Behavioral Investing For the DIY investor

Behavioral Investing For the DIY investor

Can a DIY Investor use Behavioral Investing to Meet Long-Term Goals?

 

Behavioral investing is style of investing that stems from an age-old battle in investment theory. The basic question: are investors mostly rational or irrational?

If they are irrational, then can you come up with an investment thesis that profits from the irrational (and thus unpredictable) behavior? That is, are there predictable pricing distortions in the market due to investor’s emotional errors? Or, since they are irrational, do errant emotional responses not provide actionable investment theses?

Rational or irrational, this battle pits traditional modern portfolio theory (which argues that the market and individuals are rational) against behavioral finance (which argues that investors have inherent biases).

But where the rubber hits the road: can a DIY investor use behavioral investing to meet long-term investment goals?

Let’s look at behavioral investing and try to find “behavioral alpha;” that is, excessive returns derived from understanding people’s cognitive biases.

 

Understanding Behavioral Investing: The Central Thesis

The central thesis of behavioral investing is: in order to outperform the market average, you must understand behavioral finance. If people are irrational and this leads to price inefficiencies, then how do you take advantage of the inefficiencies in order to improve investment performance?

The keys to the central thesis of behavioral investing:

  1. How can you measure the price distortions caused by behavioral errors?
  2. Once measured, can you consistently take advantage of them?

Before we answer those key questions, let’s review traditional investment theory: modern portfolio therapy. From there, we can understand the age-old battle and the evolution of behavioral investing.

 

Modern Portfolio Theory and Bubbles

Modern portfolio theory (MPT) became standard investing theory by 1980. At its core, there is the assumption that markets and people are rational. The theory is useful because it clearly defines inputs and allows modeling based upon these rational (linear and non-adaptive) inputs. Markets are efficient, and people respond rationally to them.

Slowly at first, folks noticed that MPT could not model the foibles of the stock market of the 80’s and 90’s. Thus over time, Behavioral Finance is born.  [Nod to Kahneman and, of course Richard Thaler (of Nudge fame)]

The damning truth is MPT cannot explain bubbles, momentum investing, actual investor returns, or any number of phenomena seen in the stock market. Neurologist-turned finance guru William Bernstein decimates MPT in his books, but see especially his most recent book The Delusion of Crowds: Why People Go Mad in Groups.

QED: how are bubbles rational?

MPT remains necessary to model rational behaviors, but behavioral finance fills in the many gaps. The market is a complex, non-linear, and adaptive system better explained by behavioral finance than MPT.

This is not just about just being contrarian—behavioral finance helps define herd mentality and why shortcuts in thinking (heuristics) and emotions (biases) cause assets to be mispriced

The explanatory power is strong—in theory—but can you profit from it?

 

How you can Profit from Behavioral Finance

Can you monetize behavioral finance? That is, how do you systematically take advantage of errors caused by human thinking and emotion?

First, some definitions:

  • Behavioral Finance studies the interaction between finances and human psychology. It is, in essence, the study of heuristics and biases and why they cause misbehavior. You can consider behavioral finance as the successor of modern portfolio theory, as we learned that neither the markets nor individual investors are truly rational. Behavioral Finance is a sub-field of behavioral economics.
  • Behavioral Investing, then, attempts to use behavioral finance to actually find and utilize inefficiencies in the market caused by emotional miscues. Questions to consider here: how do you measure the effects of heuristics and biases in prices, and how do you take advantage of them? An irrational investor is one who doesn’t understand behavioral finances.

Don’t be an irrational investor! But learn the truth—we all are!

So, how can you understand behavioral finance and thus profit from behavioral investing? Start with this: understand that you, too, have the same biases and behavioral glitches as everyone else. Women have less!

Think about weight issues in modern society for a second. Everyone knows that you can eat less and exercise more and thus obtain an ideal weight. Knowledge is not enough.

If you understand how complicated weight is, then you begin to understand how complicated behavioral investing is as well. Knowing how to lose weight is MPT. Losing weight is behavioral investing.

Just like not everyone is cut out for losing weight, not everyone should be interested in behavioral investing, either.

 

Can a DIY Investor use Behavioral Investing to Meet Investment Goals?

Not everyone is cut out to be a behavioral investor.

What kind of investor are you? Let’s group investors by type, and then attempt to understand some basic heuristics and biases.

