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Behavioral Finance

 

Behavioral Finance was coined by Professor Daniel Kahneman who was awarded the Nobel Prize in Economics in 2002 for having: "integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty".

 

Behavioral Finance helps understand why under-performers inefficient behavior may lead equity markets to show pockets of anomaly. This, in turn, represents a boon to the rational active investor seeking to outperform its peers.

 

EQUITY GPS expert-system aims at identifying objectively when and to which extent structural underperformers drive stock prices to anomalous levels, using 4 axes of objective analysis: 

  • Valuation
  • Outlook dynamics
  • Wide coverage
  • Daily re-assessment

 

  • Valuation: Benjamin Graham seminal intuitions that value investing delivers performance over the medium term, while obviously correct, did not go the extent of why that is the case. He invented a fictional character, “Mr Market”, and plainly suggested he was a structural underperformer offering fantastic opportunies to rational investors by foolishly offering them to sell very cheap and buy very high. Behavioral Finance identified 50 years later why and how gregarious instincts litterally force underperforming market participants into behaving like "Mr Market".
    EQUITY GPS ratings are calculated using a 50% weighting for 8 objective valuation criteria. Cheap stocks will carry high EQUITY GPS Valuation subscores while expensive stocks will score low, ceteris paribus.
     
  • Outlook Dynamics: academic and empirical research conducted at EQUITY GPS suggest that outlook dynamics is important in assessing the future performance potential of a stock, and many “momentum” investors do use this pattern in managing their portfolio. This pattern actually works because structural underperformers tend to be subject to selective hearing and selective memory. So they will not change their minds quickly enough about a specific situation. This is further complicated when decision making involves a group of persons : even rational people working together can lead to irrational decision-making processes, whether too slow, vague, or non-explicit. Slow investors will only react after some time to an objective, meaningful change in a situation. Their lagged buying and selling activity provide much seeked-alpha to more agile players who have realized sooner that something was happening and who acted before the slower, less efficient players.
    EQUITY GPS ratings are calculated using a 50% weighting for 7 outlook dynamics criteria. When an inflexion point of sufficient magnitude happens on the financial perspectives of a given company, it is immediately reflected in its next-day’s EQUITY GPS rating. Investors are thus warned in an objective, focused and timely manner that it may be worth prioritising some of their time to review a specific situation that is potentially ahead of significant price action.
     
  • Familiarity bias causes structural underperformance by limiting one’s universe of choice, thus reducing the probability, the number, as well as the attractiveness of potentially interesting encounters. Behavioral Finance has shown that investors tend to shy away from situations they feel uncomfortable with, and over-represent in a portfolio stocks which they can relate with (country, sector, region, ...) . Although explicit specialisation on a narrow universe of stocks can provide an hedge in terms of know-how, the involuntary restriction on the “usual suspects” in terms of stock selection is a cause for structural underperformance especially, after adjusting for risk. 
    EQUITY GPS covers 6 000 stocks worldwide, which encompass 85% of the world’s market cap. Provided a stock belongs to an investor’s investment universe, it will show up in the daily reports he or she receives if something worth drilling into happens. 

     
  • Regret aversion is another root cause for structural underperformance. It describes the aversion, for instance, to sell a “loser” in a portfolio, for all kinds of bad pretexts. As Behavioral Finance suggested, this aversion comes from the fact negating oneself provokes a very uneasy feeling if not controlled. Portfolio management is not a science. The most successful investors do accept with no hurt feelings that they are necessarily often wrong, while the structural underperformers tend to succumb to regret aversion. 
    A sports comparison comes to mind: the very top professional tennis players, hugely successful in their careers in systematically outperforming their peers, have won a considerable 85% of all their matches since they turned pro. To achieve this kind of dominance, they "only" have won 53% of all points involved in any given match, and they have been "wrong" or "beaten" ... 47% of the cases.
    EQUITY GPS helps investors focus on the best potential stocks “for the future” by recalculating ratings afresh on a daily basis in a fully objective manner. Stocks regularly come in and out of our top and bottom deciles or centiles : this is precisely what we designed our model to provide.  

 

 
Last update : 31/03/2016