Behavioral Portfolio Management. C. Thomas Howard
the case following the 2008 market crash when investors withdrew billions of dollars from equity mutual funds during a period in which the stock market more than doubled. The end result is that investors frequently suffer the pain of losses without capturing the subsequent gains. [18] Again this is the result of not carefully separating emotions from risk and thus allowing emotions to drive investment decisions.
Assimilating Basic Principle III
Principle III will likely be the most difficult to assimilate. It involves redirecting the powerful emotion of loss aversion, while acting contrary to the hardwired tendencies of thinking short-term and social validation. For a number of investors, this may be too much to ask. But for others, progress may be possible. A first step is calling things as they are. Rather than labelling everything risk, be careful to identify and separate that portion which is really emotion. There are risks that must be taken into account when making investment decisions but don’t muddy the water by carelessly lumping emotions and investment risk together into a single number, as is the case for many popular risk measures.
A flying analogy may help think about the separation process. All of us who fly have experienced turbulence, which can range from being unnerving to downright frightening. When asked about their flight, many travelers will comment on the amount of turbulence they encountered. However, we know from years of FAA (Federal Aviation Administration) research that turbulence rarely causes injury or death. Instead, pilot error (over 50%) and other human error are the leading causes of plane crashes.
What if the FAA had instead listened to passengers to determine the risk of flying? Rather than meticulously studying each accident and uncovering the true cause, the FAA would have spent considerable time trying to reduce turbulence, as requested by passengers, thus missing the critical role of human error in accidents. By focusing on short-term turbulence, they would have actually made flying more dangerous. Luckily they did not and as a result 2012 was the safest year in commercial flight since the dawn of the jet age.
We are not so fortunate in the investment industry. Rather than carefully separating risk from emotions, the industry provides a mixed bag of risk measures that exacerbate the emotional aspects of investing. As I argued earlier, this means many long-horizon portfolios are built to reduce short-term volatility, while at the same time increasing portfolio risk.
So to make the transition, it is necessary to allay the fears of clients while at the same time disregarding many a conventional wisdom. Unlike those who have a fear of flying and only have themselves to change, the investment professional has to confront both clients and the investment establishment. Sadly, the risk measures put forward by the industry are more emotional measures than they are investment risk measures.
Summarizing the three Basic Principles
Behavioral Portfolio Management focuses on the behavioral aspects of financial markets to help make better investment decisions. BPM’s first basic principle is that Emotional Crowds dominate the determination of both stock prices and volatility, with fundamentals playing a small role. This means that more often than not prices reflect emotions rather than underlying value, a consequence of arbitrage failing to keep prices in line with fundamentals. As a result, price distortions are the rule rather than the exception, making it possible for BDIs to build superior portfolios, which is the second basic principle.
Volatility and risk are not synonymous. In the case of meeting short-term financial goals, volatility is an important contributor to investment risk, as measured by the chance of underperformance, and this is the third basic principle. On the other hand, volatility plays a much less important role when building long-horizon portfolios. By focusing on short-term volatility when building long-horizon portfolios, the investor injects emotions into the portfolio construction process. It is important to distinguish between emotions and investment risk so that the best decisions can be made.
The bottom line is that building successful investment portfolios is straightforward but emotionally difficult. Making decisions based on price distortions created by the Emotional Crowd and ignoring short-term volatility when building long-horizon portfolios presents significant challenges for investment professionals. This is because such a strategy is frequently going against the Crowd, thus depriving the client of social validation, and in turn asking them to set aside the strong emotions associated with volatile prices.
Consequently, it is necessary to mitigate the impact of client emotions. Emotion mitigation is a fact of life in the investment industry and both advisors and investment managers should develop such skills. The goal is to be sensitive to the emotional reactions of clients while minimizing the damage to their portfolios. Developing an approach that keeps clients in their seats while building superior portfolios is important for clients, advisors and investment managers alike.
Endnotes
1 Daniel Kahneman, Thinking, Fast and Slow (Farrar, Straus and Giroux, 2012). [return to text]
2 Shefrin (2008) introduces the concept of “knife edge” market efficiency which exists only with the occurrence of a rare combination of wealth and investor emotions. Thus he argues stock prices rarely reflect underlying fundamentals. [return to text]
3 Robert Shiller, ‘From Efficient Market Theory to Behavioral Finance’, Journal of Economic Perspectives 17 (2003), pp. 83-104. [return to text]
4 R. Mehra and E. Prescott, ‘The equity premium: A puzzle’, Journal of Monetary Economics 15 (1985), pp. 145–161and R. Mehra and E. Prescott, ‘The Equity Premium in Retrospect’, NBER Working Paper No. 952 (February 2003). [return to text]
5 S. Benartzi and R. Thaler, ‘Myopic Loss Aversion and the Equity Premium Puzzle’, Quarterly Journal of Economics 110:1 (1995), pp. 73-92. [return to text]
6 Hersh Shefrin, Behavioralizing Finance (Now Publishers Inc., 2010). [return to text]
7 See the behavioral finance summaries in Shefrin (2010), Hirshleifer (2008), Barberis and Thaler (2003), Baker et al. (2007), and Subrahmanyam (2007). [return to text]
8 See articles by Alexander, Cici, and Gibson (2007); Baker, Litov, Wachter and Wurgler (2004); Chen, Hong, Jegadeesh, and Wermers (2000); Cohen, Polk and Silli (2010); Collins and Fabozzi (2000); Frey and Herbst (2010); Kacperczyk and Seru (2007); Keswani and Stolin (2008); Kosowski, Timermann, Wermers, and White (2006); Pomorski (2009); Shumway, Szeter, and Yuan (2009); and Wermers (2000). [return to text]
9 There is another research stream that shows truly active managers are able to earn superior returns. See Amihud and Goyenko (2013); Brands, Brown, and Gallagher (2006); Cremers and Petajisto (2009); Kacperczyk, Sialm, and Zheng (2005); and Wermers (2010). [return to text]
10 It is an open research question to determine the source of these excess returns, that is, what portion is due to harnessing behavioral factors and what portion is due to generating a superior information mosaic. It is difficult to untangle these two return drivers, so for now we are left with the plausible supposition that emotionally-driven prices are the most important source of excess returns for fund managers. [return to text]
11 See Bollen and Busse (2004); Brown and Goetzmann (1995); Carhart (1997); Elton, Gruber and Blake (1996); Hendricks, Patel, and Zeckhauser (1991); Jensen (1968); and Fama and French (2010). [return to text]
12 Other possible reasons why a fund might purchase other than best idea stocks, as the fund grows in size, is mimicking the index to lock in a past alpha and becoming a closet indexer to avoid style drift and tracking error. [return to text]
13 J. B. Berk and R. C. Green, ‘Mutual Fund Flows and Performance in Rational Markets’, Journal of Political Economy 112:6 (2004), pp. 1269-1295. [return to text]
14 See Chen, Hong, Huang, and Kubik (2004); Han, Noe, and Rebello (2008); and Pollet and Wilson (2006). [return to text]
15 H. Markowitz, ‘Portfolio Selection’, The Journal of Finance 7:1 (March 1952), pp. 77-91. [return to text]
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