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Behavioral finance: Nobel-worthy ideas go mainstream

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Behavioral economics has busted out of the stuffy world of academia and entered the mainstream of best-selling books, podcasts and TED talks. And it offers some powerful insights for investors. Loss aversion and ownership effect, just to name two of its tenets, can have profound impacts on how people view their savings.

What does it mean for wealth management pros? Plenty. It can be used on the investment side to suss out undervalued stocks due to other people's irrational decisions. In fact, we have a Q&A with JPMorgan on this topic that delves into "saliency bias," among other topics.

It also can help advisers dealing with the pitfalls in customers' thinking. To that end, we have articles from Morningstar and the MIT AgeLab on various ways to tackle some of the most common mental flaws at the center of behavioral economics.

Simply educating clients so they recognize the major biases, such as overconfidence, anchoring or herding mentality, can be a way for you to add value. Indeed, advisers can benefit more than most from this research since they can stand at the ready with a helping hand when clients' cognitive biases affect their money decisions.

That said, I worry that behavioral economics, and its flashier cousin behavioral finance, may have gone too mainstream.

To be sure, any new idea that helps people save is a good thing. The idea of setting a default choice to opt-in is especially relevant to increasing retirement savings—not to mention organ donation—and improving people's lives.

But discussing cognitive biases feels like watching CNBC in 1999.That is, a topic previously left to the wonks is now providing fodder for everyday conversation. And it enables anyone to feel like an expert. Yes, there's a behavior bubble.

Perhaps it's not that surprising. Behavioral finance is a relatively new field, as academic disciplines go, so it offers the chance to be in the zeitgeist. Even better, it's largely based on the premise that the experts have been wrong for years.

This is where I begin to sound like an apologist for economics (which, in full disclosure, was my major in college). Behavior is a good tweak (OK, a major tweak) on economics. But it's not a wholesale replacement of what came before, which is the view that some of the major proselytizers seem to be taking, not to mention the newly converted. This desire for a completely new world view could hurt the social science in the long run by ignoring a lot of previous good work in favor of a new concept. Throwing out babies with bath water is never a good idea.

Behavioral finance can be used to suss out undervalued stocks due to other people's irrational decisions, or it can help advisers with client management and dealing with the pitfalls in customers' thinking. But discussing cognitive biases feels like watching CNBC in 1999.That is, a topic previously left to the wonks is now providing fodder for every day conversation.

To be sure, a new concept can be novel one day, and then simple common sense 10 years down the road. So I'm trying not to fall victim to hindsight bias (see how easy it is to think you're an expert). But I wonder why human foibles didn't get so much attention when they were called psychology.

I've often described behavioral economics as a healthy dose of psychology infused into economics. And yes, that infusion was long overdue. But it wasn't new. The first generation of modern economists who laid the groundwork for the dismal science (most importantly Adam Smith) factored human psychology into their thinking.

The idea that people and firms act like robots making purely rational decisions (Homo Economicus) was not part of Smith's classical economics. That idea was added decades later as part of the neo-classical economics school. Granted, it held sway in economic curriculums through much of the 20th century, which, in hindsight, was short-sighted. But the neoclassical school also had some good points. One notable example is the so-called "marginal revolution," which, despite the self-deprecating name, was important. The idea of the margin, first novel and then common sense, helped answer the "water-diamond" paradox that flummoxed Smith his entire life. (Why is something as crucial as water cheap, while diamonds, essentially useless, are so expensive?)

But even that was not a wholesale replacement of what came before. Rather, it was a major new idea that was incorporated into the discipline and advanced the whole field.

Much like what behavioral economics can do if its proponents will let it.

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