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Essay: Practical application of Behavioural Finance in Asset Management

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  • Practical application of Behavioural Finance in Asset Management
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My research interest centres on the practical application of Behavioural Finance in Asset Management. Behavioural finance is a relatively new but fast–growing field of finance following the pioneering work of Amos Tversky and Daniel Kahneman; Richard Thaler; Robert Shiller and others researchers (Sewell, 2010). The motivation to study this subject stems from my observation that, while a lot of work has been done in identifying various behavioral influences that affect the investment behavior of people, not much has been done to apply this knowledge in different areas of finance, including asset management.

Most of the early research work on the stock market strongly supported the Efficient Market Hypothesis (EMH), an idea whose development is usually attributed to Eugene Fama in the 1960s. EMH assumes rational expectation of investors, and that financial markets are informationally efficient. Conventional financial theory has been largely based on this believe and has assumes that the world and its participants are, for the most part, rational \”wealth maximizers\” and that people behaved logically and rationally. This led to the development of finance models built on the fundamental assumption that economic agents are efficient and unbiased processors of relevant information and that their decisions are consistent with utility maximization. According to Barberis and Thaler (2003), the advantage of this framework is that it is elegant and simple.

However, from the early 1980, researchers started to notice occurrences in financial markets that seemed to question the validity of the EMH. Barberis and Thaler (2003) posited that with time, it became obvious that the conventional framework could not adequately explain several observations in financial markets, including behaviour of the stock market in aggregate, the cross-section of average returns, and individual trading behaviour.

In their quest to understand some of the anomalies, several researchers, including psychologists, Drs. Daniel Kahneman and Amos Tversky, and economist, Richard Thaler carried out ground-breaking research studies that have helped us to better understand the impact of psychology and neuroscience on investment behavior. This led to the discovery that, in many instances, emotion and psychology influence our decisions, causing us to behave in unpredictable or irrational ways. This movement led to the development of behavioural finance, which explores cognitive biases and other psychological and social factors that affect how people make economic decisions. Although a relatively new field, behavioural finance now has a considerable body of literature to draw knowledge from.

Evidence of cognitive biases in finance has typically come from cognitive psychology literature and has then been applied in a financial context. Some of the biases that have been identified in the literature include the following as summarised by Alistair and Brookes (2008):

• Overconfidence and over optimism—investors overestimate their ability and the accuracy of the information they have.
• Representativeness—investors assess situations based on superficial characteristics rather than underlying probabilities.
• Conservatism—forecasters cling to prior beliefs in the face of new information.
• Availability bias—investors overstate the probabilities of recently observed or experienced events because the memory is fresh.
• Frame dependence and anchoring—the form of presentation of information can affect the decision made.
• Mental accounting—individuals allocate wealth to separate mental compartments and ignore fungibility and correlation effects.
• Regret aversion—individuals make decisions in a way that allows them to avoid feeling emotional pain in the event of an adverse outcome.’’

Apart from the behavioral biases identified above, another important work that has deepened our understanding of behavioral finance was by Kahneman and Tversky (1979), who developed the prospect theory; a behavioral model which illustrate how people decide between alternative choices based on risk and uncertainty. Their result shows that people are risk-averse, and therefore are more willing to take risks, in order to avoid losses.

It has therefore been established that investors make decisions largely based on emotion, not logic. The impact of this is that people are prone to making suboptimal investment decisions, as psychological mechanism could result in investment mistakes (Schulmerich, 2011). These factors affect not only individual investors, but also professional investors and advisers (Byrne & Utkus, 2013).

According to Byrne & Utkus (2013), although the biases are incurable, their impact can be mitigated using several techniques including feedback, audit trails for decisions, checklists, and ‘devil’s advocates’. This has the potential of improving the quality of decisions taken by guiding the investors to adopt a more rational approach, thereby enhancing the chances of success. Pompian (2006), towing a similar line, also believes that an understanding of how investor psychology impacts investment outcomes will generate insights that benefit the advisory relationship in several ways, including understanding client’s financial goals, delivering what the client expects and ensuring mutual benefits. Olsen & Riere (2010), conclude that advisers who incorporate knowledge of behavioral finance into their investment management practice will likely improve the outcomes for their clients.

There is therefore a movement towards incorporating more behavioural sciences into finance. Thaler (2010), predicts that in the not too distant future, the concept of behavioral finance will be part of mainstream finance, and economist would build behavior into their models in line with observed realities. The challenge however remains in how incorporate into everyday practice what we have learnt about how people make decisions.

Some researchers have made attempts to develop models for incorporating behavioral finance into asset management. Shefrin and Statman (2000) published an article on behavioral portfolio theory where they argue that behavioral portfolios could be constructed as layered pyramids in which each layer is tailored to meeting a particular objective. For example, using their model, an investor may construct a base layer of low-risk assets, intended as “protection from poverty”, whereas a higher layer of risky assets represents “hopes for riches.” In this framework, behavioral investors do not consider the covariance’s between the layers in the way that modern portfolio theory would normally recommend.

This study is significant in that it will enrich existing literature on the application of behavioural finance in wealth management. The outcome of the study should serve as a guide to the investment managers and investment management firms who are interested in improving their relationship with their clients as they support them in building and managing wealth. Further, in view of its integrative nature, the study will further extend the frontiers of knowledge in the broad areas of finance and investment management.


The investment management industry has played crucial roles in wealth creation and management over the years, providing investors with the benefits of expertise of professional money managers. According to PwC (2014), global investable assets for the asset management industry will increase to more than $100 trillion by 2020, with a compound annual growth rate of nearly 6%. This necessitates that the asset management firms must both ‘create positive social impact and deliver the clear message that they are a force for good, to investors and policymakers’.

