Behavioural finance has been talked about, urgently for at least a decade now. Many, perhaps most, professional investors now accept its central insight that flaws in human psychology and perception ensure that markets cannot be as efficient as they were once supposed to be. But until now there has been a persistent complaint. Behavioural finance may be a great idea, but you cannot make any money out of it.
That orthodoxy is now being turned on its head, along with other orthodoxies, by a cheerful career academic from Denver, who took up professional investment management only in his sixties.
Tom Howard, of AthenaInvest, is a finance professor who used to accept modern portfolio theory but was ever more impressed by the literature about behaviouralism, and started to do his own research on active fund managers.
This found, against received wisdom, that most active managers pick stocks well, and that strong performing funds could be identified in advance. Using data on managers’ holdings, Mr Howard could spot the most popular stocks among good managers and pick them in a successful portfolio. He also identified the worst picks of the worst managers, and sold them short, profitably.
As for his own fund, it has been successful. But those interested in investing in it should beware of the following. It has only ten stocks. Mr Howard does not know the names of any of the stocks he holds. And he does not know the price he paid for them.
All of this makes more sense on a second examination than it does at first. Mr Howard’s analysis of fund managers involves looking at all their holdings. Past performance is not predictive, but past behaviour does have importance.
This revealed three key traits. First, a manager must show that they have a strategy which is disciplined. Second, that strategy must be followed consistently. Finally, successful managers follow their strategy with high conviction.
That conviction shows itself in a concentrated portfolio. There is little extra diversification in adding more than about ten stocks to a portfolio. Concentrated bets have the best chance to outperform. Such a portfolio will be more volatile, but that is different from being more risky.
Note that this aptly describes Warren Buffett, who calls diversification “di-worsification”. But Mr Howard found other strategies, beyond Mr Buffett’s, that can outperform. The key is to pursue them consistently and with conviction.
These traits are most likely to be found in small and young funds, run by young managers. Once funds grow much above $1bn in assets, and the manager grows older, returns go off the boil. They have a high active share, meaning that they differ significantly from the index.
On Mr Howard’s research, some 80 per cent of active fund managers prove to be good stockpickers. But they are not so good at building portfolios. In general, they will only have a dozen or so truly good ideas, and they come unstuck when they pad out their portfolio, to reach a typical count of 100 stocks.
From 1997 to 2012, the S&P 500 averaged 6.1 per cent per year. Truly active funds managed 8.9 per cent, while a more concentrated portfolio of good managers’ best ideas made 13.9 per cent. Meanwhile, the low-conviction stocks used by poor managers to pad out their portfolios prove terrible picks that should be shorted.
Behavioural finance is gaining traction. Mr Howard may even be right that it is emerging as the dominant paradigm, following modern portfolio theory, which held sway from 1974, and before that fundamental investing, inspired by the work of Ben Graham, which emphasised careful analysis of balance sheets.
Behavioural investing is about rigid control of emotions, jettisoning the notion that risk is about volatility, or about the chance of underperforming the benchmark.
But behavioural investing is very difficult. It requires iron control of our emotions. Mr Howard takes this to what many will regard as eccentric lengths by deliberately ignoring the names of the stocks he holds. He builds up a long list, and then sweats it down to a short list without viewing the names of the stocks. This makes him immune to waves of sentiment surrounding the stock.
He also does not record the price at which he buys, because it is irrelevant. This avoids loss aversion, one of the greatest behavioural flaws; the tendency to believe that the difference between -0.5 and +0.5 per cent cent is greater than the difference between +5 and +6 per cent.
His results are great, so far. His fund has gained 66 per cent since inception in 2004, against 38.8 per cent for its benchmark, the Russell 2000.
But to achieve this, he needed such indifference towards the sentiment surrounding his holdings that he could not even remember their names. This may be a great way to make money, but few will find it easy to copy such iron self-control.