Behavioral Portfolio Management. C. Thomas Howard
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of active equity managers. (See Chapter 14.)
Superior performance is driven by the consistent pursuit of a narrowly-defined strategy, while investing in a small number of high-conviction positions that have been identified based on a small set of measurable and persistent behavioral price distortions. (See Chapter 15.)
Dividends provide valuable information regarding future company performance and, as a result, stock performance, while at the same time providing signals about future volatility. These are good reasons to consider dividends when analyzing, buying and selling stocks, and dividends should play a prominent role in an equity strategy. (See Chapter 16.)
The best markets are identified by means of deep behavioral currents in contrast to trying to time the choppiness on the surface. The goal is to uncover behavioral measures that are predictive of expected market returns. The resulting expected market returns are then used for executing a behavioral market timing strategy. (See Chapter 17.)
Behavioral price distortions will persist for a very long time. Throughout my career, my professional colleagues attempted to explain the anomalies bedeviling the EMH, but things have only gotten worse, with more anomalies than ever. So I’ve decided to be the student picking up the $100 bill on the sidewalk and not the professor spouting the rationality model. (See Chapter 18.)
Chapter 1: Behavioral Portfolio Management
On the first day of my securities class, I would lay out a $1, $5, $20 and $100 bill on the front table. I would then ask the class which they would choose. I got puzzled looks from the students, wondering whether this was some kind of trick or whether I had lost my marbles.
After some assurances from me, they all agreed that they would pick the $100 dollar bill. I then explained that the four bills represented the expected payoff on four different investments, with the same holding period and equal initial investments. Not surprisingly, they all again chose the $100 investment.
I further explained that each of the four investments represented somewhat different levels of risk, with the $100 investment the least risky (this last point being contrary to conventional wisdom, as I explain further in Chapter 12). But the real difference across the four investments was that there was considerably more emotion associated with the ever larger payoffs. Now the choice was not so clear. It was obvious that they were trying to conduct some sort of return, risk, emotion trade-off.
The four investments are proxies for choices typically available to investors. The $1 bill represents an investment in default-free treasury bills, the $5 bill an investment in bonds, the $20 bill an investment in the stock market, and the $100 bill an investment in an active equity portfolio earning an excess return. The payoffs roughly capture the relationship of ending values for each of these investments over a long time period, say 30 years.
I then challenged the students by stating that over their investment lifetimes few will choose the $20 investment and a countable, small number will choose the $100 investment. Instead, most will build portfolios heavily made up of $1 and $5 investments. They will do this because they apply emotional brakes during the investment process and, what is worse, will be encouraged to do so by the emotion enablers that currently dominate the investment industry.
Consequently the typical investor leaves hundreds of thousands if not millions of dollars on the table during their investing lifetime, because they aren’t able to release their emotional brakes and the industry does little to encourage them to do otherwise.
The triumph of reality over rationality
Consider the following allegory:
The finance professor and his student are walking to lunch one day and come upon a $100 bill lying on the sidewalk. The student leans over to pick it up but is restrained by the professor with the admonition “Do not bother to try to pick it up, for if it were real, it would have already been scooped up. So our eyes must be playing tricks on us.” The student responds “With all due respect professor, I do not believe in your rationality model,” then leans over to pick up the bill and stuffs it into his pocket.
Ten years ago I was the professor and now I’m the student picking up the $100 bill and stuffing it in my clients’ pockets.
Behavioral Portfolio Management (BPM) is set in a world in which prices rarely reflect underlying fundamentals – instead they are driven by emotional crowds who are unable or unwilling to release their emotional brakes. BPM focuses on how investors, advisors and asset managers can go about releasing their own emotional brakes and harnessing the behavioral price distortions uncovered by means of careful research.
BPM is based on my research and the research of other behavioral and finance academics, as well as my experience in managing active equity portfolios. Along the way, BPM rejects the rationality-based concepts and methods of Modern Portfolio Theory, the primary tools used by those industry professionals who I will refer to as Cult Enforcers. The most important conclusion of BPM is that building high performance portfolios is surprisingly straightforward but emotionally difficult.
My BPM transformation
I began my career steeped in the concepts of MPT. Early on, I was able to release my emotional brakes to the point of being able to concentrate my investment portfolio in the $20 investment (i.e. 100% allocation to equities). For many years I continued to believe that hiring an active equity manager was the triumph of hope over reality, so I invested in equity index funds rather than in actively managed funds. More recently, my ideas began to change, based on my research and the research of others, and I am now a strong believer in active management.
In July 2002 I began managing what has become AthenaInvest’s flagship concentrated stock portfolio, Athena Pure Valuation/Profitability, earning a nearly 25% compound annual return over a 12-year time period. During 2013, it produced a greater than 60% return. One needs to remain humble whenever reporting results like these, since, as 2002 Nobel laureate Daniel Kahneman of Princeton University reminds us, “reversion to the mean can be just around the corner.”
But I am encouraged that we are heading in the right direction in that our other portfolios, among them mutual fund allocation, equity dividend, ETF, hedge fund, and global tactical ETF, are all producing superior returns. Like Pure, each portfolio is based on harnessing behavioral factors that have been identified through careful research as measurable and persistent emotionally-driven price distortions.
We do not attempt to out-analyze or outsmart other professional investors by creating a superior information mosaic for the investments we make. Instead, we attempt to understand the emotional crowds that dominate market pricing and, in managing our portfolios, exercise the consistency and persistence necessary to earn superior returns. In short, we practice BPM.
At first I was rather surprised by my portfolio performance. But as I conducted additional research and carefully reviewed the finance literature, I found that building a successful portfolio is not uncommon within the industry and the way in which I had been managing Pure is very similar to the way others who are successful manage their portfolios. Thus over time my methodology became embedded in a broader research stream which I will report on in the remainder of this book. The rest of this chapter is devoted to the foundational concepts underlying BPM.
Evolving market paradigm
Equity market theory has passed through two distinctly different paradigms over the last 80 years and currently is experiencing the rise of a third. The first paradigm was launched in 1934 when Benjamin Graham and David Dodd of Columbia Business School published Security Analysis, the first systematic approach to analyzing and investing in stocks. Graham and Dodd (GD) argued that it was possible to build superior stock portfolios using careful fundamental analysis and a set of simple decision rules. These rules were based on behavioral price distortions as identified by fundamental analysis. The success of GD is all the more impressive as their book appeared in the depths of the Great Depression, when stocks were crashing and market volatility reached levels not seen before or since.