It is therefore important that asset managers understand the needs and constraints of investors in totality, to create a positive impression. Incorporating behavioural finance into asset management is an important aspect of achieving this. To this end the study wishes to provide an answer to the question, ‘how can we incorporate the knowledge of behavioural finance to asset management?’

To answer the research question the study intends to achieve the following aims:
i. To determine whether asset managers understand the behavioural biases and heuristics that influence investors buying decision in the capital market.
ii. To determine whether asset managers currently take cognisance of behavioural biases and heuristic in offering financial advisory services to their clients.
iii. To develop a robust framework by which asset managers can incorporate investors behavioural biases into the process of giving financial advice to their clients


The research will adopt a phenomenological philosophical paradigm. This approach considers a wider range of research variables and characteristics than is embraced by positivist research. It involves qualitative analysis, and encourages the researcher to consider a range of issues and to obtain the views of a number of important people. Phenomenology seeks a deeper and richer understanding of why events occur, accepting that researchers can benefit from dealing with subjective experience rather than remain restricted to objective, measurable variables. Since the focus of behavioral finance is human behavior, the research will include a significant qualitative/subjective element and extensive use will be made of qualitative data and assessments in order to set the main study results in context.

Within this broad paradigm, the survey methodology will be adopted using a combination of structured interview and questionnaires as the primary sources of research data. Structured, face-to face interviews will be arranged with investment managers in selected investment management firms to obtain their opinion on the practical application of behavioural finance in asset management. Responses will be fed into a database and basic statistical tools and techniques will be used to analyze the response data.


The time-table below gives a broad outline of the activities that will be involved in the research and the projected timescale for completing them. Apparently, this is indicative, and will be fine-tuned in the course of the program as required, under the guidance of the project supervision.

Activity Months
Initialization 2–3
Background reading 4–7
Formulation of the research proposal 8–12
Submission of the research proposal 12
Literature review 12–18
Submission of the literature review 18
Development of the research methodology 18–20
Survey/ cross-sectional study 20–25
Writing up 26–30
Final submission & viva voce 31–36


The research will be conducted to the overall interest of the University of Exeter, any collaborating companies and individuals, the research community and the researcher.

The University’s Research Ethics Policy clearly states the university’s determination to promote the highest standards of scientific, scholarly and professional integrity and to give due consideration to the ethical, social and environmental issues arising from its activities. This will be strictly adhered to, along with other relevant guidance, in the professional interests and standards of the University. With respect to collaborating organizations, any information provided will be related with due consideration and any agreements on security will be honored. Also, information volunteered by individual employees will be handled with due care and responsibility. Individual’s preferences to be anonymous and/or to maintain the confidentiality of their response will be respected. Further, the research will be conducted with the highest level of intellectual honesty and integrity. Data and research findings will not be fabricated or falsified. Finally, any assistance or additional resources obtained to conduct the research will be duly declared.


The research will be conducted in such a way that the risk to the health and safety of all persons involved will be minimized. Health and safety issues may arises in research work where the researcher needs to have direct contact with research participants, usually outside of university premises, in private settings or environments unfamiliar to the researcher in the process of data collection, interviewing, surveys and observational studies. Necessary precautions will be applied to ensure that possible risks are mitigated.


Alistair B. & Brooks M (2008) Behavioral Finance: Theories and
Evidence. CFA Research Foundation. Retrieved from

Barberis, N., and R. Thaler (2003). A Survey of Behavioural Finance. In Handbook of the Economics of Finance. Edited by G. Constantinides, M. Harris, and R. Stulz. Amsterdam, Holland: Elsevier/North-Holland.)

Byrne A. & Utkus S. (2013) Behavioral finance: Understanding how the mind can help or hinder investment success. Retrieved from

Hammond R.C. (2015). Behavioral finance: Its history and its future. Selected Honors Theses. Paper 30. Retrieved from

Olsen B. & Riepe M.W. (2010).Using Behavioral Finance to Improve the Adviser–Client Relationship. CFA Research Foundation Publications December 2010 | Vol. 2010 | No. 2 | 30 pages. Source: CFA Institute Bryan Olson, CFA | Mark W. Riepe, CFA. Retrieved from

Pompian M. (2006). Behavioral Finance and Wealth Management: How to Build Optimal Portfolios that Account for Investors Biases. Published by John Wiley & Sons Inc., Hoboken, New Jersey. Retrieved from

PwC (2014). Asset Management 2020. A Brave New World.

Richard H. Thaler (2010). The End of Behavioral Finance. CFA Research Foundation Publications December 2010 | Vol. 2010 | No. 2 | 11 pages. Source: CFA Institute
Richard H. Thaler. Retrieved from

Shefrin H. & Statman M. (2000). Behavioral Portfolio Theory. The Journal of Financial and Quantitative Analysis Vol. 35, No. 2 (Jun., 2000), pp. 127-151

Schulmerich M. (2011) Behavioral Finance in Asset Management: A Primer. Retrieved from Originally published in \”Behavioural Finance in Asset Management: A Primer\”, by Marcus Schulmerich, CFA, FRM, (Investment Quarterly, Q3, 2011).

Tversky A. & Kahneman D.(1979). Prospect Theory: An Analysis of Decision under Risk. Retrieved from First published as: Prospect Theory: An Analysis of Decision under Risk Author(s): Daniel Kahneman and Amos Tversky Source: Econometrica, Vol. 47, No. 2 (Mar., 1979), pp. 263-291 Published by: The Econometric Society Stable URL: Accessed: 10/06/2009 07:36)

University of Exeter Research Ethics Framework

Sewell, M (2010). Behavioral Finance. Retrieved from

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