I received my CFA Level 3 curriculum the other day and I have just finished reading my first Study Session entitled, “Behavioral Finance”. Behavioral Finance is Study Session 3 in the Level 3 curriculum. I skipped over Study Sessions 1 & 2 (Ethical and Professional Standards) for two reasons:
- I have already been subjected to heavy doses of Ethics between CFA Levels 1 & 2 and two classes with Creighton University, and I wanted to read something new.
- My Portfolio Management class at Creighton University is starting soon and I wanted to get a jump on the class reading which I anticipate will be voluminous.
Unfortunately for me, reason #2 did not work out so well as the class syllabus, which was just made available, indicates that we will start with Study Session 4. Shucks.
Fortunately for me, reason #1 was all I needed. The material was indeed new and I think I learned more about myself than about the material I need to pass the CFA Level 3 Exam. The main point with behavioral finance is that everyone has biases (cognitive and emotional) to some degree, and accounting for these biases can lead to better outcomes than just selecting the tangency portfolio along the efficient frontier and treating people like robots. Because of these biases people may not behave as rationally as finance theory suggests they should, myself included.
One of the points in the readings talked about how poorly financial analysts are at forecasting earnings. There is a nice graph in the curriculum which shows how analysts’ earnings forecasts trail reported earnings almost perfectly. It turns out that they are much better at telling you what happened instead of what will happen. Financial analysts have biases too (surprise!), and they are reluctant to adapt to changes as quickly as they should. As an aspiring financial analyst, this is troubling.
So what is an aspiring financial analyst to do?
I am hoping a solid understanding of probability and statistics and a liberal application of Bayes’ Theorem will make me a better analyst in the future. One thing that the CFA program has continuously done for me is to instill a desire to become more proficient with quantitative analysis. I enjoy the concrete certainty of mathematics. Additionally, and not any less important, it is critical to know and understand my own emotional and cognitive biases. Awareness that these biases exist and identifying how they effect my analysis can diminish their impact and improve accuracy. All is not lost.
Everyone has flaws, and anyone who thinks otherwise about themselves is likely delusional. How we adapt to or moderate these biases is what separates the wheat from the chaff.