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Thursday, July 22, 2010

Can You Make Money Using Behavioral Finance ?

I am a big fan of behavioral finance. I think it is an essential antidote to the rigid efficient/rational market thesis. The whole debate is outlined brilliantly and without a single equation in Justin Fox's book The Myth of the Rational Market. In my work as an advisor and in my personal investing it is extremely useful to use the insights of the approach that incorporates psychology into investing in performing "behavioral therapy" on my clients and myself to prevent the well known traps that investors fall inot which are so well described by Daniel Kahneman and those that followed in his footsteps.

On the other hand I have great sympathy for those that have criticized behavioral finance as having many interesting 'stories" but no overarching theory. As a correlate they point out that behavioral finance doesnt identify any particular anomalies that can be systematically exploited for a profit. The market may not be rational, it may be subject to bubbles and busts where price is not equal to value. But it remains what is called 'weak form efficient" there are no systematic ways to consistently bear the market.

In light of that I found this article from the FT about a fund that is trying to put the insights of behavioral finance to work in an investing strategy quite interesting. My bolds, my comments in blue.

Decoding the psychology of trading

By James Mackintosh
Published: July 16 2010 20:28 | Last updated: July 16 2010 20:28
Before you even started reading this article, it had already been electronically scanned and its language examined by dozens of computers at hedge funds and investment banks.
At MarketPsy Capital in Santa Monica, California, remote servers will have rated how positive or negative it is on the economy and checked for emotional content on thousands of companies. Finding nothing useful, the computers will then move on.
From the tens of thousands of newspaper articles, blogs, corporate presentations and Twitter messages being analysed every day, MarketPsy builds a picture of investor feelings about 6,000 companies. When emotions are running high, the hedge fund steps in and trades.
MarketPsy is tiny by hedge fund standards, but it is at the cutting edge of behavioural finance, the intellectual offspring of psychology and economics.
Like others focused on behaviour, MarketPsy has long since discarded the idea that investors are rational, and tries instead to judge exactly how irrational they are. The answer is simple to explain, if hard to implement: two standard deviations of moves in its measures of emotion is a strong trading signal. When people are deeply gloomy about a stock, it is time to buy; when they are raving about its brilliance, sell....

Anybody who does behavioural finance will tell you they buy when people are overly pessimistic [and so the price is low],
 I would disagree with this. As is mentioned in the article below those that believe in behavioral finance believes that markets overshoot and that there is a momentum factor in the market. That momentum factor has been well documented in academic research. It is also a basic element of technical analysis, long dismissed by academics but now given more respect by some of them including the well respected Andrew Lo of MIT. When a technical analyst is trading based on a price crossing the 200 day moving average he is trading based on momentum. And whether the  technician explicitly acknowledges it or not believe in momentum in markets is part of behavioral finance.

Not surprisingly the use of behavioral finance has a mixed reccord in creating alpha:

The strategy worked beautifully through the crisis, returning about 45 per cent in its first 12 months, and 30 per cent last year. This year it has lost money, after getting caught the wrong side of short squeezes in biotech companies (as a result it no longer trades biotech, with Dr Peterson concluding there is too much insider information in the sector).
I have the sneaking suspicion that in the future there will be another type of stock that doesn't peform as hoped and another post facto reason, After all was it that there is too much insider information on biotech stocks as a group or was there something unique to biotech stocks in 2010 or to a couple of individual biotech stocks that created particularly large losses.
Furthermore it already seems that whatever "alpha" existed related to the behavioral strategy is extremely difficult to catch on an ongoing basis:
More seriously, the number of trading ideas has shrunk 40 per cent, as day traders give up and chatter on web sites plunges. “There’s probably emotional exhaustion,” Dr Peterson says. “The people who are still trading are a lot more savvy than they used to be.”
Still, the public has woken up to the failure of the efficient market hypothesis, and behavioural finance is an obvious beneficiary....
It is results such as this that have persuaded the biggest names in investing that they need to pay close attention to the theories behind market psychology.
Mohamed El-Erian, co-chief executive of Pimco, one of the world’s largest fund managers, reels off technical terms from the language of behavioural finance to explain market moves,....
Pimco uses behavioural explanations to help understand markets, and also as a structure to try to avoid being caught up in the type of irrational investing the academics have documented.
Yet behavioural finance has plenty of critics. It doesn’t, they note, provide an intellectual framework for its findings. Even Prof Ariely agrees that “behavioural economics is a collection of facts, not a complete theory”.

