Difficult to apply
Behavioural finance achieved real respectability three years ago when Daniel Kahneman won the Nobel Prize for his work in this area.
Kahneman and his colleague Amos Tversky are best known for their work on Prospect Theory. A simple rendering of this theory would be that people have an irrational tendency to be less willing to gamble with profits than with losses.
Tversky and Kahneman's work on judgment suggested that that people have cognitive capacity limitations - they cannot know everything - and so have to simplify some of the complex problems they confront using rules of thumb, over and under reaction to good and bad news, and intuitions that are plain wrong.
This challenges economists’ assumption that people are rational utility maximisers who compute any action's likely effect on their total wealth, and choose accordingly.
It also challenges some the assumptions of the efficient markets theory that people’s irrational actions are random and so likely to cancel each other out. On the contrary, behavioural finance suggests that people make the same mistakes at the same time.
This creates anomalies, and anomalies create opportunities for asset managers. We look at how two asset managers - one in Belgium and one in the UK - apply behavioural finance to their business.
The Belgian asset manager Degroof Institutional Asset Management (DiAM) is the one of the pioneers of behavioural finance in Europe, and Jan Longeval, CIO and chairman of DiAM’s executive committee, one of its most enthusiastic proponents.
Longeval points out that the understanding the theory of behavioural finance is relatively straightforward. Putting the theory into practice is the real task.
“It’s a long leap between behavioural finance and behavioural investing,” he says. “There is no magic formula to beat the market systematically. You can find lots of good ideas on behavioural finance that you can apply to investing but there is no clear-cut strategy that you will find in any paper on behavioural finance. That’s what makes it difficult to apply.”
Longeval uses a cooking analogy to describe the “We say the ingredients are in the cookery book but we are the cook. Everything you need to know is in the theory, but only we know the way we apply it.”
One way in which DiAM puts theory into practice is its search for the drivers of the value premium – the fact that cheap (low price to book) shares outperform expensive ones.
Traditional modern portfolio theory suggests the value premium is simply reward for excess risk. Behavioural finance supporters maintain that here must be other reasons behind it. “One of the reasons behind the value premium is the way people over-react to old information, a phenomenon described by behavioural finance,” says Longeval.
Another reason, slightly outside behavioural finance is the phenomenon of competitive dynamics. Longeval illustrates this with reference to DiAM’s version of the ‘wheel of fortune’, a notional representation of the market’s perception of companies’ fortunes and misfortunes (see chart).
“Back in 1999 Nokia would clearly be in the ‘success’ quadrant of the wheel of fortune, while Ericsson would be in the ‘decline or fall’ quadrants,” explains Longeval.
“This is where the human phenomenon play its role. While the management of Nokia has become slightly complacent, Ericsson’s management has been sharpened by the problems they face. They have a different mindset from a successful company.
“Now, six years down the road, the situation is completely reversed. Nokia is losing market share and Ericsson is climbing back up.”
The position of the two companies on the wheel of fortune in 1999 reflected the fact that investors tend to over-react to old information, says Longeval. “People were over-reacting to Nokia, extrapolating too much of the good news of the past, as they were extrapolating too much of the bad news about Ericsson.”
The market did not realise what was happening and why it was happening, he says. “One can see the mean reverting clearly in terms of earnings per share, but the market still tends to extrapolate too much of the good news of the past and discount too much of the bad news.
“So if you combine the two phenomena, you can see that the value premium is driven by a combination of over-reaction and competitive dynamics, where companies becoming arrogant because of too much success and companies become sharper because they are in trouble.”
The value premium can be found in all sectors and companies, says Longeval: “The value premium is not related to the type of sector because the same phenomenon of over-reaction occurs in all sectors.
“The mistake that traditional value managers are making is that they avoid investing in certain parts of the universe, such as hi-tech, and are therefore missing some of the value premium. By looking for the value premium across the whole universe you are typically much better diversified.”
Behavioural finance holds that people will tend to make the same mistakes at the same time in the same direction. This means that asset managers who want to capture the value premium must do so at an aggregate rather than an individual, company level.
“This is one of the most difficult things about this type of investment to explain to people. You have to explain that you are not buying a company because of some recent news. The phenomenon of over-reaction to old news, and under-reaction to surprises, plays at an aggregate level, and if you are systematic in your approach you will be able to exploit it.”
