Behavioral Portfolio Management. C. Thomas Howard

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СКАЧАТЬ 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 with their market experiences. But it is necessary to go beyond what a majority of investors believe and examine what stock price data tell us regarding the importance of emotions in the price discovery process.

      There is considerable evidence that stock prices are driven by something other than fundamentals and that emotions play a major role. I now discuss what I believe are the two most germane research streams. The first stream deals with excess stock market volatility. Robert Shiller of Yale – 2013 Nobel laureate – highlighted excess volatility in 1981 and since then it has been hotly debated. But after 30 years of empirical efforts to explain excess volatility and thus resurrect the Efficient Markets Hypothesis, Shiller stands by his initial assertion:

      “After all the efforts to defend the efficient markets theory there is still every reason to think that, while markets are not totally crazy, they contain quite substantial noise, so substantial that it dominates the movements in the aggregate market. The efficient markets model, for the aggregate stock market, has still never been supported by any study effectively linking stock market fluctuations with subsequent fundamentals.” ^[3]

      The fact that noise, rather than fundamentals, dominates market price movements is clear evidence that Crowds dominate stock pricing.

      The Equity Premium Puzzle research stream provides additional evidence that emotions play a prominent role. The long-term equity risk premium should be associated with long-term fundamental risks. Rajnish Mehra of the University of California, Santa Barbara and 2004 Nobel laureate Edward Prescott of Arizona State University report that the US stock market has generated a risk premium averaging around 7% annually from the 1870s to the present. They argue that this premium is too large, by a factor of two or three, relative to fundamental market risk, so they coined the term Equity Premium Puzzle. ^[4] Over the last 25 years, there have been numerous attempts to find a fundamental explanation of this puzzle, but with little success.

      However, Shlomo Benartzi of UCLA and Richard Thaler of the University of Chicago provide an emotional explanation:

      “The equity premium puzzle refers to the empirical fact that stocks have outperformed bonds over the last century by a surprisingly large margin. We offer a new explanation based on two behavioral concepts. First, investors are assumed to be “loss averse,” meaning that they are distinctly more sensitive to losses than to gains. Second, even long-term investors are assumed to evaluate their portfolios frequently. We dub this combination “myopic loss aversion.” Using simulations, we find that the size of the equity premium is consistent with the previously estimated parameters of prospect theory if investors evaluate their portfolios annually.” ^[5]

      The observed 7% equity premium is thus the result of short-term loss aversion and the investor ritual of evaluating portfolio performance annually, rather than the result of fundamental risk. Putting these two results together leads to the conclusion that both stock market volatility and long-term returns are largely determined by investor emotions.

      Beyond these two emotion-driven results, numerous other pricing distortions have been uncovered. Many of these have been linked to the decision errors documented in the behavioral science literature. David Hirshleifer of the University of California, Irvine provides three organizing principles to place the price distortion phenomena into a systematic structure:

      1 People rely on heuristics because people face cognitive limitations. Owing to a shared evolutionary history, people might be predisposed to rely on the same heuristics and therefore be subject to the same biases (read Emotional Crowds).

      2 People inadvertently signal their inner states to others. This means that nature might have selected for traits such as overconfidence in order that people signal strong confidence to others.

      3 People’s judgments and decisions are subject to their own emotions as well as to their reason.

      Santa Clara University’s Hersh Shefrin, in Behavioralizing Finance, provides an excellent summary of four behavioral finance studies, including David Hirshleifer, mentioned above, along with Nicholas Barberis of Yale University and Richard Thaler; Malcolm Baker of Harvard, Richard Ruback of Harvard, and Jeffrey Wurgler of NYU; and Avanidhar Subrahmanyam of UCLA. He also presents a comprehensive list of behavioral finance articles.

      The ineffectiveness of arbitrage

      A key difference between BPM and MPT is the extent to which arbitrage is effective in eliminating stock price distortions. Research over the last 40 years has shown that arbitrage has not been able to eliminate such distortions, termed anomalies since they are inconsistent with Efficient Market СКАЧАТЬ