Investors like to think that only the other guy gets trapped in behavioral tendencies that can shred a portfolio. Even after decades of academic research into the human mind’s wiring and how it can lead the most sophisticated professionals astray, many investors still haven’t codified the findings of behavioral finance in a way that can protect portfolios from costly, if understandable, mistakes.
However, several fund firms are starting to integrate behavioral finance, which uses a mix of neuroscience, psychology and economics to understand decision making, into their stock- and bond-picking rules.
Michael Ervolini co-founded Boston-headquartered Cabot Research to give portfolio managers and research analysts insight into their behavioral tendencies and investment skills in an effort to stave off bad decisions. As chief information officer of real estate firm AEW Capital Management and co-founder and CEO of Charter Research Corp., both based in Boston, before starting Cabot in 2004, Ervolini had long been involved in using technology to help institutional investors oversee portfolios. At Cabot he leverages that experience and combines it with behavioral finance research.
“People may have a suspicion that they aren’t perfect, but they view behavioral tendencies as happening to someone else,” Ervolini says with a laugh. Most feedback that portfolio managers get is useless when it comes to combating mistakes, he adds, because the traditional measurements that fund companies employ, such as performance attribution, tell managers only which sectors or stocks drove a portfolio’s returns. In contrast, Cabot Research analyzes managers’ decisions over time, with the aim of advising them on what to do in the future.
Jeff Schwarte, portfolio manager at Principal Global Equities, a division of $368 billion, Des Moines, Iowa–based Principal Global Investors, co-leads investments that include thematic and active quantitative strategies. Schwarte has been studying behavioral finance and how to apply it at his firm for a decade. “You can’t remove behavioral tendencies, but you can identify when folks let emotions drive decision making,” he says.
Principal, which is a Cabot client, has developed a framework enabling it to take advantage of periods of market volatility, like the one seen this year. “Volatility can be an entry point, but if a portfolio manager is worried about the next quarter, for instance, that volatility will make them question their investment savvy,” Schwarte notes.
One behavioral tendency that Schwarte has studied is people’s aversion to change. Principal tries to identify when companies are starting to make big changes; the firm’s goal is to profit from the fact that investors — driven by a desire for the comfort of certainty — often sell such companies, leaving those stocks undervalued. Conversely, investors may overvalue businesses that seem to offer stability.
Cabot has helped Principal to study every aspect of its investment process and staff decision making. In turn, Principal coaches employees on avoiding habitual mistakes. Endowment (or status quo) bias, for example, leads people to value a thing more highly if they already own it than if they don’t. To counter its consequence in investing — holding positions for too long — the firm systematically asks portfolio managers if they would buy an existing holding today. If not, Schwarte says, they are “nudged” to put the money to work in something else.
J.P. Morgan Asset Management has designed vehicles such as its Intrepid Growth and Intrepid Value funds wholly around behavioral finance themes. Portfolio manager Phil Hart, who thinks of the discipline as the study of “the effect of market pressure on investor behavior,” says that $1.7 trillion JPMAM believes there are two key elements to ensuring that investment choices are determined objectively.
The first is to run an investment process the same no matter what is happening in the market. The second involves people: At J.P. Morgan the optimization process for portfolio construction forces certain tilts in the fund, and then it ensures that managers follow them, within limits. If investment staffers want to go against the guidance, they need to actively opt out of decisions, for instance. “More times than not, folks don’t have the willpower to do something under stress unless they’ve predetermined to do it,” Hart says.
Dennis Ruhl, CIO of U.S. behavioral finance at JPMAM, adds that formalizing the process is critical. “It provides a guidepost or a light when everything else goes dark,” he says. The JPMAM team practices what it will do during a market correction and how it will react to events. Ruhl says the group has signposts and other signals that it will use to remain rational in difficult times. The biggest danger is thinking that the current markets are somehow different than those of the past, he warns.
The JPMAM behavioral team follows procedures like writing down an investment’s original thesis and determining what conditions would warrant selling. In mid-February the group put its system to work, adding to its value bets even though the market remained turbulent. No one used the opt-out feature.
Rationality pays off. Managers often perceive themselves based on anecdotal evidence rather than accurate analytical feedback, Cabot’s Ervolini says: “In volatile markets that creates greater angst, because all the ducks aren’t in place. Then you get extreme behaviors.”
