How Advisors Can Apply Behavioral Finance
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Indeed, we have to distance ourselves from the presumption that financial markets always work well and that price changes always reflect genuine information…The challenge for economists is to make this reality a better part of their models.
Robert Shiller, “From Efficient Markets Theory to Behavioral Finance”
Professor Shiller wrote those words in 2003. Ten years later he received the 2013 Nobel Prize in Economics for his pioneering behavioral finance research, sharing the prize with Lars Peter Hansen and Eugene Fama. Naming Fama as co-recipient created a Machiavellian buzz in anticipation of the award ceremony, as Shiller had described Fama’s efficient market hypothesis (EMH) as “the most remarkable error in the history of economic thought.”
Who says the Nobel committee didn’t have a twisted sense of humor?
The shift to behavioral finance received a further boost in 2017 when the Nobel Prize in Economics was awarded to Richard Thaler of the University of Chicago, also home to Fama. Throughout his career, Thaler focused on the cognitive errors made by individuals and how government and business policy can be revised in order to “nudge” people to make better decisions. Thaler and Fama are good friends and regularly play golf together. Most likely the EMH joins religion and politics as taboo topics while enjoying a friendly round!
Today, behavioral finance appears everywhere in the financial services industry. Advisors are warming to the notion that behavioral coaching is important for the successful execution of a client’s financial plan. Many are concluding such coaching should represent a significant portion of time spent with clients.
The 15 years since Shiller’s statement above has seen an avalanche of new academically verified pricing anomalies, further challenging the notion “that price changes always reflect genuine information.” This has gotten to the point that we have to wonder if collective cognitive errors are the primary drivers of investment returns, displacing new information as the most important driver.
A behavioral framework
Viewing investors and markets as emotional decision makers rather than as rational computational entities forces us to reconsider every aspect of how we operate in financial markets. The behavioral financial markets (BFM) concepts I discuss below provide a framework for rethinking client financial planning, asset allocation, investment manager selection and the creation and execution of investment strategies.
Shifting to a behavioral perspective is the first step in becoming a behavioral financial professional. It might seem like a radical step, but really it is just the formal recognition of the obvious. Wisdom is seeing the world for what it is, not what we would prefer it to be. After recognition comes a formal transition to improved analytic tools, some of which I will discuss.
As Shiller suggests, it is time to move away from the EMH, one of the pillars of modern portfolio theory (MPT), to a more promising alternative, behavioral finance. Behavioral finance’s more realistic representation of financial markets and human behavior will eventually replace MPT as the paradigm of choice
Five foundational concepts
I introduce five concepts underpinning the notion of BFM.
BFM concept 1: Market prices are mainly driven by emotional crowds not fundamentals.
We have difficulty understanding why markets and their underlying securities move the way they do over shorter time periods. This is disconcerting as we are investment professionals and our clients expect us to understand and explain what at times are unsettling, if not downright terrifying, market movements. But the truth is that the vast majority of individual security and market movements are unexplainable because they are driven by emotional crowds for no identifiable rhyme or reason.
An entire media and professional ecosystem has grown up to the fill this information void. Market events are continuously ascribed to one new piece of information or event. People understand the world by means of stories. The more detailed the story, the more believable it becomes in the eyes of the public. Interestingly enough, more detailed stories are much more likely to be wrong, highlighting one of the many cognitive errors so frequently observed.
So, if we’re asked by clients why the market, a stock, or other security moved the way it did on a particular day, the correct answer is almost always, “I have no idea.” Unsettling as this may be, it is the consequence of the first BFM concept: emotions – not fundamentals – are the main movers of financial markets.
When asked such a question, I respond as follows: “I have no idea why the market went down today. Some days it goes up and some days it goes down and I don’t know why. But I do know 55/65/75: the stock market produces a positive return in 55% of days, 65% of months, and 75% of years. I like those odds and so I keep playing this game over and over!”
Needless to say, rarely does the press ask my opinion regarding daily market movements.
Some may feel that admitting that much of what happens in markets cannot be explained means that as an investment professionals we have little to offer. But quite the contrary, this admission is the first step towards providing greater client value. Financial markets cannot be easily explained or neatly packaged into a set of mathematical equations. Markets are noisy and largely unpredictable, and the only way to operate successfully is to avoid being fooled by the messiness.
BFM concept 2: Investors are not rational, financial markets are not informationally efficient.
These concepts run counter to the major pillars of 20th-century financial theory: that investors are expected utility maximizers and market prices reflect all relevant information.
Behavioral research decimates the expected utility maximizer concept. It is virtually impossible for an individual to collect all needed information and then accurately process that information to come up with a rational decision. This concept is known as bounded rationality, first introduced by economist Herbert Simon.
Even more damaging, Daniel Kahneman, Amos Tversky and others convincingly demonstrate that even when all information is available, individuals are highly susceptible to cognitive errors. As Kahneman and Tversky concluded after years of research, human beings are by and large irrational decision makers.