Here is the crux of the paradox of integrating behavioral finance into aninvesting strategy:
For investors, many fund managers who use behavioural approaches end up with much the same bets as traditional “value” or “momentum” managers, who exploit anomalies in markets identified decades ago.
Christopher Blum, chief investment officer for behavioural finance at JPMorgan, the US bank, admits that there may be overlap in trades driven by psychology and those driven by value or momentum. The difference is that behavioural finance investors understand why their trades work, he says. “Behavioural finance is really an explanation of why markets behave the way they do and why they are inefficient.”......
Andrew Feldstein, chief executive of BlueMountain Capital, a New York hedge fund, agrees. “When you can explain [price distortions] in terms of psychology it gives you much more comfort in taking advantage of opportunities,” he says.
Of course, followers of traditional academic finance also had an explanation, at least for the outperformance of value stocks, those that have been beaten down in price: they are higher risk, and so provide higher returns.
 The above summarizes the intellectual debate brilliantly. Researchers led by Eugene Fama and Ken French for years have presented data related to the outperformance of  value and especially small value stocks. Despite the fact that many of the traditional risk measures did not show these stocks to be riskier Fama a hard core efficient markets proponent insisted that other risk factors accounted for the outperformace. Withoug reconstructing the entire debate others argued the anomaly was due to behavioral factos. In a more recent paper Fama has reluctantly acknowledged that not all market participants may be profit mazimizers hence price my deviate from value in some stocks. (Justin Fox goes through all of this material extremely well)

 As I noted academics have long noted a short term momentum factor in stocks which could not be explained other than by incorporating concepts of behavioral finance.

The fact that we know that value strategies can be profitable and that there is a momentum factor creates the paradox that we know a priori how difficult it is to make money based on behavioral finance.

  • The insight with regard to markets overshooting that leads to profitability of value strategies. Would lead the behavioral trader to sell stocks that have had large increases in price relative to earnings or book value and sell those that have fallen in price.

  • The existence of momentum means that stocks can continue to be "over" or "under" valued for significant periods of time. As Keynes noted "the market can be wrong longer than you can hold onto your position". Of course once leverage and shorting is involved this is particularly true. And momentum can turn extremely quickly there is no consistent way to exploit the momentum factor.
The proof of the difficulty of profiting from these factors can be seen in the wide swings in profitability of hedge funds which make consistent use of momentum and shorting of "overvalued " trades.

So as a firm believer in behavioral finance how do I use it in my investment management process ?

  •  I do find the evidence of a long term outperformance of value stocks. Rather than trying to pick value stocks or managers however I make use of etfs based on a value strategy giving a value "tilt" to a portfolio.
  • Markets are subject to bubbles and busts even if they can't easily be predicted. The instruments available to "buy volatility" like the VXX and VXZ etns can be incorporated into a portfolio to hedge against this.
  • Pointing out to myself and my clients when we are falling into the well known behavioral finance pitfalls can be as important to investment success as any other factor.
I would certainly agree with this (below) the fund management industry has found a new buzzword ("absolute return" is so 2008). No doubt we will soon see the marketing blitz of behavioral finance funds with fat fees. My advice would be to buy some cheap value etfs instead

One thing behavioural finance academics did not have to discover was that the finance industry jumps on any new trend. So it should be no surprise that many fund managers have been rebranding their business as based on the discipline. “It has been co-opted as a marketing gimmick,” Dr Peterson laments. That behaviour, at least, was entirely predictable.


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