UNIVERSITY OF GLASGOW TALK JANUARY 2022

Behavioural finance is at an exciting juncture. There is no single unified theory, no integration with conventional economics, but real, practical application is now emerging. This is happening as the early behavioural focus on biases is questioned, as is the over-simplified distinction between emotion and thinking. However, classical economic theory - resting on its pillar of equilibrium to make the maths work - still survives and is taught as the core from which presumably irrational behaviour departs.

Thinking Fast and Slow

Our minds are the union of two systems.

• The intuitive and fast System 1 operates below the level of consciousness and tends toward simple tactics guided by heuristics which short circuit our intense cognitive machinery. The unaided intuition of System 1 drives us to disbelief in System 2 as a separate entity.
• The hard work of contemplation and computation of higher math depends on System 2. System 2 is lazy because invoking its power strains our brains with mental heavy lifting.

“Your subjective experience consists largely of the story that your System 2 tells itself about what is going on.”

Source: Kahneman, “Thinking, Fast and Slow”

But this sharp distinction does not fully cover all the aspects of psychology that are relevant to investment – we can learn much more. Quite apart from cognitive dissonance, there are also differences in beliefs – not just emotion but hard-wired differences in people’s view of how the world works, the logic of it. Rationality is hard to define – in a number of areas, the science is not settled. Sensible, thoughtful people expect entirely different outcomes to well-informed considered decisions. And, with most firms making decisions in groups, social behaviour matters too.

An issue I will focus on particularly here, is the role of incentives – we expect them to shape behaviour and outcomes, yet fail to understand just how precisely they can be gamed by humans. There are often unintended consequences. I prefer to view behavioural finance through the lens of the five issues I list here. Incentives explain a lot – in finance, these usually involve money.

The pareidolia slide is an example of where we try to create a pattern or narrative out of randomness. We bring a lot of previous experience and modelling to this, and these patterns are quite difficult to unsee. Similarly, for me standing upside down in the Museum of Illusions in Vilnius in Lithuania. Some of these actual problems are difficult to unsee even when we are aware of the error.

The Bristol Café Wall illusion has been stylised in this picture making it very difficult to accept that the blue lines are in fact horizontal. It will take some new frame, such as a ruler or grid to help us to see this as it is.

For our sense of scale and perspective, we rely a lot on visual cues and assumptions about vertical, horizontal and relations between objects. But there is a cue in what I have suggested about putting a ruler to the wall illusion. Sometimes the assistance of a frame or taking a different perspective can much reduce a bias. This concept of framing, the context in which we look at information or a decision – is one of the useful learnings from behavioural finance.

A key starting point for behavioural finance was loss aversion and this differs by age, context and wealth. It has proved to have useful application in wealth management and recognising that the right financial planning for one person might not suit another with different emotion on loss and risk.

Added to this challenge - interpreting what is new without drawing on unhelpful previous experience - is the difficulty of investment itself. Even the best managers find it difficult to pick a single stock and a specific timeframe. It is a noisy environment in which we are ill-equipped to understand what is statistically valid.

ECB forecasts

A noisy environment is compounded by headlines and comment that may be based on little fact or insight. And, we can see just how difficult it is for experts to make forecasts when we see the ECB inflation forecasts here in blue, that are all wrong with no apparent learning, so rooted are they to assumed correlation with money supply.

Chart period shown: 2013 - Dec. 2019.

Source: Berenberg, 31 January 2020

And company management is difficult, too. We pay attention to the social validation of reputation, but it may not be relevant. And a lot of the numbers that we must work with as analysts are not what they seem - even things that look precise, like earnings per share or organic growth. These may not be comparable between companies, or even in the same company from year-to-year.

Research points to the impact this has on pay, despite the lack of correlation with actual share price performance. That is, non-GAAP or non-IFRS measures that adjust statutory earnings (also called Alternative Performance Measures) appear not to fool analysts and markets. But they do mislead company boards who reward executives based on those adjustments.

Guest et al., “High Non-GAAP Earnings Predict Abnormally High CEO Pay”, Massachusetts Institute of Technology Sloan School of Management, May 2018.

Source: Robert Pozen et al., High Non-GAAP Earnings Predict Abnormally High CEO Pay, MIT Sloan School of Management, May 2018.

