It is well known that achieving above average returns on the stock market, in a consistent way, is not a simple task. At BLI, we are convinced that the premise to achieve this objective is to adhere to a stringent investment methodology and apply it rigorously. But when it comes to everyday decision-taking, things get complicated. One element especially causes problems: the human mind behind the decisions!
The illusion of efficient markets and rational investors
Our investment methodology implies buying companies with a competitive edge at an attractive price with a long-term investment horizon, by exploiting opportunities that the market offers. Financial markets are not efficient, so in a world in which passive investing and short-term trading have become more and more popular, widening distortions between company fundamentals and valuations should give rise to many stock-picking ideas.
“The investor’s chief problem, and even his worst enemy, is likely to be himself.”
Things get tricky when it comes to implementing this approach and making the right stock-picking and selling decisions. Human psychology and emotions come into play and significantly influence the decision-making process. The branch of finance that covers this subject is called “Behavioural Finance”. It proposes theories based on human psychology to explain stock market anomalies and analyses how investors are guided by cognitive biases.
Psychologists Daniel Kahneman* and Amos Tversky first introduced the notion of cognitive bias almost 50 years ago in their research paper entitled “Judgement under Uncertainty: Heuristics and Biases”. Their research has become the starting point for the development of numerous theories on decision-making processes. It is a good illustration of why, oh so often, human behaviour and everyday decisions are far from rational.
Seven sins of fund management
I had my first ‘aha’ experience on the subject of behavioural investing more than 10 years ago, after I read a collection of notes published by James Montier*, who at that time was a global equity strategist at Dresdner Kleinwort Wasserstein. Based on behavioural finance theory, Montier explored the most obvious behavioural weaknesses inherent in the investment process. He identified several common mistakes that many investment managers are prone to making and he regrouped the findings in a white paper entitled “Seven Sins of Fund Management”:
- The illusion of knowledge – more information is not better information
- Meeting companies
- Thinking you can out-smart everyone else
- Short time horizons and overtrading
- Believing everything you read
- Group decisions
Cognitive Biases affect our decisions
In order to understand why avoiding these “sins” can help you become a better manager, we have to understand the main cognitive biases that govern them.
Scientific evidence suggests that people are notoriously bad at forecasting. So why do we still put such an emphasis on it? Well, first, professional managers suffer from the overconfidence bias, the false assumption that they are superior to others. Second, in the face of uncertainty, we like the idea of having an anchoring point (anchoring bias), in this case a forecast that we can rely on, unreliable as it is. The problem is that overconfidence and anchoring biases give an illusion of control, lead to misjudgements and make it more difficult to recognise mistakes. The risk is to rely too much on forecasts by guessing what the future will hold, instead of objectively reacting to facts.
The illusion of control is strengthened by a tendency to accumulate as much information as possible, leading to the illusion of knowledge. Research shows that humans are not able to make better decisions above a certain amount of disposable information. On the contrary, while accumulating more and more information, they only increase their confidence level, which, again, leads to the problem of overconfidence. When searching for information, we also have to overcome our confirmation bias, the tendency to only consider information that confirms, while rejecting information that challenges our investment case.
Overconfidence and confirmation biases are also the reasons why meeting companies can be problematic. When meeting companies, we get the false impression of benefiting from an informational edge over other investors. We also have to fight our urge to ask questions that confirm our view of the company. Instead, we should ask hard questions that challenge our base case. But, even if we manage to ask the right questions, we still have to be able to discern truth from deception, a skill most humans lack.
The abundance of available news online, on Bloomberg, Reuters, TV or in the newspapers, is one reason why investment horizons are getting shorter and shorter. In their vain bid to out-smart others, investors accumulate as much information as possible, irrelevant as it may be. This makes them vulnerable to acting on mere noise, instead of relying on fundamental news. Short-term trading is problematic for several reasons: it has nothing to do with investing but is pure speculation, it induces costs and, most importantly, most investors are also particularly bad at it. They tend to fall into the trap of one of the most prominent cognitive biases, the disposition effect. The disposition bias relates to the tendency of investors to sell winning stocks too soon, while keeping stocks that have fallen in value for too long, with the risk of ending up with a portfolio of losers.
Emotional rollercoaster on the stock market
When it comes to group decisions, psychologists have shown that these are often the worst decisions ever made. The main reason can be found in the herding bias. Individuals tend to conform to the group rather than challenge the main opinion, as they enjoy enhanced credibility among their colleagues when their inputs are consistent with the group view. As a result, group meetings tend to reduce the variance of opinions, while raising the confidence level of the individual when it comes to the group’s decisions, once again giving way to the problem of overconfidence.
Behavioural finance at BLI
While radically steering clear of Montier’s seven sins at all times is clearly unrealistic, being aware of the cognitive biases driving them can certainly help to improve investing and decision-making processes. For several years now, BLI has collaborated with Herman Brodie, a specialist in behavioural economics and trainer for decision-makers in the finance industry. Mr. Brodie is the founding director of Prospecta Ltd. and the author of the blog “Do we really think like that?”, where he looks at everyday observations and interactions from the perspective of behavioural economics. The trainings and presentations from his side, combined with regularly reading about findings in the field of behavioural finance, have helped us reshape and fortify our approach to fund management based on behavioural finance concepts.
We avoid group decisions when it comes to buying and selling stocks. We have clear responsibilities within our different investment funds, with one fund manager being solely responsible for the investment decisions. Being located in Luxembourg, we are shielded from the buzzing and noise surrounding the global financial centres, making it easier for us to focus on our long-term investment approach. As we are aware of the risks associated with company meetings, we try to avoid the most common mistakes associated with them. When we meet companies (which is not a prerequisite to invest), it is mostly to enhance our understanding of the company’s underlying business. We prefer talking more about the current facts and the structural business drivers, than heeding their short-term forecasts.
