According to the “efficient market hypothesis” (EMH), stock markets are efficient and market prices reflect all available information and are based on rational foundations, like the fundamental financial health and performance of a company. But many studies of financial markets historical developments have shown that many phenomena cannot be captured plausibly in models based on perfect investor rationality (such as bubbles or the fact that many investors – of whom Warren Buffet or Georges Soros – consistently beat the market for very long period). A new model has then emerged proposing psychology-based theories to explain stock market anomalies: Behavioral Finance. These researches have been awarded by three Nobel prizes in Economic Sciences in 15 years, including R. Thalers’ one in 2017.
Fields of application in finance
Thus, individual (personal logic, emotion interferences…) and collective bias could explain many market inefficiencies. The purpose of Behavioral Finance is to identify and understand why people make certain financial choices. Understand human behavior is crucial for investors because the ways bias operates in thought processes can often be predicted. Most important of all, the methods and means to counteract biases are becoming more sophisticated and effective. New client tools and investment opportunities given to investors have begun to emerge with the help of digital technology.
Enhancing investment process
- Financial markets developments forecasting
Big Data and Artificial Intelligence make it possible to analyze markets not only in a quantitative approach but also in terms of “market sentiment”, scanning articles, analysts’ opinions, social networks, etc. Beyond early signals detection of a mindset shift, Behavioral Financial tools can detect when markets deviate from their fundamental ratios, giving the opportunity to investors to surf on the wave… or let it flow and anticipate its break point.
See article: HowAI disrupts research in AM? In DigiBook #9
- Portfolio construction and monitoring
Investment managers are seeking a competitive edge and —even more important— to improve the value proposition of active management. Behavioral price distortions are essential to successful active management. For instance, investor preferences on risk are asymmetric, with steeper downside risk intolerance. Furthermore, investors are seemingly unable to contemplate accurately differences in portfolio time horizons where they are greater than a year. This could be considered to build portfolios or calibrate portfolio insurance. The knowledge of investment biases is also helpful in counteracting natural tendencies such as “familiarity bias” which push portfolio managers to prefer local equities and, so, mismanage the risk.
Some Asset Managers have already started to apply behavioral economics to portfolio construction, such as BBVA AM, JPMorgan AM, Wells Fargo, Sterling Capital or Degroof Petercam AM.
Consequently, behavioral scientists and business leaders and Fintechs have developed methods for “de-biasing” asset-management decision making.
McKinsey proposes techniques and programs to reinforce informed and well-reasoned decision making. It affirms that, even under conservative assumptions, debiasing will allow funds to undo negative impact and reap the performance rewards. In looking at actual funds, it sees potential potential improvements of “between 100 and 300 basis points” [1].
Another example: Essentia Analytics– which is among the 5 Fintechs recently selected by UK trade body The Investment Association (IA) for their abilities to be an “accelerator” for asset management – harnesses behavioral data analytics with human consulting to help fund managers measurably improve investment decision-making.
Behavioral funds offering
Behavioral funds seek to take advantage of pricing anomalies that may exist in the continuum between rational investors and irrational investors by tracking their sentiment and decision-making. Their investment strategies generally pursue the following themes:
- Finding irrational biases in the market, which may exaggerate the impact of negative news-beating the stock prices to much deeper levels (for low-cost buying opportunities), or overplay the impact of positive news by pumping the stock prices to higher levels (for high-cost short selling opportunities)
- Identifying stocks temporarily having lower/higher than expected indicators (like price-to-earnings ratio). Comparing these against other fundamentals, like a company’s credit risk and valuations, may indicate better investment picks in a timely manner
- Investing in stocks that may have temporarily underperformed relative to the overall market based on irrational exuberance, but continue to have strong fundamentals
- Picking stocks based on other potential developments leading to profitable opportunities, like from an expected share buy-back or stock split.
JPMorgan AM is one of the most active in launching behavioral funds, with the “Intrepid” range ($7.6bn of AuM) for large and mid-cap values and the Undiscovered Managers Behavioral Value Fund ($6bn) for small caps. This latest fund seeks to capitalize on behavioral biases that may cause the market to overreact to old, negative information or underreact to new, positive information on a company. It is sub-advised by Fuller & Thaler AM, a pioneer in the application of behavioral finance, managing $9bn, with as principals… two Nobel prize winners in Behavioral Finance: R.Thaler (2017) and D. Kahneman (2002)!
We can also mention Athena Global Tactical ETFs, which portfolio utilizes patented behavioral market indicators to gauge expected returns and select broad market-exposure ETFs among various equity markets or cash each month. It is rated 5 stars by Morningstar in the Tactical Allocation category and ranked #1 out of 224 funds over 5 years at the end of June 2018.
What about performance?