The very concept of “utility” is flawed. If utility seeks to inject a happiness measure into economic theory, then what aspect of happiness is it gauging: expected, realized or remembered? Research has found that those three are quite different, even when the same person experiences each. Happiness and, in turn, utility are hopelessly malleable concepts.
Since we are strongly predisposed to make cognitive mistakes due to our emotions, it takes only a small step to conclude that markets cannot be informationally efficient. The evidence supporting this conclusion is vast: There are hundreds of statistically verified anomalies in the academic literature and more continue to be found. The result is a bleak picture: Emotional investors, burdened by cognitive biases, with a penchant for herding, regularly drive prices away from underlying fundamental value.
But all is not lost
Unexpectedly, analyzing investors and markets through a behavioral lens provides a more reliable framework than with the EMH and MPT. Why? Because individuals rarely change their behaviors. And investing crowds are even less inclined to alter their collective behavior.
Financial advisors are building practices around the behavioral concepts and biases uncovered over the last 40 years by behavioral scientists such as Kahneman and Tversky. The resulting financial plans and ongoing coaching are anchored in behaviors that are unlikely to change any time soon.
Portfolio managers and analysts are building strategies based on measurable and persistent behavioral factors, frequently using fundamental data as an objective proxy for these factors. The well-known result that individuals and groups are loathe to change their behavior means these funds have an excellent chance of long-term outperformance.
Consultants and gatekeepers can focus on behavior as well. They need to create incentives to encourage high performance behavior by investment managers. According to academic studies and industry analysis, including my own research, these behaviors include consistently pursing a narrowly defined strategy, while taking only high-conviction portfolio positions. To date, the focus has been on reducing short-term volatility and tracking error. Changing incentives will lead to funds behaving in a way that builds long-horizon wealth for investors.
BFM concept 3: There are hundreds of behavioral price distortions (anomalies) that can be used for building superior portfolios.
When an event like the surprise 2016 Brexit vote triggers our emotions, most of us react in a similar way. This collective response is further amplified by herding. Indeed, herding can occur even without an external event. We collectively react because we see everyone else reacting, even though we do not know the reason for the sudden stampede.
Emotional crowds rampaging in markets create numerous opportunities for professional investors who are not caught up in the moment. I refer to these opportunities as “behavioral price distortions.”
Alternatively, these are dubbed “anomalies” in the academic literature because their existence is inconsistent with the EMH. When they are included in asset-pricing models or in constructing smart-beta portfolios, they are called “factors.” I prefer the term behavioral price distortions because they are the consequence of collective emotional behavior.
Distortions are the ingredients active managers use when creating an investment strategy. In the case of smart beta, they are the entire strategy. For other active managers, they represent only a portion of the strategy because an investment manager’s “recipe” or decision-making process makes up the rest. Behavioral price distortions are essential to successful active management.
BFM concept 4: Investment strategy can be used to create alternative tools for analyzing Behavioral Financial Markets.
Once it is accepted that emotional crowds, rather than fundamentals, are the most important drivers of price changes, traditional economic modelling approaches break down. In order to apply such an approach, it is necessary to posit what investors are attempting to maximize, such as expected utility. But in the case of investors making emotional investment decisions, this becomes challenging, if not impossible. Behavioral models that specify investor maximization remain the province of theoretical academics such as Hersh Shefrin, and, up to this point, have yet to yield usable results.
Another problem is that security prices and volatility are polluted by investor emotions, so virtually all of the quantitative measures in current use, such as beta, efficient frontier and Sharpe ratio, among others, are problematic for managing and evaluating investment portfolios.
Shiller and others have shown that volatility is largely driven by emotion, not fundamentals. So, beta is actually capturing non-diversifiable market emotions, while both the efficient frontier and Sharpe ratio are emotion-return not risk-return measures. It is important to avoid baking investor emotions into our analytic tools.
Collective intelligence of active investment managers
Focusing on the collective intelligence of active investment managers allows us to circumvent these challenges, thus providing an alternative framework for analyzing and investing in behavioral markets. Over the last 15 years, proof-of-concept research and actual investment management has been conducted by my firm, AthenaInvest, using active equity managers. However, the following ideas are applicable to any financial market in which managers are attempting to beat a benchmark.
Active investment managers aim to harness the collective cognitive errors of a small set of emotional crowds operating in the market. They do this by constructing a narrowly defined investment strategy, using objective measures, such as financial data and primary firm research, for tracking the behavioral factors driving their portfolio returns.
We have found that active equity managers are about as likely to change their strategy as investors are to change their behavior. In managing a portfolio, desirable fund behaviors include consistent pursuit of a narrowly defined strategy while focusing on high-conviction positions.
The thousands of existing active equity funds can be formed into peer groups, within which each fund is pursuing a similar self-declared strategy (see this study for more details). Each fund in a group attempts to harness a similar set of behavioral factors in order to generate superior returns. The very size and diversity of the fund universe means that they fully span the set of behavioral factors driving individual as well as market-wide stock returns.
