The main take-away from prospect theory is that investors tend to hold on to losing positions for too long (loss aversion, risk seeking and confirmation bias). Investors simply hate to be proven wrong and love to be proven right. This is exactly why investors also sell their winners too quickly; the certainty effect causes them to be risk-averse in the domain of gains. (Remember the old proverb: a bird in the hand is better than two in the bush.)
Integrating Behavioural Finance Into Your Investment Process
So how can investors avoid behavioural biases while attempting to exploit the biases of others? A quantitative process can help. First, by focusing on a few crucial elements for stock selection, you can avoid falling into the illusion that more information is better. What are the most important factors that drive a stock’s returns? Use this insight on as many stocks as you can, instead of trying to know everything about a few.
Second, by integrating an optimizer (an investment software) into your portfolio construction process, the memory-free machine will not have an attachment to existing views when new information comes along. It will therefore be less subject to a confirmation bias. Based on new evidence, the optimizer will objectively evaluate the new information’s value and arrive at a new price estimate without the past price being as relevant an anchor. The optimizer does not care about a firm’s past earnings pattern. If fundamentals and sentiment are good today and value is appealing, the optimizer will consider it for inclusion in the portfolio. And because most optimizers on the market have been developed using an expected utility framework, they will not fall prey to risk aversion or gambling in the domain of gains or losses. If a better opportunity comes along—meaning investors will have to sell a relatively worse-ranked stock at a loss—the machine will not have second thoughts about it.
The Five Financial Ws
The psychology of investing has been embraced by more and more portfolio managers over the past 15 years and has produced a different approach to stock selection and portfolio construction. It does not replace sound financial analysis but complements it by helping investors to remove emotional elements from the investment process. It brings investors’ attention to the five Ws they should always ask themselves before adopting a ranking process to select stocks:
1. What works?
2. Where does it work (in which part of the investable universe)?
3. When does it work (up/down markets)?
And by exploring the field of behavioural finance, investors can get answers to the last two Ws:
4. Why does it work?
5. Will it continue to work?
But is it really crucial to understand why these anomalies exist? Is it not enough to know that these biases exist and lead to mispriced assets that can be exploited? Behavioural finance is both fascinating and challenging, given the fact that investors are all subject to cognitive and emotional limitations. It also puts a human face to the black-box reputation of quantitative investing. But while the understanding of market anomalies can be insightful, investors should avoid the overconfidence and the illusion of control that comes with additional information. By combining the fundamentals derived from the analysis of financial statements and the study of investor psychology that creates mispriced assets, investors hope to generate returns in excess of the market over the long term. BC
Sources available on request.
Sophie Mayrand is vice-president and senior portfolio manager at State Street Global Advisors in Montreal.
sophie_mayrand@ssga.com
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© Copyright 2010 Rogers Publishing Ltd. This article first appeared in the September 2010 edition of BENEFITS CANADA magazine.