Let’s look at growth investing, value investing, dividend investing, MPT investing, and finally, behavioral investing:

 

  • Growth Investing: the truth is, 4% of stocks drive all of the return of the index (the other 96% return, on average, the same as the risk-free rate). Stock pickers think that they can outperform the index by finding these needles in the haystack. For those who understand the evidence-based idea that the market as a whole gets the median return, for most picking stocks is a fool’s errand. Not everyone is above average.
  • Value Investing: here, you try to buy low and sell high (or never sell). Stocks can be cheap because they deserve to be, or because they are a diamond in the rough. To have an advantage, you need to know the future, or be able to suss out which details matter in a financial statement. Nothing the DIY investor cares to do…
  • Dividend Investing: perhaps the worst of both worlds, dividend investors believe that income is the answer. I wrote on the topic in RIP Retirement, but the short of the matter is dividend stocks are a risky and tax-inefficient way to invest.
  • MPT Investing: buy-and-hold the efficient frontier. This can get you average returns, which is a great goal for DIY investors. If you can invest tax-efficiently and with low fees, your average returns will put you in the top quartile decade after decade.
  • Behavioral Investing: the most difficult to do, you need to understand where others fail, and more importantly, how you can take advantage of the irrational behavior. All while understanding and battling your own heuristics and biases…

 

As a DIY investor who is drawn to complexity (see Rick Ferri’s Evolution of an Index Investor), I still think that it is possible to do better than the market (which is described better by chaos theory than current models). Not by picking growth or value stocks, and not by picking trends or sectors, but by understanding my own weaknesses. There are many!

As humans, recency and overconfidence bias are strongly entrenched after a decade-plus bull market. Who has actually lost money in the last decade? Well, anyone not 100% invested in the S&P 500.

More important than knowing what worked in the past (because it only works well until it stops working well), it is knowing what your thesis is for the next 5 or 10 years. Care to predict the future?

I predict that people will still have heuristics and biases 5 or 10 years from now.

So now, how do I profit from that prediction?

 

Where Can You Invest in Behavioral Finance? 

This is just a primer on behavioral investing. I hope you found some of the ideas interesting. What did you take from this ditty?

If you think people are irrational, how do you take advantage of it and get positive behavioral alpha?

One idea is to pick better stocks. AthenaInvest has some good education to review. Their goal is to use quantitative analysis, active management, concentration and leverage to provide behavioral alpha. The idea: they can measure price distortions caused by investor irrationality and take advantage of it through stock selection. Unfortunately, they only have SMAs and expensive tax-inefficient mutual funds, so I have no desire to participate. The company founder wrote the book on Behavioral Portfolio Management and is quoted below.

Next, what about picking less poorly performing stocks? As 96% of stocks underperform, what if you got rid of some of those and were able to keep the winners? Again, for education only, check out New Age Alpha. Through quantitative analysis, they attempt to de-select equities that humans have mispriced. They have moderately expensive ETFs that select the 50 equities in the S&P 500 that they perceive are least likely to be losers. Interesting.

I don’t think any of these ideas are prime time yet. That is, don’t invest in them. Learn from them… how are fund managers approaching the idea that 1) there are price deviations that are measurable and 2) you can find a way to take advantage of them.

 

Behavioral Alpha—Investors (including you) will continue to have biases in the future

So, I hope you understand the theory—the one thing that won’t change—people are irrational. Markets are made of people and are also irrational.

Behavioral investing attempts to identify measurable and persistent distortions in the prices. These data are derived empirically. From the data, what strategy can you use to take advantage of the irrationality of other people?

 

The final insight that might allow behavioral alpha: understand that you are also irrational.  

How can you profit from understanding that you are irrational? From the book Behavioral Portfolio Management, comes a discussion on the true nature of risk, volatility, and mental accounting.

Think of your goals, and separate short-term needs and long-term investing.

Volatility is very important to consider for short-term goals, but needs to be ignored with long-term goals. You invest differently depending on when you need the money. Risk is actually the possibility of you not meeting your long-term goals through investing, not volatility!

For your long-term investing, volatility (the day-to-day or even year-to-year price fluctuations) is meaningless. Mitigating short-term volatility is the cause of underperformance in long-term portfolios. That is, usually behavioral alpha is described as a negative return—the amount DIY investor underperform the indexes as they dance in and out of strategies. Investors are worried about short-term volatility thus they underperform in their long-term portfolios.

Understand there is positive behavioral alpha to be found if you reject MPT and use behavioral finance as the underpinning of your long-term portfolio. Separate your long-term portfolio (via mental accounting) and ignore volatility! Risk is not volatility; it is not meeting your investment goals.

 

Can a DIY Investor use Behavioral Investing to Meet Long-Term Goals?

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Summary—Can a DIY Investor use Behavioral Investing to Meet Long-Term Goals?

In Summary, there is behavioral alpha in the market. Both negative (chasing returns, worrying about volatility in long-term portfolios) and positive (understanding and meeting your long-term goals).

You can look for it in the investment to select (behavioral investing), the funds that you don’t pick (those active funds that will likely underperform indexes), and also in you.

Yes, you are irrational, too. You have heuristics and biases, but honestly, it is easier to see them in others than it is to see them in ourselves. Remember, you can be an excellent DIY Physician investor!

 

That people are—and will remain—irrational seems to be a given. Given that irrational is unpredictable, positive behavioral alpha is hard to come by.

One way to profit is to wall off your long-term investments, and don’t concern yourself with short-term volatility. Easier said than done?

So, can a DIY investor use behavioral investing to meet long-term goals? Yes! It is as easy as losing weight.

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