Due to the narrowness of behavioral funds and a record 10 year-bull market, it is not clear whether behavioral funds using such strategies have outperformed the market. However, some signs suggest that including behavioral finance in investment process could bring value in active management:
- Most of behavioral funds are rated from 3 to 5 stars by Morningstar
- The BUZZ NextGen AI US Sentiment Leaders Index™, created by an index provider, BUZZ indexes, and which identifies the 75 large cap US stocks which exhibit the highest degree of positive investor sentiment and bullish perception, outperformed the S&P 500 index over the last 5 years. The insights are statistically derived using machine learning and artificial intelligence analysis techniques applied to millions of unique stock-specific data points. Content is aggregated from online sources including social media, news articles, blog posts and other alternative datasets. The data is filtered through an analytics model which utilizes Natural Language Processing Algorithms and Artificial Intelligence Applications and translates the results into actionable investment insights.
Maybe to confirm its promises, this Nobel-awarded thesis needs to experience nonlinear and more volatile market. The time for asset managers to learn about their own biases.
Personal finance investing services
Beyond usage for their own needs, Behavioral Finance could give asset managers the opportunity of developing new services for their clients, advisors and individuals. The purpose is to help them identify investors biases and take them into account and compensate them to optimize their investment decisions.
- Educational platform: the identification of behavioral biases
Schroders has launched an interactive website – InvestIQ – that uses behavioral finance to engage more closely with retail investors. The InvestIQ site provides a test that generates a personalized report detailing an individual’s investment character and behavioral traits, as well as tips on how to manage them. The site has already been launched in the UK and Continental Europe (Italy, the Netherlands, Portugal, Spain, Sweden).
Capital.com – a trading platform – has launched a specific AI-powered function that provides investors with tailored content based on behavioral analysis: SmartFeed. Analyzing this data, the app identifies the cognitive biases that seem to influence the trader’s behavior, alerts the trader about them and provides him with analytics and relevant educational content to fix the biases.
B*Capital, the trading-specialized subsidiary of BNP Paribas Private Banking, proposes a mobile app dedicated to behavioral finance, called B*Fi. It proposes investors a quick questionnaire to define the typical investor profile, based on reactions to market movements and natural trends. The solution also provides its users with educational videos to help them better understand these biases.
- Customized experience: proposing bespoke advice
Robo-advisors are obviously at the forefront of personalized approach. At Betterment, there is a “behavioral finance and investing” department comprising five experts focusing on how to improve their system’s investment advice and “behavioral design”— trying to ensure that its customers display rational economic behaviors with their investments. For example, the company’s algorithms attempt to discourage such irrational behaviors as active trading and market timing.
Vanguard Personal Advisor also exploits the results of the Vanguard’s Center for Investor Research (CIR) which studies individual investors behavior and how they make their decisions exploiting its databases and digital capabilities (see article about Vanguard Innovation Center).
Beyond D2C services, some asset managers and FinTech have developed B2B services providing advisers with digital tools that assess client behaviors and financial knowledge, in the aim of giving bespoke advice. Thus, the Schroders InvestIQ test also targets advisers to help them build a comprehensive view of their clients and propose asset allocation portfolios to match the investment characters revealed.
Advisor Software Incorporated employs a tool named Behavioral IQ, that gives client’s risk scoring and investment profile, based on behavioral science. Financial DNA, in partnership with Schwab Intelligent Technologies, provides solutions to Goals-Based Financial Planner with a “financial personality”.
United Capital for its part proposes a platform for advisers that incorporates applications (Money Mind® analyzer) that probe clients' views about money and the deeper reasons behind how they prioritize goals. Advisers using this “FinLife Partners” tool declare that they have found knowing more about their clients, have strengthened their connections to clients and have helped them grow revenue.
- Trading recommendations: anticipate share prices evolution
De-biasing individual investment behaviors is an answer to assist clients in making investment decisions. But the choice of equities to put in portfolios is another question that investors have to face off. As we have seen before, market fundamental ratios are insufficient to explain and anticipate movements. It is the same for each equity and “stock sentiment” could be an early warning of potential value move.
Fidelity Investments for example provides a measure of the social media sentiment (the S-Score) about an equity and gives investment recommendations on the basis of this indicator.
An embedded value
Richard Thaler have suggested that behavioral finance will become sufficiently established to become mainstream. At this stage, all finance will be behavioral and behavioral ideas will be well embedded in the investment and financial planning processes.
Furthermore, this approach allows to build more customized experience of investing, which is one of the attempts of Millennials and younger investors, who want to feel more part of the decision-making process. It also allows to draw a client’s total wealth picture and constitute a valuable advisor tool to give a “frame” of long-term goals investment in portfolio discussions.
"Behavioral finance tries to balance giving you what you want without sacrificing what's good for you.” (CEO of United Capital)
Author: Pascal Buisson - November 2018
[1] An analytics approach to debiasing asset management decisions - McKinsey – Dec. 2017