We quite often see in company or fund manager presentations, a striking graph suggesting growth. It is interesting that this graph actually comes with a narrative that dismisses the dull earlier performance as an investment phase and ignores a more recent downturn, whilst all the time making the reader forget that constant growth rates show straight lines on logarithmic paper not in the way presented here. It takes a trained eye and discipline to cut through an impression given of strong and consistent performance, so powerful are images.

Becoming a good investment analyst and manager does involve understanding the theories and techniques that are, say, in the Chartered Financial Analyst course. But applying all this in the real world and becoming a consistent high performer in the profession, is I believe greatly helped by an understanding of behavioural finance. Much of the data on which good analysis depends is inconsistent, or not truly comparable and presented along with often misleading narrative, the stories that executives and investors tell.

Anchoring & bias

• Using earnings forecasts alone creates target price forecasts that are predictive of future share price performance.
• Non-fundamental influences like 52-week highs distort the target price forecast.
• The higher the 52-week high of a stock relative to its own history, or the more optimistic investor sentiment is, the more the target price will be subject to optimism bias.
• Higher past share prices anchor analysts to higher target prices and thus to less accurate forecasts.
• Target price forecasts are useful when share prices are low and investor sentiment is subdued, but as markets climb, analyst target prices become less useful as a predictor of future share price developments.

Source: Joachim Klement, Liberum, 17.3.2024

Compounding this problem is the fact that it takes many years (22) for investment performance to be meaningful, and predictive. And even then, what it indicates is the likely longer term results, not the sort of yearly variability we actually see from good managers.

Some of the expense in the investment system, and cost to investors, results from the chopping and changing after periods of underperformance by managers. Managers who were thought good enough to invest with in the first place.

Amidst this noise and confusion, the search for meaning often focuses on narratives. Inevitably, managers with periods of underperformance must construct stories and there is good research on manager behaviour with underperformance. For some, it will mean cutting risk until a record is rebuilt. In other cases, some high profile managers wish to demonstrate that their confidence is undiminished and that they will actually make bigger bets after a tough period. Whilst intended to support a narrative of confidence and consistency, this signalling is in itself a style shift.

Richmond & Byrne, “How to deal with underperforming managers”, CFA Institute Monograph, 2013.

This concept of narratives, attempting to link events in a coherent or apparently plausible way, carries through into a lot of fund manager reporting. Often this sounds convincing, even though it may seem outrageous when dissected.

Consider how a manager here is unable to see his own conflict in making a significant investment in a major distributor promoting his fund, whilst readily able to interpret what the market might be basing a small bounce from share price lows on. Here, as with the other stories, the manager aims to underline confidence in the story, despite all that has happened, by adding to the investment.

I think there is often an intellectual arrogance in contrarianism for its own sake – something that Professor Richard Taffler of Warwick Business School highlights in his emotional finance work. A heroic struggle against adversity and unworthy opponents.

Tuckett & Taffler, “Fund Management: an emotional finance perspective”, CFA Institute Research Foundation Publications, August 2012, Vol. 2012, No. 2.

Investment managers are particularly prone to creating self serving narrative that often misunderstands conflicts and distorts information. And the “better” managers may in fact be worse in this area, given that they can be articulate in excusing failings and can also often be overconfident.

The overconfidence has led to fund failures, but more generally it can undermine learning, create oversized portfolio positions and encourage excessive trading. Professor Terrance Odean of UCLA has researched this, and identified that overconfidence and excessive trading tends to be more prevalent amongst male portfolio managers.

Sometimes it is possible to quantify confidence, or the extent to which it might be misplaced. Woodford helpfully from launch provided a lot of detail on individual holdings and performance. I captured this in mid-2017, well before there were public concerns about these funds – at which point the information was all taken down.

We can see here that the large investments intended to display confidence, being 6, 7 or 8% of the fund. This represented a huge risk budget but not adding disproportionately to performance. That is, the liquidity risk of these concentrated holdings was disproportionate - effectively there was a good case for splitting these into smaller liquid, diverse holdings.

Also of interest, is the fact that all but two of the holdings over 1.5% were in positive territory, which made me question how active price discovery was in these stocks.

Portfolio weightings: manager confidence

CF Woodford Equity Income Fund: 3 Year Perf.

Contribution % / Size of Holding % — June 30 2017

The chart compares portfolio contribution with size of holding, highlighting concentrated holdings and their contribution to performance.

Source: Fund report 2017, SVM analysis.

