Behavioral Finance Helps Fund Managers Spot Losers
Most of us rely on gut instincts to help us make myriad decisions throughout the day. The same goes for money managers, who often turn to their gut in the pursuit of superior returns.
"Up to 95 percent of the decisions we make every day are made by our subconscious, as life is too complicated to process one thing at a time," says Mike Ervolini, CEO of Cabot Research, a Boston-based company that has developed a mathematical model to understand and manage investment behaviors. "We have an analytic brain that does math and comparisons, and then we have a subconscious brain that decides whether we turn left or right, or pick up a fork or a spoon."
The subconscious plays a big role in financial decision making, adds Ervolini, whose company helps managers identify persistent bad tendencies that affect their performance when buying or selling stocks. Even managers with superb returns, he continues, are susceptible to emotions' effect on their decisions, such as when to buy or sell stock. Through behavioral finance, however, Cabot aims to help managers overcome these behavioral tendencies to optimize their performance.
Model Behavior
Mathematical models, of course, are not new to the investment industry. Many quantitative shops use mathematical models to guide their trading. "Their models rank all the stock in their universe, and the manager chooses which ones to buy," Ervolini comments.
The models typically indicate the top stocks that are most likely to outperform others. "But managers don't just buy the stocks ranked No. 1 or No. 2," Ervolini notes. "Someone might say, 'I really like the company ranked No. 8 -- I know its management team and their new plan, so I'm going to buy that as well.' We can help managers understand when their judgments are effective and ineffective," Ervolini contends.
According to Ervolini, behavioral finance has been around for decades. But until now it was little more than a quirky subject for discussion at conferences where an academic would demonstrate that people acted in silly ways under certain circumstances. Fund managers did not know what to do with this information, he points out.
The precipitous drop in the cost of computing power, however, has helped move behavioral finance from the halls of academia onto the trading floors of Wall Street firms, Ervolini suggests. "What we do would have been unaffordable 10 years ago," he says.
The time also was right to start zooming in on behavioral finance, Ervolini adds. "Managers were looking for the next thing to do," he asserts. "The last in a long series of analytic improvements had penetrated the marketplace -- from basic risk models to portfolio optimizers, attribution analysis and market impact analysis. Those added more performance. Then there was nothing new."
"Any system is going to have certain ways of looking at things. I subscribe to the behavioral finance theory that we do things and are constantly justifying things in our own head," Gordon continues. "So it's nice to have a mechanism to see whether there's a systematic pattern and to see whether it's getting in the way."
Melanie Rodier has worked as a print and broadcast journalist for over 10 years, covering business and finance, general news, and film trade news. Prior to joining Wall Street & Technology in April 2007, Melanie lived in Paris, where she worked for the International Herald ... View Full Bio
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