By MARCEL PORCHERON 25/05/2007
In recent years we’ve seen some fund managers adopt behavioural finance techniques in the belief it gives them an edge on the markets. Here we take a look a look at what these techniques are and whether they appear to work.
| "The backbone to behavioural finance theory is that investors don’t always behave in a rational, efficient way." |
The backbone to behavioural finance theory is that investors don’t always behave in the rational, efficient way that is normally assumed. They are human and emotions often override logical thought processes. For example, people buy stocks because everyone else is buying, sell falling stocks in a panic or hold onto poor performers because they cannot admit they were wrong. In the words of Warren Buffet, behavioural finance investors aim to “Profit from folly rather than participate in it.”
Common behavioural traits include:
Information overload – leads to mental shortcuts which often do not focus on the important issues – beware Bloomberg watchers!
Confirmatory bias – the habit of looking only for information that agrees with us.
Anchoring – emphasising a single piece of information, often historical, that should have little relevance to a decision. This is typified by research analysts who are slow to upgrade their earnings forecasts, allowing nimble investors to profit.
Framing – the inability to see through the way information is presented. For example, new listings often seduce investors through portraying a glamorous view of their future potential.
Preconceived ideas – investing on the basis of pet theories rather than a rigorous valuation methodology.
Halo effect – the tendency to infer a number of positive attributes from a single one.
Herding – preferring to follow the crowd irrespective of what valuations are telling them (think of the technology bubble in the late 1990s).
Overconfidence – people tend to overestimate their own abilities and tend to overpay for good stocks and ignore indifferent stocks at cheap prices.
Do you suffer from any of these traits? Answer the following:
If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?
The answer is 5 minutes. If you thought 100 minutes then you were guilty of ‘framing’.
Behavioural finance investors therefore require a rigorous philosophy and process to take advantage of these traits. This invariably means that quantitative analysis, i.e. number crunching, takes precedent over more conventional qualitative research. Using extensive rules based computer analysis reduces the risk of emotional intervention and is a popular route. For example, the Artemis SmartGarp system uses a complex computer program to analyse a large number of variables on a wide universe of companies before churning out a list of potential ‘buys’.
| "When reviewing behavioural finance managers, ensuring they have a proven and robust process is the key consideration." |
When reviewing behavioural finance managers, ensuring they have a proven and robust process is the key consideration. It’s also important to ensure they adapt their process moving forwards to reflect changing market dynamics, i.e. what works successfully today may not fare so well in five or ten years time.
Below are some of our recommended funds that successfully employ behavioural finance techniques:
Artemis European Growth
Artemis Global Growth
Artemis Capital
Investec Global Free Enterprise
JPM US