However, the most important element in circumnavigating as many of the cognitive biases as possible, is to rely on a stringent investment process.
“We obsess with outcomes over which we have no direct control. However, we can and do control the process by which we invest.”
At BLI, we base our investment decisions on the principles of business-like investing. We invest in good businesses and don’t merely trade pieces of paper on a market. We put a lot of emphasis on identifying a company’s competitive advantage and its structural long-term growth drivers, and worry less about short-term news flow and quarterly numbers. We know that over the short term we can be right or wrong for the right or wrong reasons, but over the long term we should be right for the right reasons.
We do not focus only on stories but also on hard facts. We verify if a company’s upbeat-sounding competitive edge is underpinned by the numbers: the analysis of a company’s profitability and FCF generation are quantitative metrics that we place at the centre of our analysis. We check, based on past decisions, if company managements act according to their words and whether their past investment decisions have been wise. We are sceptical when it comes to listening to sell-side analyst recommendations and base our decisions on our own analysis and not on some enticing stories. We use sell side-analysts solely to help us gain a better understanding of the market environment and the fundamentals of the companies.
When it comes to valuation, we avoid relying on forecasting as much as possible. In its initial step, our valuation model, based on an approach pioneered by Bruce Greenwald*, a professor at Colombia University, looks at the value of the company based on current earnings and free cash flow. Comparison with the current stock price allows us to estimate how much (risky) growth is priced into the shares. It is only in the second step that the long-term growth potential of the company is estimated and an intrinsic value is calculated. This approach is quite prudent, leading to an anchor point (in this case the fair-value calculation) that is rather conservative. We prefer using this conservative anchor point based on the companies’ fundamentals as a reference, instead of relying on more arbitrary anchor points like historic stock prices or relative valuation multiples. And we only initiate positions when the current stock price offers a discount to the fair value.
Our rigorous analytical process helps us to be well prepared and committed before investing in a company. While this often means we have to wait patiently for the stock price to come down to the right level, it prevents us from having to take decisions in the heat of the moment.
Controlling my emotions
While the process of initiating positions is strongly anchored across all equity funds at BLI, each fund manager’s individual approach is predominant when it comes to weighting and selling portfolio holdings.
In the BL-Equites Japan fund, I force myself to create good portfolio diversification by fixing strict limits in terms of weightings for different types of companies (growth stocks vs. value stocks, domestic players vs. export companies). When it comes to determining the weighting of the individual positions, I have developed a quantitative model based on several objective and subjective criteria. Elements like valuation, the strength of the competitive advantage, liquidity, volatility and my sentiment about the company, are combined in order to come up with individual weightings. This quantitative approach prevents me from being dependent on a single anchoring point (thus reducing the anchoring bias) and allows me to take decisions as free from emotion as possible. It also prevents me from making big bets on individual holdings, however tempting the investment thesis and valuations might sound.
When it comes to selling stocks, things get trickier. A recent study published in August 2018, entitled “Selling fast and buying slow: heuristics and trading performance of institutional investors” shows that, while professional investors clearly display skills when it comes to buying stocks, they are very bad when it comes to sell decisions. Investors often lack sell discipline because they do not employ the same strict process as for buy decisions, making them more vulnerable to behavioural biases. For my part, I adjust my approach to selling based on different types of companies. For example, for some companies (especially companies with strong growth prospects), high valuation is never the predominant reason to sell. This helps avoid the bias of selling stocks too soon. On the other hand, I have to accept that I cannot be right all the time and that stocks can go down. When I realise that I have been wrong for fundamental reasons, I have to fight my loss-aversion bias and sell the stock at a loss, ideally before it has completely tanked.
Be different, be yourself
When it comes to trusting BLI with their money, we are aware that our clients themselves have to overcome certain biases. According to common belief, the typical asset management organisation is located in one of the world’s big financial centres and manages a lot of assets. It inspires confidence by its sheer size and its large investment teams sit close to the companies they invest in. Due to a multitude of different strategies, it always has good-performing products to promote, enabling it to strengthen its brand image based on the halo effect (a cognitive bias that boosts the overall reputation of a company based on one outstanding product). Trusting such an asset manager with your money also goes nicely with your herding bias, while abundant news flow about such a company serves your confirmation bias.
“Being different isn't a bad thing. It means you're brave enough to be yourself."
Luna Lovegood, Harry Potter and the Deathly Hallows
At BLI, we don’t fit too much into this scheme. However, we are convinced that being different and thinking differently does not prevent us from being competent fund managers. On the contrary, our small structure, our geographical location, our clear responsibilities and our stringent investment process help us achieve good performances by steering as clear as possible from the many cognitive biases that negatively impact portfolio management decisions.
* Daniel Kahneman, who was awarded the Nobel Prize in Economics in 2002, is also the publisher of the bestselling book “Thinking, Fast and Slow”, on the subject of the human mind and decision-making processes.
Another interesting read is the book “Misbehaving: The Making of Behavioural Economics”, a fascinating tale about the history of the development of behavioural economics, written by Richard Thaler. Thaler has worked closely with Kahneman and Tversky and was awarded the Nobel Prize in Economics in 2015
For those who want to read a very accessible book on the subject, I recommend “The Little Book of Behavioural Investing: How not to be your own worst enemy”, written by James Montier.
Explanations on the valuation approach mentioned in this blog can be found in the book “Value Investing: From Graham to Buffett and Beyond”, written by Bruce Greenwald.