Between 1984 and 1995, the average stock mutual fund achieved a 12.3 percent annual return; the average investor in a stock mutual fund earned just 6.3 percent.
According to Michael M. Pompian, the shortfall is largely attributable to investors’ departures from economically rational behavior. He details in Behavioral Finance and Wealth Management: How to Build Optimal Portfolios That Account for Investor Biases a variety of common cognitive errors and biases—all documented by academics in the field of behavioral finance. These systematic mistakes include, among others, overconfidence, excessive emphasis on recent events, and unreasoned preference for the status quo.
The evidence collected by behavioral finance specialists makes entertaining reading. In one experiment, subjects indicate that they would be equally happy to receive either a coffee mug or some candy bars. Later, they are given one item and then offered a chance to swap for the other. Their choice is strongly conditioned by which item they received and, therefore, must face giving up. In a similar vein, real estate agents’ property appraisals are influenced by what they are told the listing price is. Another experiment involves an auction for basketball tickets. Bidders who are allowed to pay by credit card bid twice as much as those who are required to pay immediately in cash, which illustrates the phenomenon known as mental accounting.
Most previous books on behavioral finance have proposed strategies for profiting from securities mispricings that may arise from similar irrationality. Pompian, who is director of Private Wealth Practice at Hammond Associates, focuses instead on counseling bias-prone clients who harm their own financial success. He gives advisers a step-by-step manual for identifying individuals’ misperceptions, steering them toward more rational behavior through education, and if they prove intractable, designing the most optimal portfolios that the clients deem acceptable.
Pompian’s well-structured book makes excellent use of research, not only in behavioral finance but also in the study of personality. His final chapter discusses the emerging field of neuroeconomics, which relates decisions to specific brain functions. This territory is new even for most of Pompian’s fellow CFA charterholders; subtopics range from dopamine and serotonin to the amygdale and prefrontal cortex.
In more conventional areas of financial economics, regrettably, Pompian is occasionally on less solid ground. For instance, evidently unaware of Peter Garber’s (2000) debunking of the story, he cites 17th century Dutch “tulipmania” as a demonstration of investor irrationality. Also, Pompian notes that the tendency of stocks to perform well in January is attributable to year-end tax selling, but he never mentions research that casts doubt on that explanation (Haugen and Lakonishok 1992). Finally, Pompian professes surprise that anyone doubts the relevance of behavioral finance. In fact, active managers have a practical interest in the still unresolved question of whether cognitive biases identified in laboratory settings can actually be exploited to achieve superior risk-adjusted market returns, net of transaction costs.
Editorial lapses in Behavioral Finance and Wealth Management are minor but are likely to cause some confusion. For instance, Pompian cites the economist Adam Smith (1723–1790). A few pages later, heading a chapter with a quotation from “Adam Smith,” he neglects to explain that in this case, it is the pen name of contemporary financial author George Goodman. In case studies near the end of the book, Pompian suddenly urges counselors to use the “Behavioral Asset Allocation Factor” model. This title apparently refers to an algorithm provided earlier in the text but not explicitly labeled the “BAAF” model. At another point, he introduces “Vickrey auction” (a special type of sealed-bid auction) without defining the term.
Only a few errors escaped the copy editors’ notice. One that did is the transformation of Nobel Laureate Daniel Kahneman into “Khaneman”. In addition, the text vacillates between the spellings “extrovert” and “extravert”.
Taken on the whole, Behavioral Finance and Wealth Management valuably connects important analytical discoveries with a burgeoning area of practice much in need of applied research. Along the way, the author offers such fascinating tidbits as the fact that deaths from falling airplane parts are 30 times as frequent as fatal shark attacks. Readers will find Pompian’s treatment of a highly useful topic anything but dull.
—M.S.F.