fact that bonds don’t trade through transparent centralized clearing exchanges produces some odd pricing disparities. Behavioral, like stocks with easy to pronounce tickers trade at a premium. Behavioral explanations have become core to explaining why active management is worth paying for.

This may sound odd coming from a proponent of behavioral economics, but … I’m short ‘market irrationality’. My life’s work, at some level, is making the behavioral arbitrage opportunities go away. Not by taking advantage of them, but by preventing them. And I believe that’s more long-term profitable. And I think that helping people, rather than taking advantage of them, is way more interesting.

Here’s why.

Why I’m short market-irrationality

Arbitrage opportunities are ephemeral or risky, not risk-free

I believe just enough in traditional market efficiency to believe that “in the long run” the effect of finding and publishing such anomalies is to render them obsolete. I genuinely believe that the market abhors riskless arbitrage. And there is research that supports that market anomalies are temporary. Risky profit-making activities persist, of course. But as people realize there is risk-free money to be made, those opportunities disappear. Almost every day there I hear of some very smart person trying to make the market just a little a little bit more efficient, but in some way that’s hardly risk-free.

Irrationality doesn’t imply arbitrage-ability

To paraphrase John Maynard Keynes “The market can stay irrational longer than required for you to make a living off it’s irrationality.” In order for a market irrationality to be profitable to exploit, you generally need to be able to crystalize a gain in a sufficiently short period of time to make a living, or retain investor confidence that you’re right.

If an ‘irrational’ factor is caused by a persistent mispricing, be wary. Any trade that assume the market will be more rational in the future (rational = agree with your view) is unlikely to work. For example, if ZQX trades at a discount to a ‘fair value’ you’ve calculated because it has an awkward ticker, that will also be true in the future. 

Irrationalities balance

Markets are made up of many different actors, some of them not even human. But even amongst the human ones, there is a diversity of biases at any given time.  Two people may validly view the same stock as being a loss or gain depending on when they bought. As a result, their biases about that stock may be completely different.

There are fewer ‘irrational’ actors in the markets.

Most trades today are made by computers. I’m not sure how we expect behavioral biases to persist in a world where most trades are placed by index funds (or any other systematic, algorithm based strategy), high-frequency traders, and active managers who all know about the same persistent premia. With fewer individual investors trying to beat the market, there are fewer suckers at the table, reducing the returns to trying to arbitrage them.

Low societal benefit

Finally, even a tremendously successful behavioral market arbitrage will be underwhelming to society. It will make a very concentrated few slightly wealthier, and existing capital pricing will be a little bit more ‘efficient’. But most of us will hardly notice or benefit. While I wish these behavioral arbitrageurs good luck, I do feel a twinge of disappointment. There is so much more value these smart people could be doing that isn’t zero sum.

Helpful behavioral improvements are a sustainable business

The “capacity” of a trade

When active managers think about a strategy, they often talk about it’s ‘capacity’. Capacity is a measure of how much capital you can put into a trade before you start undoing your own profits, as you move markets. Your strategy may have very limited capacity if the market is shallow or there are few people to take advantage of. Needless to say, there are very few profitable trades with huge capacity.

An indeed, there is fairly limited capacity for arbitraging specifically the behavioral mistakes on stock markets. It’s not risk free, and you may have to wait a while to profit from it. Again, paraphrasing Keynes “A good trade can can stay unprofitable longer than you can defer the bills.”

Conversely, there is huge ‘capacity’ for helping people improve their investment decisions. By working alongside customers to improve the growth of their wealth, you genuinely create more wealth in the world (rather than redistribute existing wealth). And it will tend to be more equitably distributed, as opposed to narrowly distributed in the ‘winners’.

A smartphone, not a cellular network

Behavioral experts usually face one constraint: they recommend small or incremental changes to existing systems that have huge effects… but the infrastructure of those systems must already be in place and running. Smartphones are a great example: without existing cellular data networks, they’d be useless. But given a network, they change our lives and society, and make the cellular network much more valuable. 

Historically, financial markets were one arena where you can apply behavioral insights ‘at scale’ by ‘fixing’ the market outcome through arbitrage. But we now have another option. Behavioral architects can apply their insights at scale via technology. What does this look like?

Save More Tomorrow increased savings rates or ordinary individuals dramatically, and QDIA requirements generally puts them into sensible, diversified, risk managed funds (even if some are far too expensive for what they do).

Direct-to-consumer saving apps like Digit, Even, Qapital are making saving effortless. I tried out Digit and was blown away how much it saved without me noticing. Be careful about running up commensurate credit card bills though!

Helping people make better decisions or is not zero sum. When you arbitrage an irrational consumer, you’re making yourself better off at their expense. When you help them make better decisions, you’re both making them, you, and the market/society at large better off.

There are a few easy to spot areas of opportunity:

  • Health care
    • Helping consumers pick the right health care plan for them.
    • Helping them pick what treatment plan is best
  • Taxes
    • Helping customers pay the right amount of taxes, or helping the working poor get the EITC tax credits they deserve.
    • Helping self-employed individuals not under-fund end of year taxes.
  • Education
    • Helping prospective students decide if they should go to college
    • What major should they pick
    • How much should they take out in loans


Working alongside the customer

The vast majority of high-confidence, real-world research we have on applied behavioral finance is generally done via systems or technology. We have studies based on masses of individual investors and traders. Studies on how we frame information in 401(k) plans influencing the decisions of thousands of employees at a time.

The feedback loop is less immediate and less personal. It’s less certain to make you rich in terms of money. But your dividends will be paid in solid evidence that you’re improving decisions, little by little, for many people. You’ll see them start to save more, be healthier, have more stability, be able to plan further ahead, have more fulfilling lives. It will come in a snowball of quick ‘thank you’ notes, pride discussing what you do when people ask, and invitations to talk with strangers. And if you’re good at it, you’ll probably do well in money terms too.

So if you’re considering applying behavioral insights, as Dick Thaler pleads, ‘nudge for good’.


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