A couple of weeks ago on the heels of a CFA Society of St. Louis Luncheon with BlackRock's Benjamin Kelly, I wrote about cutting out a layer of behavioral bias with the use of index funds (or index-based ETFs). Today, we'll begin to look at some of these biases by introducing the concept of Loss Aversion.

Consider two sets of choices:

CHOICE 1

You can pick between:

A: A 100% chance of receiving $15,000 -or-

B: A 20% chance of receiving nothing and an 80% chance of receiving $20,000

Go ahead and make your choice and write it down.

CHOICE 2

You can pick between:

A: A 100% chance of losing $15,000 -or-

B: A 20% chance of losing nothing and an 80% chance of losing $20,000

Write that choice down.

MODERN PORTFOLIO THEORY vs BEHAVIORAL FINANCE

Modern portfolio theory, the underpinning of finance for years, assumes that people are risk averse, that is, given the same expected return, people will choose the less risky option. In fact, what behavioral finance has discovered is that many people are loss averse. What's the difference? Let's look at the two choices above:

In CHOICE 1, the expected return of option B is 0.80 * $20,000, or $16,000 - more than option A. If you're extremely risk averse, you may pick the 'sure thing' of option A. If you are risk neutral, you'll pick option B due to its higher expected payout.

A funny thing happens when you look at CHOICE 2 though. Here we are talking about losing money, not gaining. If you look at it closely, it's the same problem in reverse. Here though, many of the most risk averse individuals will not take a sure loss even though picking option B is both riskier and has a worse expected income. Investors get anchored to their current level of wealth and as a result, losses hurt much worse than the satisfaction you get from a similar upside gain.

How does this manifest itself in investing? If you (or your portfolio manager) pick individual stocks, you are more likely to sell winners to 'lock in gains' and hold losers too long in hopes they will 'bounce back'. Capital-weighted index funds (like S&P 500) avoid this because as the stock price grows, so does the stock's weight in the index.

In the next few weeks we'll look at some other biases, such as overconfidence.

We all have flaws in our thinking that get in the way of making the best decisions. Even professionals.

It was my pleasure to hear Dr. Benjamin Kelly speak at today's CFA Society of St. Louis luncheon on the topic of Behavioral Finance in Investment Decision Making. Kelly, an investment strategist with BlackRock, is a charming fellow (despite being a Blackburn Rovers fan) with a knack for explaining Behavioral Finance.

The field has been around for a few decades - its earliest practitioners receiving the Nobel Prize in 2002. I'll dive a little deeper into some of the more relevant aspects in subsequent posts, but the gist is this: people are wired such that they do not always make the best decisions, especially when it comes to money.

The surprising part of today's talk (and others like it to CFA societies across the globe) is that it was being given to money professionals with the message that essentially says: you too.

This means that not only do investors have to overcome these detrimental biases, the next layer managing their money - the stock pickers, the active mutual fund managers - have to as well. And this is even before you factor in behavior caused by misaligned goals (poorly performing funds taking on huge risks to 'catch-up' by year-end, churning by brokers, etc.).

The easiest thing to do then to avoid multiplying the cognitive biases involved is to remove the opportunities for them to occur. Index funds instead of active management removes the opportunity for bias (and is a heck of a lot cheaper). Target asset allocation with rules for rebalancing avoids flawed subjectivity by swapping in objective boundaries. And avoidance of overconfidence leading to undue concentration of 'bets' on the market (or, God forbid, single stocks) can be had through diversification.

These are all 'unforced errors' that can be avoided once we are aware of them. The market will beat you enough days, don't beat yourself.