Overconfidence poses particular problems when managers are faced with extended periods of underperformance. I should add that underperformance for extended periods is more widespread than you might think, given how the statistics work. There is a lot of variability year-by-year even for managers with a true edge. Some of this arises from changing economic conditions. Good research has been done in this showing why managers often fail to learn from mistakes and take the wrong actions to remedy. This goes along with a defensiveness on criticism instead of learning.

There are learnings from behavioural finance that you could apply to improve performance, decision-making and forecasting. These have wider application beyond investment, being useful in many other fields.

Learning from mistakes

You can improve more by remembering and examining past mistakes than past successes. For inexperienced investors, the first lesson to learn should thus be to focus on your mistakes. Once you have learned that lesson, your learning curve becomes immediately much steeper.

211 individual investors in Hong Kong who were at least 25 years old and had various degrees of investment experience were asked if they could remember their best and their worst investment.

Researchers were more interested in how well investors recalled their worst investments.

Source: Joachim Klement, Liberum, 15.12.2020.

For those interested in improving forecasts, there is good work being done by Professor Philip Tetlock of University of Pennsylvania and his research partner Barbara Mellers in the Good Judgement Project. This shows the behaviours that separate out the better and more consistent forecasters from others. Much is to do with rigour of process and learning from errors.

There are often patterns in how managers change their engagement with colleagues and clients, or parse different periods to help clients frame what is happening.

Kahneman notes that stories tend to be judged by our perception of coherence rather than the quality of evidence. The world – and investment, in particular – is less coherent and more ambiguous than we believe.

“The world makes less sense than you think”.

“We are too easily convinced by simple vivid stories, rather than admitting our discomfort with complex abstract and often random reality”.

The investment profession needs people who can be comfortable with that ambiguity, but it may not be the way we train analysts. The intake for the profession tends to be quite deterministic and numerate in mindset.

Viewed from the outside, research in psychology seemed simply to be a growing pile of increasingly specific biases. Many of these appear to contradict – which matters more; priming or recency? It seems too much has been expected of biases – many are likely to have small effects and be very context or culture dependent. It is little wonder that this has not built a coherent substantial economic theory.

Behavioural research often points to what appears to be irrationality in people’s choices or alternative opportunities - often expressed simply in terms of expected value. Certainly, on a repeated basis, 50% chance of £2 million exceeds a 90% chance of £1 million, but a decisionmaker would need to know more about the number of repetitions.

Learnings from proportional betting strategies, such as Kelly, point us to different conclusions about rationality. This would be an example of flawed behavioural research.

Kelly criterion: referenced in the original presentation.

But for the biases that do seem persistent, some solutions have emerged. On hiring, for example, or manager selection, it is now considered good practice to have a process that involves different stages of systematic screening and data collection with separate people handling interviews.

Equity analysis typically also works best in a systematic process, although it can be challenging to gather comparative company data and to be disciplined in rejecting the spurious idiosyncratic numbers that management often push out.

In recent years, much effort and legislation has been directed to company incentives and metrics. I will not deal here with the absolute level of executive reward, but bonuses and other incentives, and consequent behaviour.

Unfortunately, most companies are still obsessed with growth, despite the low growth in the economy in general and the difficulty of measurement. And it is too easy to focus on adjusted numbers, which can become an exercise for CEOs to mark their own homework. Now, much of the focus on audit is on cost rather than quality. And auditors are responsible only to shareholders (as a body) despite the broader obligations of company boards.

Financial incentives can over time have a very big impact on shareholder value, often negative. We should remember that value creation is usually driven by more than the few executives at the top, and question how deeply and well-aligned incentives are within a business.

And, it is also worth remembering that many public and not-for-profit organisations are driven very successfully by mission-driven individuals motivated largely non-financially.

Incentives are usually taken very seriously by management and do direct behaviour. Perhaps this is to be expected when bonus can be twice salary or more - even small components of the bonus mix get attention.

Incentives & culture

Note in this recent research for Professor Shiva Rajgopal of Columbia Business School that incentives often win over culture.

• 91% of 1,348 North American executives believe culture is “important” or “very important” at their firm.
• 79% say culture is at least a Top 5 value creator.
• 92% believe improving culture will increase firm value.
• 52% indicate their firm's culture very closely tracks with their stated cultural values.

Corporate culture may be most important during times of distress.

The best way to understand culture is by conducting 5–10 interviews of former employees. Shiva argues that 5–10 interviews would produce more valuable output than a survey with 1000+ respondents.

