Behavioral finance has cataloged an array of self-inflicted errors that can work against investors’ best interests — most often, these errors stem from functional but imperfect mental shortcuts that the brain applies in order to avoid serious cognitive effort. Successful investors understand that the market conventions arising from these kinds of shortcuts can be deeply flawed, and they recognize the importance of examining prevailing assumptions in greater detail. One such example is Martin S. Fridson, CFA: at the 69th CFA Institute Annual Conference in Montreal, he asserted that the majority of market participants are regularly projecting the high-yield default rate incorrectly.

“Most projected default rates in the marketplace, and you can read about this in the press, are based on a calculation method that takes the spread over Treasuries and subtracts a fixed illiquidity premium,” Fridson said. “This is wrong for a number of reasons.” Read More