This quarter we will examine the field of behavioral finance. Classical economists believed that people, driven by their self-interest, would naturally behave in a rational manner. Observers of human behavior challenged this belief in many areas and especially with respect to personal finance. By combining the study of finance with human psychology, the field of behavioral finance was born. Most notably, behavioral economists believe that our inherent biases as human beings inhibit our success as investors.
Today’s posting will dig into the history books and discuss investments in which the shareowners pool their funds to gain the advantages of scale. Several types qualify under this broad definition including open ended mutual funds, closed end mutual funds, exchange traded funds (ETF), unit investment trusts (UIT), and collective investment trusts (CIT). All share the same characteristic of allowing the shareholders to diversify risk because the pooled sums will permit the purchase of more types of securities than any individual could acquire on their own. The two largest classes are open-ended mutual funds and exchange traded funds so we’ll limit most of the discussion to the history of those two investment vehicles.
Since the times of Adam and Eve, it has been important for mankind to learn from its collective experiences. Observing and adapting to our surroundings is fundamental to both survival as well as improving our circumstances in life. Regular readers of this blog know that a frequent topic (January 29, 2020; Dec. 4, 2019; June 17, 2019 et al) that is discussed is the proliferation of debt in our society. This build-up of borrowed money has taken place at the individual, household, corporate, state, and federal level. The enormous increase in unemployment caused by the coronavirus pandemic has increased the need for borrowing as we all attempt to survive through a period of limited cash inflows. Effective contingency planning will always suggest that consumers maintain a reserve of borrowing capacity so that it is available to them specifically for times such as these. Clearly, those who have prepared are under less financial stress than those who have not.
The world is reeling from the worst economic downturn since the 1930’s due to the Covid-19 pandemic. Unemployment has skyrocketed and governments around the world have seen their tax revenues plummet at the same time that their social safety nets are most stressed. It’s hard to find any positive financial news but the economic decline has resulted in some positive forecasts on the environmental front.
A recent study by Clever Real Estate found that the chances of a home borrower defaulting on a mortgage had declined to 2.3% in 2019. This is in sharp contrast to the percentage likelihood in the Great Recession when it peaked at more than 16% for mortgages originated in 2006. The improved payment results can be attributed to several things including the robust employment circumstances we’ve enjoyed in 2018-19. Likewise, there has been more scrutiny of borrowers as the lending institutions have tightened their requirements on the potential mortgagees. Consequently, fewer home loans are being approved.