For example, DiAM systematically sells any company that drops into the third quartile of its ranking. “Some might say how can you sell a company when there’s not fundamental news out there telling you should sell it? But that’s missing the point, because we know that once in our ranking, when a company goes into the third quartile, at the aggregate level the risk just becomes too high, and means reverting will come into play,” says Longeval.
The need for a disciplined, repeatable investment process means that a quant approach to behavioural finance is inevitable, he says “Even the brightest people after being exposed to pressure for a certain period of time will have a tendency to give in to
their emotions So any behavioural approach should have some degree of quants in them.
Yet DiAM retains a human backstop to the computer driven selection process. Portfolio managers have the right to reject any company proposed by the model, although they have to accept the next best one.
“You need to have some human filter to avoid doing stupid things,” says Longeval.
Selecting the humans for this task is important. Longeval takes a holistic view of behavioural finance and rejects the piecemeal application of its tenets.“You can’t be half pregnant,” he says.
This means that he has no place for traditional stock-pickers. “I don’t want traditional stock-pickers because I don’t need what they are doing. I need people with a very strong scientific background, self-assured people who don’t really care about reading or hearing stories about companies. They care about one thing – to be the best in class in terms of performance and ranking.”
On the other hand, he does place DiAM alongside those who believe that behavioural finance does not reject the whole of the efficient markets theory.
“Behavioural finance does not reject the efficient markets theory, but it has made a number of modifications to it. Behavioural finance recognises that the stock market is quite efficient but there are certain phenomena that cannot be called efficient. These phenomena stem from the irrational behaviour of people, acting at the same time, in the same direction.
“This is what we are looking for. To recognise these mistakes and take advantage of them through an appropriate strategy.”
In the past few years, a new area of research, neuroeconomics, has arrived to provide a scientific explanation for much of this irrational behaviour.
Neuroeconomics is the interdisciplinary study of biology, economics, law and cognitive neuroscience to help understand human decision-making. The long-term aim of neuroeconomics is to develop a biological model of decision-making in economic environments.
For Longeval, neuroeconomics has arrived at the right time. “Behavioural finance just describes a certain number of anomalies and phenomena, but it doesn’t explain them. Thanks to neuroeconomics we can better understand why these phenomena are taking place.”
He cites the work on the effects of two neurotransmitters, serotonin and dopamine. Dopamine is the pleasure chemical of the brain, while decreased levels of serotonin is associated with anxiety.
The biochemical impact of serotonin is twice as strong as the impact of dopamine, Longeval points out. “This links with the ‘prospect theory’ of Kahneman and Tversky that people tend to hold on to their losses much too long, to avoid the pain, and will cut their winnings short.
“This is perfectly in line with this serotonin/dopamine phenomenon. Chemically speaking, we humans are calibrated by our brains to be more risk-averse than gain seeking.”
Neuroeconomics also provides a biological explanation for the tendency of people to over-react to old information, he says. “There is an area of the brain, the anterior cingulate, which becomes active the moment there’s a repeat of anything. So from the moment you’re faced with a repeat of anything - say a company announcing twice in a row that it has beaten its quarterly earnings forecast - then this part of the brain becomes active and the neurones start firing. And by doing so it creates the urge to extrapolate the fact that a pattern has been formed.”
Longeval suggest this kind of finding provides comfort to asset managers who have backed behavioural finance in their investment strategy. “Neuroeconomics doesn’t really add much to behavioural finance itself, but what it does is explain why these phenomena are there. It also confirms that that you can count on these phenomena to last until the future and that you are doing the right thing.”
Part of stock picking processes
For some asset managers, behavioural finance provides a useful tool for sharpening their stock picking skills.
Investec Asset Management, a London-based alpha-specialist investment management house, uses behavioural finance to drive its ‘bottom up’ stock picking process.
It uses a process it calls four-factor research to identify stock. James Hand, head of four-factor research at Investec, explains: “We always look for four factors in any stock we buy. These factors are a good strategy, a cheap stock, a company that’s giving positive earnings revisions and a company, which is in a positive share price trend.
“The four factors are split between traditional finance - the valuation and strategy component – and behavioural finance - the earnings revisions and the technical.
“The behavioural factors add discipline to the selection process,” he says, “We take the two behavioural factors and we score them objectively. We can only look at stocks that grade highly on our screen.”
