Behavioral Portfolio Management. C. Thomas Howard
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dominance lasted 40 years, until it was pushed aside in the mid-1970s by the ascendency of Modern Portfolio Theory. MPT accepted the fact that there were many emotional investors, but argued there existed enough rational investors to arbitrage away any resulting price distortions and therefore market prices were informationally efficient. A prediction of this theory was that it was not worth conducting a GD type of analysis, nor any analysis for that matter, and instead an investor should buy and hold an index portfolio.
MPT immediately ran into problems in the late 1970s when S. Basu of McMaster University published a study demonstrating that low PE stocks outperformed high PE stocks and Rolf Banz of Northwestern University published a study in the early 1980s demonstrating that small stocks outperformed large stocks. MPT had no answer for these anomalies and so in order to save the model the two anomalies were sucked in as return factors. Never mind that it was never determined whether these represented risk or opportunities and that recent studies show these two effects disappearing. It was better to have them inside the theory rather than outside challenging the theory’s credibility. It has been downhill ever since for MPT, with study after study uncovering one pricing anomaly after another.
As MPT was rising to prominence, a parallel research effort was studying how individuals actually made decisions. The conclusion of this behavioral science research stream was that emotions and heuristics dominate decision making. It is amazing how little rationality was uncovered in these studies!
Because of the many problems facing MPT and the growing awareness of provocative behavioral science results, we are witnessing the decline of MPT and the rise of behavioral finance. Among other things, this transition brings back Graham and Dodd as an important way to analyze the market’s faulty pricing mechanism.
Behavioral portfolio management
Behavioral Portfolio Management, henceforth referred to as BPM, is an approach to managing investment portfolios that assumes most investors make decisions based on emotions and shortcut heuristics. It posits that there are two categories of financial market participants: Emotional Crowds and Behavioral Data Investors.
Emotional Crowds are made up of those investors who base decisions on emotional and intuitive reactions to unfolding events and anecdotal evidence. Human evolution has hardwired us for the short run, loss aversion, and social validation, which are the underlying drivers of today’s Emotional Crowds. Emotional investors make their decisions based on what Daniel Kahneman refers to as System 1 thinking: automatic, loss avoiding, quick, with little or no effort and no sense of voluntary control. [1]
On the other hand, Behavioral Data Investors, henceforth referred to as BDIs, make their decisions using thorough and extensive analysis of available data in order to tease out stable pricing relationships. BDIs make decisions based on what Kahneman refers to as System 2 thinking: effortful, high concentration, and complex. BPM is built on the dynamic interplay between these two investor groups.
MPT, as the prevailing theory of financial markets, posits that even though there are numerous irrational investors (think emotional, heuristic investors), the price discovery process is dominated by rational investors who quickly arbitrage away any price distortions. This implies a number of things regarding markets, such as prices fully reflecting all relevant information, the lack of excess returns to active investing, and the superiority of indexed portfolios over their actively-managed counterparts. In short, MPT contends that rational investors dominate the financial pricing process.
What if it is the other way around, that is, what if emotional investors dominate? Put another way, what if emotion trumps arbitrage? If this were the case, then price distortions would be common and could be used to build superior portfolios relative to the corresponding indexed portfolios. Active management could generate superior returns. In fact we would see the impact of emotions in every corner of the market and they would have to be taken into account when managing investment portfolios.
There is now ample evidence, which I will review shortly, supporting the argument that Emotional Crowds dominate market pricing and volatility. Emotional Crowds drive prices based on the latest pessimistic or optimistic scenarios. Amplifying these price movements is a market in which trading is virtually free and so there is little natural resistance to stocks moving dramatically in one direction or the other. “If anything is worth doing, it is worth overdoing,” is the market’s mantra.
Rational investors, or what I call BDIs, react to the resulting distortions by taking positions opposite the Emotional Crowd. But they are not of sufficient heft to keep prices in line. As a consequence, the resulting distortions are measurable and persistent. BDIs are able to build portfolios that harness these distortions as they are eventually corrected by the market, either rationally or simply because the Crowd is now moving in the other direction.
The Emotional Crowd, BDI interplay
BPM is built on the dynamic interplay between Crowds and BDIs. Crowds more often than not dominate market pricing and it is only by chance that individual security prices fairly reflect underlying value. Price distortions partially offset one another when aggregated across all securities, but even at the market level significant distortions remain. Thus prices more commonly reflect emotions than they do underlying value.
The events that trigger Crowd responses may be short lived, but the subsequent emotions are long lasting. As a result, price distortions are both measurable and persistent. This provides BDIs with an opportunity to identify distortions and build portfolios benefiting from them. Even though a BDI portfolio will outperform, building such a portfolio is emotionally difficult because the BDI is frequently going against the Crowd. The need for social validation acts as a powerful deterrent for most investors. Given the difficulty of behavior modification, there is little reason to believe that this situation will change any time soon. So I contend that BDIs will have a return advantage relative to Crowds into the foreseeable future.
BDIs depend upon Emotional Crowds for generating superior returns. But the impact of emotion is felt well beyond this relationship. Market professionals, such as portfolio managers, mutual funds, hedge funds, institutional funds, consultants and financial advisors are also impacted. Viewing the world through the lens of BPM reveals that the decisions made by these professionals are often based on faulty emotional analysis. It appears that much of what passes as professional analytics and due diligence is a way to rationalize emotional catering.
In this book, I focus on managing equity portfolios as a way to illustrate the three basic principles of BPM, with the proviso that these principles apply to managing portfolios in other markets as well.
1 BPM’s first basic principle, that Emotional Crowds dominate market pricing and volatility, is presented along with supporting evidence.
2 The second basic principle, that BDIs earn superior returns, is presented along with supporting evidence from the active equity mutual fund research stream. I also discuss the evidence regarding average equity fund performance and reconcile these two results.
3 The third basic principle, that investment risk is the chance of underperformance, is presented alongside the argument that emotions need to be carefully distinguished from investment risk.
I now discuss each of these basic principles in more detail.
The basic principles of BPM
Basic Principle I: Emotional crowds dominate pricing
The dynamic interplay between Emotional Crowds and BDIs is the focus of BPM. In contrast to MPT, I posit that the Crowd more often than not dominates the price discovery process. This means that prices infrequently reflect true underlying value and, even at the overall market level, price distortions are the rule rather than the exception. [2]
For many market participants, the first principle is uncontroversial. The chaotic nature of the stock market shows few outward sign of rationality as prices swing wildly based on the latest events or rumors. For many investors, the contention that prices are emotionally determined is consistent