Quotes from interviewing 20% of US market capitalization

1. “There is no one in the boardroom pointing their fists. The people on the board are for the most part, handpicked by the CEO and share his long term vision”
2. “Incentive compensation is strong motivator and driver of the behavior and ultimately if that is not aligned with culture it will change the culture”

Source: Prof Shivaram Rajgopal, co-author Corporate Culture Evidence from the Field, cited Jefferies, 21.7.2021.

While there is evidence noted in research from Robert Pozen et al, that US earnings adjustments are increasing, it appears less dramatic in the UK. The extent to which bonuses can be driven by adjusted numbers seems to be the main factor, rather than earnings smoothing.

With a tailwind from easy money, perhaps there has been little need to be concerned about funding or cash needs. Indeed, there are some general patterns on presentation of numbers for growth businesses. Analysts looking for traditional methods of earnings manipulation may miss subtle flattering of gross margins or unit economics that investors favour, and which drive high share ratings.

The trend for claw-back provisions now goes only in a very small way to bringing accountability back into a bonus package. Generally the metrics for bonuses do not address quality of earnings or service, risk, or the capital consumed by the strategy.

As Yale’s Robert Schiller commented, an obsession with growth frames our thinking and seems to derive from central bank policy. Monetary authorities have targets above zero but inflation has been so low we have forgotten to adjust for it. With bigger numbers for everything, it is easy to believe that we live in an exceptional age. Bigger GDP, larger daily swings in stockmarket indices etc.

Robert J Shiller, “Silent Inflation”, Project Syndicate, 23.11.2018.

Just as we have trouble in bringing these back to real and per capita measures – such as the lack in the West of real per capita wage growth – it stops us getting to the root of growth.

Analysts might decide that rolling out new units in a retail consumer business is not organic growth. (This is the source of a lot of our misunderstanding of consumer businesses, as unit economics tend to flatten out after 18 months and subsequently there is little inherently organic in growth of those units.)

But is raising prices of say, iPhones but selling far fewer, really sustainable organic growth? Or maintaining pricing in consumer items but trimming off a piece of the chocolate bar. We might think much the same of shrinkflation as it now hits the long established consumer staples businesses.

I think we would agree that it is not quite as good as finding more customers or actually getting those customers to buy more goods and services. I sense that stockmarkets are beginning to work out what true growth is, but there is an urgent need for boards, remuneration committees and CEOs to get the message.

In summary, the market is beginning to think more about sustainable margin and true growth rates.

The problems with growth don’t end in the listed sector. Regulation and presumed efficiency on public markets has moved many longer term investors onto alternatives, and private equity in particular.

This is a world of its own valuation metrics and often a firm belief in network effects and the winner takes all strategy of a platform business. I do find valuation of private growth businesses to be strange at times. Often the investors in a private company will re-value their investment to the level of the latest and most optimistic buyer, without it being clear what the rights attaching are.

For those entering the profession, I think it is interesting to see how investment firms are evolving. Already, many investment management firms are finding that younger analysts are bringing with them new sources of information and search tools. This has the potential to help create alpha and bring an edge back into active management.

I will finish with some salutary research. Work by Bessembinder has pointed to how narrowly performance is based.

Many investors fail to recognise these base rates; remarkably few stocks really perform but those winners could create great wealth, whilst over time it appears the majority of companies fail to perform at all or even to survive.

Without studying stockmarket history, it can be instructive to pull out a Financial Times or WSJ from 30 and 50 years’ ago and check how many of the companies in the index are still around today.

“The results in this paper imply that the returns to active stock selection can be very large, if the investor is either fortunate or skilled enough to select a concentrated portfolio containing stocks that go on to earn extreme positive returns. Of course, the key question of whether an investor can reliably identify in advance such ‘home run’ stocks, or can identify a manager with the skill to do so, remains”.

Disclaimer

This document is for information purposes only and should not be considered as an offer, investment recommendation, or solicitation to deal in any of the funds or companies mentioned and does not constitute investment research, investment recommendation or investment advice.

To the extent that it is passed on, care must be taken to ensure that it is in a form which accurately presents the information presented here. Past performance is not necessarily a guide to future performance.

Stockmarkets and currency movements may cause the value of an investment and the income from it to fall as well as rise and investors may not get back the amount originally invested.

The information and author’s opinions presented in this document have been obtained from sources believed by SVM to be reliable, however, SVM makes no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material.

Issued by SVM Asset Management Limited which is authorised and regulated by the Financial Conduct Authority.

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