Using the screen in a disciplined, repeatable way eliminates behavioural biases. “That is the crucial step that most people don’t take. Plenty of people build screens but then they use them to find ideas that they quite liked anyway, he says.
“In the same way lots of people understand the theory of behavioural finance and why there are the anomalies, but then fall into exactly the same trap themselves, largely because they don’t have an objective, disciplined way of applying the theory.
“It is one thing to say that you appreciate all the errors that somebody else makes. It is quite another thing to do something explicit that changes your own behaviour to take account of these errors.”
The four-factor screening also works on the sell side. Fund managers are generally better at buying a stock than selling it, says Hand. “This is because there is a tendency for fund managers to fall in love with stock that they hold. They’ve researched it, they know it well, and they’ve probably met the management. This is what behaviourists call ‘the endowment effect’ - liking something just because you own it.”
Applying the four factor screening process removes the endowment effect, says Hand. “Any company that doesn’t have one of these four factors will be a potential sell candidate for us. For example, if a company performs well and gets expensive, or if it starts to get earnings downgrades or its strategic profile changes, that’s when we’ll look to sell the stock.”
Equally fund managers must have an objective reason for not selling. Simply having a warm feeling about a company is not a reason, Hand says. On the contrary, subjective feelings can lead to miswriting.
Markets misprice stock because they under-react to good news, he says. “When you first get a positive profits statement, it takes them a little bit of time for people to react. Most of the evidence suggests it takes about six pieces of news before people finally fully react to what has changed and realise that the company is on a different track to the one it was on before.”
Often there is a bias against good news because fund managers do not want to hear it. “If a company that nobody likes that comes out with a positive statement, the first reaction of sell side and buy side people is to search for something negative because they don’t like the stock, and they’ve got an underweight on it.”
Unusually for bottom up stock-pickers, Investec does not carry out company visits. One of the reasons for this is to protect against what behavioural finance terms ‘saliency’. “Saliency is where you tend to value information that you’ve gathered recently more highly than something that has happened in the past,” says Hand. “So if you’ve just met a company’s management you will give that more weight than what the trading statement said four weeks ago.
This is not to say that company performance is unimportant, he adds. “We care very much about company performance, but we look at it objectively. We care about returns on capital, and not whether the managers made us feel good.”
“One of the interesting things about behavioural finance is that although there are many individual theories there’s no all-encompassing theory. It’s not like the general theory of capital markets where there is an explicit formula that tells you what an equity risk premium is.
“It searches for anomalies, with a large number of those types of theories, comes up with a general idea of behavioural finance. Because of that you do very much have to keep on top of changes that happen over time.
“Behavioural finance theory is still evolving and growing. The market is adapting. What might have worked 10 years ago won’t necessarily work now. So it’s very important that you’re always watching people’s behaviour in the market and you’re always keeping up to date in terms of the theory.”
Investec currently works with Decision Technology at Warwick University, a part-academic, part-commercial research group that studies human decision-making and develops practical applications.
Behavioural finance is unlikely to arbitrage itself away, as more players enter the market, Hand says, because of the diversity of theories “There is nothing that says if you do this according to behavioural finance there will be an arbitrage opportunity. It’s rather that there are 25 ways that people could react. There isn’t something that you can pin your hat on.
“Because behavioural finance is a much more diffuse theory than people give it credit for is why it hasn’t been arbitraged away over time. And many of the people who have swung towards behavioural finance have found themselves facing exactly the same problems that they’re trying to get way from.
“We have seen certain investment managers in the market who have gone with investment finance faced with a little bit of performance pressure and them moved off in the other direction and changed their processes.”
Hand does not take an all-or-nothing holistic view of behavioural finance. He argues that behavioural finance works within the context of traditional asset management and should be seen as an essential part of any stock-picking process.
“It’s very important to see behavioural finance as just a part of investing. You don’t need to over-complicate it. All it is a way of understanding market behaviour. It’s very important to always stay wedded to the fundamental aspects of any fund management house which is buy cheap companies which are able to give you a good return on capital,” he says.
“ What we’re really talking about is first principles. We think there are certain things that drive share prices. We think one of those is cheap company. You start from that base rather than capturing a theory and deciding that is the way to go. In doing that you end up with a process that covers stock picking and the behavioural side, all in one.”