Why Behavioral Finance May Be the Future of Stockpicking

Stock analysts and investors have discussed the concept of behavioral finance for over ten years. The main idea behind this concept is that the human brain makes flawed decisions, including those related to investing. One man, Tom Howard, a finance professor based out of Denver, Colorado, began his investment career as he neared retirement age, and began using this concept to his advantage.

Although Howard, currently affiliated with AthenaInvest, started out using current theories about portfolio management, he became increasingly interested in reading about behavioral finance. He studied today’s fund managers and the way they pick stocks. He found that most fund managers did well with the stocks they picked, and that it was not difficult to pick stocks that performed strongly. Howard also short sold the worst stock picks of the worst fund managers for a profit. Howard’s personal fund has seen a success, but he doesn’t have a diverse set of holdings, and he doesn’t even know the names of his stocks. He doesn’t even know how much his original investment was.

Concentrated Portfolios Outperform Diversified Portfolios

A successful fund manager has conviction, uses an effective strategy, and exercises discipline. Typically, successful managers also have concentrated, not diversified, portfolios. Warren Buffet, who is known for coining the phrase “de-worsification” to describe diversification, says it best. Portfolios with more than ten stocks are actually less likely to outperform, not more likely.

According to Mr. Howard, most fund managers do well at picking stocks, with a success rate of about 80 percent. However, they’re less successful at creating portfolios. Most of this 80 percent of successful stock pickers compile portfolios containing around 100 stocks. Between 1997 and 2012, Standard & Poor’s 500 list profited 6.1 percent yearly, while significantly active funds brought in returns averaging 8.9 percent. By contrast, the best managers’ concentrated portfolios averaged returns of a whopping 13.9 percent annually. Additionally, poor fund managers were found to have portfolios containing picks that lost money and which a smart manager would choose to sell short.

Psychology Factors into Stockpicking

The concept of behavioral finance has its roots in basic psychology and the understanding of human emotions. Tom Howard even believes that behavioral finance is likely to become the main paradigm of financial investing in the future. In addition to behavioral financial theory, Howard predicts that the other two main theories likely to influence investors and portfolio managers in the future are modern portfolio, which gained popularity in the mid 1970s, and fundamental investing, which has its roots in Ben Graham’s theories and emphasizes analyzing balance sheets with an exceptional attention to detail.

The main idea underpinning behavioral investing and behavioral finance is that one must have strong control over the emotions. This contradicts the idea that successful stocks are high-risk or that when building a portfolio one takes the risk of underperforming.

Behavioral investing isn’t easy for most investors and fund managers. It demands that one have no emotional attachment to one’s stock picks, and that one buy and sell at appropriate times rather than hanging on too long or selling too early. These choices usually result from the emotions that one feels about the current performance of the stock, the amount one originally paid for the stock, or the company who has issued the stock.

Tom Howard has managed to use behavioral investing concepts to his advantage, which is why he deliberately refuses to learn about his stocks’ names. He creates a lengthy list of stocks to begin with, then whittles it down, ultimately winding up with a very short list, but he never learns the stocks’ names. This prevents him from having an emotional attachment to his stocks, which has worked to his benefit so far.

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One response to “Why Behavioral Finance May Be the Future of Stockpicking

  1. Pingback: Predict the Stock Market, Use Brain Imaging | Alpha Banker·

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