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June 1, 2007 5:14 pm

Avoiding bad habits in investing

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We all have some bad habits. When they affect our investing, they can lose us money.

These are commonsense insights, and they lie behind the burgeoning subject of behavioural finance. This is the discipline that does away with economists’ assumption that decisions are taken rationally and, instead, substitutes findings from experimental psychology into how decisions are actually made.

This can help to explain market bubbles and panics. Investors in the aggregate, academic research has shown, tend to be excessively averse to losses, to overestimate their gains, and to be subject to “groupthink”. At the individual level, many investors use heuristics, or rules of thumb, when it appears that they are taking more rational decisions. These heuristics can be fallible.

All of this casts light on why markets work as they do. But how to make money out of it?

Until now, the most obvious way to apply behaviourist insights has been through rigorously quantitative portfolio management, using computers. Set the parameters for a computer in advance, and it will not be subject to the same flaws in reasoning that afflict mere humans.

Now there is a more ambitious attempt. Cabot Research, a Boston-based start-up consultancy, offers a new service to fund managers – it will go through the books, rigorously analyse portfolios, and find bad behavioural habits. Then it will even prompt managers every time they are about to fall a victim to those bad habits once more.

Michael Ervolini, the group’s founder, says that three to five years of portfolio data can isolate specific patterns in decision-making. “We can identify behaviours, and these behaviours by and large have nothing to do specifically with your strategy or style. They are just heuristics you have developed over time.”

He makes clear that the group’s methods “respect your style”. They will not tell growth managers that they need to change to value – merely that they are falling into behavioural traps. It is easy to fall into bad decision-making habits without realising it because, according to Ervolini, “95 per cent of decisions are made unconsciously”.

Questions Cabot might ask include: “Does your buying change when you are above or below your benchmark?” Or: “Do you sell winners differently from losers?”

The latter revealed a problem with a small-cap fund that volunteered for beta-testing. It comfortably beat its benchmark. But close analysis showed that although the average time it held a stock was three years, “winners” tended to be sold more quickly than this.

According to Ervolini, this was a “classic disposition effect” – the academic tag for the frequently observed phenomenon that investors are much more reluctant to sell “losers” than “winners”. The psychology behind this is easy enough to explain: selling a loser involves admitting to a mistake, while selling a winner means that you quit while you are ahead.

Cabot’s solution is to provide automated prompts. Once any stock is showing strong gains before the average three-year holding period is up, managers receive messages discouraging them from selling. “We simply discourage selling them,” says Ervolini. “It doesn’t mean you can’t sell it. But it’s a little prompt to overcome the conditioned behavioural reason for selling it. We believe that fund managers are very smart, but they’ve never been able to manage behaviours before.”

Ingrained behaviours can be good. But the idea, which Cabot says its analytical methods can achieve, is to separate the effects of discipline from the behavioural.

Ervolini cites the common habit of “feeding winners”. As he puts it: “You buy the stock at $20 and it goes to $24, and that makes you feel good. And then you think it would make you feel even better if you had twice as much capital devoted to that stock, so you buy more.”

This is a decision based on a human emotion, or behavioural heuristic, even if the manager taking that decision believes it is a disciplined and rational move. It is possible to make the same decision rationally.

In another case, a fund manager had suffered during the dotcom blow-out. The manager had a corporate habit of selling its losers quickly, and the firm wanted to know if it was pulling the trigger too quickly.

But Cabot’s research found that it was selling losers efficiently and rationally. Instead, it had a quite different bad habit, of holding successful stocks for too long.

This was an understandable mistake. After holding several eye-catching “busts”, it felt good to show clients a number of well-known “winners” in the portfolio. But this had come to be like window-dressing. The cost of this habit was to diminish returns by about 1.25 percentage points a year.

For now the service is available only for US equities, but international equities, and probably long/short strategies will follow. Maybe such a service will at some point be made available to retail investors. Paying someone to observe your bad habits is a tad unnerving, but the potential is obvious.

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