Risk Parity Resources: Nofsinger (2011)

"The Psychology of Investing"

Clear, succinct and authoritative summary of relevant research on behavioral finance and how the principles can be seen among real-world investors. Chapter Seven, about mental accounting and portfolio construction, is a goldmine of insights for RP investors.

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By now, it seems like every investor and their mother has read Morgan Housel’s book, the Psychology of Money. It’s a great book, and actually will be one of the first I recommend to people if they show any interest in investing. The rules, the technical aspects, and the nuts-and-bolts skills of investing all can be learned pretty easily, but the mindset…that is the true key.

But rather than be the 1,674,538th investing blogger to write a review of it (you may like this review by Larry Swedroe, or this one by The Swedish Investor), I wanted to stretch a bit beyond that into the field of behavioral finance. Simply put, “behavioral finance is the study of the effects of psychology on investors and financial markets. It focuses on explaining why investors often appear to lack self-control, act against their own best interest, and make decisions based on personal biases instead of facts.” This book by John Nofsinger, Professor of Business at the University of Alaska-Anchorage, seems to be the main textbook in the field. It is now in its seventh edition, though I will be reviewing the fourth, from 2011.

I know the word “textbook” produces a negative reaction among some readers, but really, it shouldn’t. The Psychology of Investing is crystal clear and efficient, with thorough explanations and references to relevant academic literature, all in a tidy 121 pages. It’s not a light and breezy anecdotal read like Housel’s, but I appreciated its clarity. Each chapter is to the point and leaves you feeling knowledgeable and curious for more.

As for the content, Nofsinger breaks the subject into eleven short chapters:

The intro chapter: what behavioral finance is and why it matters
Overconfidence, including the illusion of control
Pride and Regret, including the disposition effect
Risk Perception, including the House-Money effect and the Snakebite Effect (also known as risk aversion)
Decision Frames, or Framing Bias
Mental Accounting, including Sunk-Cost Fallacy/Effect
Forming Portfolios, connection with Modern Portfolio Theory, mental accounting, perceptions on risk and naive diversification.
Representativeness and Familiarity, including extrapolation bias and local bias (home country bias).
Social Interaction, with notes on neighbor imitation and herding.
Emotion and Investment Decisions, how mood impacts decisions.
Self-Control and Decision Making: a concluding chapter that looks at how lessons of behavioral finance can be understood and applied to become a better investor.

Of these, chapter 7 is the star of the book, and I have it in my notes to do a whole blog post about it. Basically, Nofsinger describes why our default towards mental accounting makes it so hard to follow Modern Portfolio Theory’s observations about optimal portfolios. Investors, Nofsinger writes, tend to view the asset classes in a portfolio one by one and have difficulty thinking about the portfolio as a coherent whole.

We might think that our “bucket” of risky assets should have all equities, and that our “bucket” of safe assets should be all bonds. We then tend to pursue what we see as the best assets within those buckets, unaware of the connection between the buckets. “Viewing each investment as a separate mental account,” Nofsinger writes, “causes investors to misperceive risk” (p. 68). To give an example, investors sometimes choose corporate bonds as their main ingredient in the bonds “account” due to their higher expected return over Treasuries. The problem is, corporates are more correlated with equity risk, and are less likely to provide the smoothing effect that inspired investment in bonds in the first place.

The analogy Nofsinger uses is that investors are like diners at a buffet, adding this tasty treat and then that one, and then that one over there, in the same way my 6-year-old daughter once tackled the dessert bar at a nice restaurant. She ended up with this monstrosity of a bowl with ice cream, pudding, gummi bears and the like, ate three bites, and then fixed her gaze on my simple slice of Sacher Torte. Like an investor, she learned that the well-assembled recipe beats a collection of individually appealing ingredients.

In all, this is a great book for those interested in behavioral finance, and though I wouldn’t necessarily read it instead of Housel’s book, it does make for a wonderful complement to it. It has more thorough explanations of the behavioral traits themselves, with more explicit connection between the academic research and investor behavior. Another great feature of this book is that each chapter finishes with endnotes that contain all the papers Nofsinger relies on. Combined, these create a handy reading list for further investigations. All in all, this is highly recommended.

Other Resources Related to this Paper:

You can find a full list of Nofisnger’s articles and books on his faculty profile from the University of Alaska-Anchorage:

Faculty/Staff Profile | UAA College of Business and Public Policy