How fund managers profit from investor biases

The three-person panel, moderated by Michael Keaveney, head of investment management at Morningstar Associates Inc. in Toronto, also included professional money managers Craig Basinger, chief investment officer and portfolio manager at Richardson GMP Asset Management, and David Wong, managing director, investment-management research, at CIBC Asset Management Inc.

"Over time, you realize that a lot of mistakes that investors make are not errors based on factual information -- as there's a fairly level playing field when it comes to access to information," said Wong. "Many mistakes are actually based on behavioural aspects such as overconfidence, and can therefore be corrected using behavioural concepts."

For example, he said, in an "infinitely complex" world it's important to think in terms of probabilities rather than certainties. Portfolio managers should be able to admit when explaining an investment thesis that there is usually an element of doubt or possibility of change, instead of asserting certainty that a scenario will unfold in a particular way. Stock pickers must continually ask the "tough questions" and update their conclusions.

"Best practice would be to think probabilistically, to continue to take in information and to frequently update the probabilities," Wong said. "If necessary, recalibrate your forecast." He suggested that the work culture for investment managers should encourage the admission of mistakes and use mistakes as a foundation for continued learning.

Most of the time when professionals decide to sell a stock from a portfolio the publicly disclosed reason given by the fund manager is that the stocks met their price targets, a better idea came along or the corporate fundamentals changed, Wong said. But in many cases, he said, the original buy decision was wrong, and the key is to admit it and get out early.

"It takes humility to admit you're wrong and it's seen as a weakness," said Wong. "But it's important to get out in time and skew the portfolio to the positive side."

Kaplan said the "value effect" of behavioural finance is that the prices of companies that are perceived as glamorous can be driven to irrational highs by positive or greedy investors, and unloved companies can be squashed or ignored. Securities can surge in popularity well beyond their worth, then crash when the mood changes.

"Investors can be drawn to particular securities simply because the companies that issue them elicit an emotional response," Kaplan said. "What investors are doing in these situations is short-cutting the analysis, and just deciding that they like certain companies, or the opposite, that they don't like them."

Basinger said investors are particularly vulnerable to "recency bias," which means they assume a particular stock or even the overall market will continue to display recent positive or negative price momentum. One of his techniques for taking advantage of this bias is to study the rankings that analysts have given a stock, and then do further investigative work on companies with few "buy" recommendations.

"Stocks with a high number of buy ratings tend to underperform those with fewer," Basinger said. "With highly recommended companies, the good news is already out there, and is reflected in the price. If you look at unloved companies with no buy rating, once they are upgraded from a sell or a hold there can be a reversion to the mean and the stock performs well."

The problem, he said, is that many investors are more comfortable buying a stock with 10 buy recommendations than one with three. "There is safety in following the herd and sticking with consensus," he said. "But the best returns in the market are not made by people who stick with the herd."

Basinger is the sub-advisor to Redwood Behavioural Opportunities (BHAV), an exchange-traded fund that was launched in January. The fund's mandate is to identify and capitalize upon market inefficiencies caused by irrational and emotional investor behaviour.

"A big source of mispriced assets is investor behaviour," Basinger said. "Emotions get the better of people. If you realize how the market is impacted by these behaviours, you can make money off those emotional mistakes."

Wong said it's important to be aware that senior executives within a company may have their own biases as well, and he is wary of the impact of a rosy forecast or persuasive personality when doing his investment research.

"Don't ignore other things that can be predictive," Wong said. "We all think we can ask the 'silver bullet' question and may ignore the checklist. It's important to look at information gathering as a mosaic, and the manager interview is just one piece. It's also important to realize that even screens and factor-based approaches can have biases built in."

The panellists alluded to evidence presented in studies by Boston-based Dalbar Inc., Morningstar and others that consistently shows the individual returns of retail mutual-fund investors on average have underperformed the long-term returns of the funds they own due to poor timing decisions on purchases and sales.

"Fear manifests in a practical way on Main Street," Wong said. "People 'buy high' due to a fear of missing out, and 'sell low' due to fear of loss, and their individual investment returns are typically lower than the long-term returns of the funds. This behaviour doesn't just apply to equities, it also spans fixed income and managed portfolios."

There is an important role that financial advisors can play in providing behaviour coaching to clients to help protect them from their own impulses and thereby improve their outcomes. A key component of helping clients is an accurate assessment of their risk tolerance, Kaplan said, and appropriate asset allocation.

"We have realized that client risk-tolerance questionnaires are not such a straightforward exercise," he said. "The same question, but worded differently, can elicit different responses from the client."

Kaplan said framing is important when developing questions to assess the needs and preferences of clients. Sometimes the same question should be asked more than once but in different ways to get an accurate picture of the investor's true risk tolerance and behavioural tendencies.