are self-healing in that negative returns are more than offset by matching positive returns within the distribution. Investor patience is rewarded by this self-healing feature. (See Chapter 8.)
Among active equity mutual fund managers, style drift is part and parcel of superior performance. Without style drift, a manager cannot produce superior investment returns. The ill-conceived, leaderless stampede that is the style grid is a major contributor to active equity underperformance. The consistent pursuit of a narrowly-defined equity strategy, while taking high-conviction positions, produces both superior performance and style drift. (See Chapter 9.)
In the pantheon of investment virtues, diversification is right up there. It is so widely accepted that nary an objection is raised against it. I feel much differently and, in fact, I believe there are very few situations in which diversification makes sense. It is akin to bubble wrapping your portfolio. (See Chapter 10.)
While emotions are part and parcel of human nature, responding to gut-wrenching volatility by exiting the stock market hurts both short-term and long-term portfolio performance. At the very least, clients should stay the course in the face of rising volatility, and maybe even increase equity exposure. In short, they should avoid falling into the Volatility Trap. (See Chapter 11.)
It is important to distinguish between emotions and investment risk so that good decisions are made. Most currently used measures of risk are really measures of emotion. As it stands, finance academics have almost nothing meaningful to say about measuring true investment risk. (See Chapter 12.)
When building a successful strategy, it is necessary to identify a limited number of behavioral factors upon which to focus. Superior portfolios are created by consistently pursuing a narrowly-defined investment strategy while taking high-conviction positions. What matters in executing a strategy is not consistent returns and not a consistent set of stock characteristics such as market cap and PE, but rather the consistent pursuit of the strategy. (See Chapter 13.)
Stock picking skill is common among active equity mutual funds. Much of that skill resides among buy-side analysts with portfolio managers displaying less skill. Best and worst stocks are identified using the relative holdings of active equity managers. (See Chapter 14.)
Superior performance is driven by the consistent pursuit of a narrowly-defined strategy, while investing in a small number of high-conviction positions that have been identified based on a small set of measurable and persistent behavioral price distortions. (See Chapter 15.)
Dividends provide valuable information regarding future company performance and, as a result, stock performance, while at the same time providing signals about future volatility. These are good reasons to consider dividends when analyzing, buying and selling stocks, and dividends should play a prominent role in an equity strategy. (See Chapter 16.)
The best markets are identified by means of deep behavioral currents in contrast to trying to time the choppiness on the surface. The goal is to uncover behavioral measures that are predictive of expected market returns. The resulting expected market returns are then used for executing a behavioral market timing strategy. (See Chapter 17.)
Behavioral price distortions will persist for a very long time. Throughout my career, my professional colleagues attempted to explain the anomalies bedeviling the EMH, but things have only gotten worse, with more anomalies than ever. So I’ve decided to be the student picking up the $100 bill on the sidewalk and not the professor spouting the rationality model. (See Chapter 18.)
Chapter 1: Behavioral Portfolio Management
On the first day of my securities class, I would lay out a $1, $5, $20 and $100 bill on the front table. I would then ask the class which they would choose. I got puzzled looks from the students, wondering whether this was some kind of trick or whether I had lost my marbles.
After some assurances from me, they all agreed that they would pick the $100 dollar bill. I then explained that the four bills represented the expected payoff on four different investments, with the same holding period and equal initial investments. Not surprisingly, they all again chose the $100 investment.
I further explained that each of the four investments represented somewhat different levels of risk, with the $100 investment the least risky (this last point being contrary to conventional wisdom, as I explain further in Chapter 12). But the real difference across the four investments was that there was considerably more emotion associated with the ever larger payoffs. Now the choice was not so clear. It was obvious that they were trying to conduct some sort of return, risk, emotion trade-off.
The four investments are proxies for choices typically available to investors. The $1 bill represents an investment in default-free treasury bills, the $5 bill an investment in bonds, the $20 bill an investment in the stock market, and the $100 bill an investment in an active equity portfolio earning an excess return. The payoffs roughly capture the relationship of ending values for each of these investments over a long time period, say 30 years.
I then challenged the students by stating that over their investment lifetimes few will choose the $20 investment and a countable, small number will choose the $100 investment. Instead, most will build portfolios heavily made up of $1 and $5 investments. They will do this because they apply emotional brakes during the investment process and, what is worse, will be encouraged to do so by the emotion enablers that currently dominate the investment industry.
Consequently the typical investor leaves hundreds of thousands if not millions of dollars on the table during their investing lifetime, because they aren’t able to release their emotional brakes and the industry does little to encourage them to do otherwise.
The triumph of reality over rationality
Consider the following allegory:
The finance professor and his student are walking to lunch one day and come upon a $100 bill lying on the sidewalk. The student leans over to pick it up but is restrained by the professor with the admonition “Do not bother to try to pick it up, for if it were real, it would have already been scooped up. So our eyes must be playing tricks on us.” The student responds “With all due respect professor, I do not believe in your rationality model,” then leans over to pick up the bill and stuffs it into his pocket.
Ten years ago I was the professor and now I’m the student picking up the $100 bill and stuffing it in my clients’ pockets.
Behavioral Portfolio Management (BPM) is set in a world in which prices rarely reflect underlying fundamentals – instead they are driven by emotional crowds who are unable or unwilling to release their emotional brakes. BPM focuses on how investors, advisors and asset managers can go about releasing their own emotional brakes and harnessing the behavioral price distortions uncovered by means of careful research.
BPM is based on my research and the research of other behavioral and finance academics, as well as my experience in managing active equity portfolios. Along the way, BPM rejects the rationality-based concepts and methods of Modern Portfolio Theory, the primary tools used by those industry professionals who I will refer to as Cult Enforcers. The most important conclusion of BPM is that building high performance portfolios is surprisingly straightforward but emotionally difficult.
My BPM transformation
I began my career steeped in the concepts of MPT. Early on, I was able to release my emotional brakes to the point of being able to concentrate my investment portfolio in the $20 investment (i.e. 100% allocation to equities). For many years I continued to believe that hiring an active equity manager