This collection of strategy-identified funds provides a data-rich organization of the underlying factors driving returns. Combining this strategy information with fund holdings, another objective measure of manager behavior, allows for the creation of an alternative tool kit for analyzing and investing in behavioral markets. These tools include objective measures of fund consistency and conviction, identification of best behaving funds, strategy categorization of stocks, identification of the best idea investments of the best behaving managers and, most surprisingly, estimates of expected market and individual stock returns.
I am not suggesting that the strategy/holdings framework is the only way to circumvent the analytic problems created by BFM, but it is very promising. No doubt other and hopefully better approaches will be forthcoming as more academics and practitioners transition to behavioral finance.
BFM concept 5: Emotions must be considered at every stage of the wealth-building process, from planning to investment management.
Emotions and the resulting behavior are important when building client wealth. The process begins with client needs-based planning, in which a separate portfolio is built for each different need. This initial planning phase is critical to removing investor emotional errors from the wealth-building process.
For the growth portion of the portfolio, the focus is on a long investment horizon. The task of the advisor is to encourage clients to adopt a long-term view while avoiding emotional reactions to short-term events. Evidence indicates that such myopic-loss-averting decisions have a profoundly negative effect on wealth. Emotional coaching is one of the most important services an advisor can offer clients.
If needs-based planning is successful, the money allocated to the growth portion of the client’s portfolio can be largely invested in high-expected-return but short-term-volatile securities like equities. Admittedly, it is a challenge to keep clients fully invested while avoiding costly trading decisions when markets turn volatile.
Portfolio managers and their analysts must deal with emotions at several levels. When building an investment strategy, only those behavioral price distortions that have been shown to be measurable and persistent based on careful and thoughtful analysis should be accepted. For example, while Fed actions and interest rates are often put forward as reasons for market movements, there is precious little evidence of such causality.
The goal is to focus only on those distortions supported empirically by large-data or real-world experience while ignoring everything else. As a result, investment teams become expert at filtering the signal from the considerable noise in the market. This means they may not be able to explain daily events, but they are able to deliver long-horizon wealth to clients.
In implementing a strategy, it is important not to succumb to the same emotions as do non-professionals. Do not fall in love with your investments, but instead remove the emotions by developing an objective selling rule. There is now considerable research (see here) showing how fund managers can avoid making the cognitive errors so detrimental to portfolio returns.
For consultants and gatekeepers, the challenge is to avoid baking investor emotions into the criteria used for adding and evaluating managers. Individuals react strongly to short-term volatility and drawdown as well as tracking error, even when facing a long time-horizon. These emotions are best dealt with by means of careful financial planning, multi-strategy portfolios and emotional coaching by an advisor.
But many in this position respond to the lowest common denominator by expecting every fund to manage each of these emotional triggers by reducing short-term volatility and tracking error. This results in underperforming portfolios and the commensurate reduction in long-horizon wealth. There is a high price to be paid by investors when emotional catering is demanded of each and every fund.
Operating in behavioral financial markets
Collective, emotionally driven behavior is the foundational concept underlying this paper. Markets are populated by human investors burdened with emotional baggage and associated cognitive errors. These errors are amplified inside a market due to herding, leading to wild price swings. Rampaging emotional crowds are the cause of excess return volatility. As Shiller pointed out in his book Irrational Exuberance, you need look no further than equity market price bubbles for evidence of the dramatic impact of emotional crowds.
Of course, economic, political, international and market information flow continuously into markets. In times past, it was thought that the arrival of these pieces of new information was the primary reason prices moved the way they did, as participants rationally processed and repriced securities. But this idyllic concept has now been shredded and replaced with emotional crowds as the most important driver.
Fundamental information, rather than being front and center, works behind-the-scenes, in the investment process of professional money managers. And if one takes a long enough perspective, it also influences the returns of individual securities and markets. The most economically successful companies earn the highest return over the long run and the reason the stock market goes up over time is directly related to growth in the underlying economy.
The pecking order has changed, with emotional crowds dominating prices and returns over shorter periods, with fundamentals holding sway only over longer periods. For those who spend time making investment decisions, this is not surprising. But for many in the academic and professional communities, it represents a sea change in how to think about and analyze markets. That is, when trying to understand price changes in the short-term, the focus should be on emotions and resulting behavior rather than on fundamentals.
Taking liberties with Professor Shiller’s quote above, “The challenge for financial professionals is to make this reality a better part of their models.” In other words, see markets as they are rather than how we would like them to be. The analytical tools derived from behavioral finance’s more realistic representation of financial markets and human behavior will eventually replace the wealth-limiting MPT tools in use today.
Dr. Howard is Professor Emeritus in the Reiman School of Finance, Daniels College of Business at the University of Denver and Founder and Chief Investment Officer at AthenaInvest, Inc.
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