Jones Villalta believes that most investors, whether professionals or laypersons, are unduly influenced by behavioral biases that shape their decision making. This can often lead to faulty investment decisions. First, most investors assume that conditions over the longer-term will continue as they are today. For example: if the price of homes appreciated significantly over the last three years, they tend to believe this trend will continue far into the future. Conversely, when the United States was attacked on 9/11 and airline travel was virtually brought to a standstill, many investors assumed travel-related leisure stocks would no longer be of any value and sold their stock.
We use the theories of behavioral finance, which combine psychology with economic and financial analysis, to better understand the economic decisions made by consumers, borrowers and investors and how these decisions affect market prices, returns and the allocation of resources. As portfolio managers and research analysts, at Jones Villalta we are sensitive to the effects of investor biases. Considering investor behavior helps us to identify sectors of the market that have been over- or under-valued because of these biases. With this information, we seek to uncover the misunderstood opportunities that have the potential to provide the Fund's shareholders with long-term growth and capital appreciation.
Each investment candidate we consider is subject to our rigorous, disciplined quantitative evaluation. The investment process used to select stocks for the Fund utilizes a number of proprietary quantitative models developed and continually refined for the firm's separately managed portfolios since its founding in 1999.
Security Selection
1. We begin with the universe of the largest 1,000 stocks issued in the domestic stock market.
Each security is screened using our proprietary quantitative models to identify those stocks we believe may be undervalued and selling inexpensively in relation to their growth prospects. This objective, consistent process provides us with approximately 150 to 200 stocks for further review.
2. Examining the list of candidates that result from our proprietary screens, we apply the "art" of our process, applying our knowledge of behavioral finance. We look for trends in sectors or industries that are exhibiting what we believe is irrational market behavior based on the intrinsic values of those stocks. We identify where inordinate pessimism has created buying opportunities. These are the stocks and industries that we delve into more deeply in step three. Conversely, we seek to avoid stocks or industries where euphoria or over-optimism prevails.
3. In our final step, we stringently evaluate the financials of companies that pass the first two steps of our process. This fundamental analysis seeks to avoid behavioral traps that investors (professional or otherwise) have a tendency to fall into, but most importantly, subjects the company's financials to a rigorous review. Our analysis is disciplined and thorough, examining a company, and the attributes that directly or indirectly affect its valuation, from a variety of perspectives both quantitatively and qualitatively.
Finally, at times we do find opportunities in the market that may not exhibit a bias that's resulted from irrational market behavior, but is simply a company that's misunderstood.
The result of our process is a portfolio of approximately 30 -35 stocks. We hold issues on average for five years.
Behavioral finance is a field of finance that combines both behavioral and cognitive psychological theories with economics and finance. It attempts to fill the void left by studies that contradict the efficient market hypothesis or that cannot be captured in models based on perfect investor rationality. While most economists believe in the theory of an efficient market – a market where current prices reflect all available information and all information is available to all participants at the same time – there are many instances where emotion and psychology influence people's decision-making, causing behavior that is unpredictable or even irrational. These conventional financial theories are valid but do not account for all situations that occur in the real world of investing. By also considering behavioral finance, there can be a broader understanding of how the financial markets function.
Numerous studies have been conducted by psychologists that track factors leading to the behavioral biases that shape investors' decision making and lead to faulty investment decisions. A great deal of academic literature is available on the subject. An extensive, yet layman's review of these theories, can be found in this Tutorial on Behavioral Finance.
The information that follows is discusses some of the more common theories underlying behavioral finance. Not all of these theories apply to the investment process followed at Jones Villalta. However, they are included here to provide a good overview of this field of finance.
COMMON BEHAVIORAL BIASES:
Overconfidence: To have confidence in one's abilities is a good thing. Overconfidence implies having an overly optimistic view of one's abilities or amount of control over a situation. A study called "Behaving Badly" conducted in 2006 by James Montier found that 74% of 300 professional fund managers believed they had delivered above average job performance; the remainder thought of themselves as average. By definition, only 50% of those surveyed could have truly delivered above average work. Similarly, in 1998, a study entitled "Volume, Volatility, Price and Profit when All Traders Are Above Average" conducted by Terrence Odean found that overconfident investors trade more frequently than those who self-identify themselves as less-confident.
First and foremost, employing theory derived from the field of behavioral finance requires a fair amount of humbleness. One needs to accept that we are all, as humans, prone to the behavioral biases that cloud decision making. Intelligence, experience and demeanor do little to alter the fact that we are all too "human." However, understanding that our decision making may be shaped and perverted by psychological biases can help us to both counteract poor decisions and take advantage of opportunities. In this respect, being irrational is not about being dumb or "crazy". Indeed Robert Shiller described it best when he noted that it "is not the error of fools. It is more the error that afflicts some of Shakespeare's tragic figures – in the sense of having subtle weaknesses or a partial blindness to reality."*
Extrapolation (Non-Bayesian expectation formation): People tend to base their decisions too heavily on the most recent events or rely heavily on specific facts. Andrei Shlefier noted that "people often predict future uncertain events by taking a short history of data and asking what broader picture this history is representative of."** It is our belief that this tendency is at the heart of almost all bubbles – in the stock market, real estate market, commodities market, in individual industries or in individual stock prices. In all of these cases, individuals (professional or layman) fail to attach reasonable probabilities to the likelihood of possible events. In most cases near-term results are weighted significantly for no reason other than that they appear foremost in the practitioner's mind.
Over the past decade we've been presented with a surprising number of instances of extrapolation. During the telecommunications, media and technology bubble of the late 1990s, professional analysts constantly pointed to the near term results of companies like Cisco, Microsoft, Intel and Amazon and presumed that their near-term growth would continue unabated for a very, very long time. Similarly, in the mid to late 2000s, one could scarcely encounter a real estate agent or TV show that wouldn't expound on the benefits of home-ownership (always citing the tendency for home prices to move up over time with little in the way of downward movements). Simply put, during good times, investors expect good times – i.e. rising markets will continue and conversely, during bad times, things will never get better.
Anchoring: Daniel Kahneman (who later won a Nobel prize for his body of work) and Amos Tversky studied this trait in the early 1970s. Subjects were asked various general knowledge questions (such as what percentage of the UN is made up of African nations), but first a wheel with the numbers one to 100 was spun in front of the subjects. The subjects were then asked if the number of African nations in the UN was higher or lower than the number on the wheel. Note: the wheel was rigged to stop on 10 or 65. The median response from the group was correlated with the higher or lower number: those that saw the spin fall to 10 had a median average of 25, while those who saw the wheel stop on 65 had a median response of 45. The study concluded that after seeing the number on the wheel, the subjects "anchored" to the number – an irrelevant figure. Investors (professional or otherwise) anchor to current stock prices, brokerage firm analyst targets, recent rates of growth in GNP and company earnings. While these numbers may be valid in some instances, in others they may be irrelevant.
Herd behavior: In the late 90's, almost all investors were attracted to dotcom businesses, despite that most of them did not have financially sound business models. Compelling many investors was a sense of being left out and the reassurance they got from seeing so many other investors putting their assets into these companies. The tendency to follow the herd results in investors who are continually pursuing the next hot thing, eating up much of their profits in transaction costs.
Equity premium puzzle: Many investors become overly preoccupied by losses in relation to an equivalent gain, putting far more weight on short-term volatility in their stock portfolios. As a result, investors believe that equities must provide high-enough premiums to compensate for their risk-aversion. According to Jason Zweig in Your Money and Your Brain (New York: Simon & Schuster, 2007), "Financial losses are processed in the same area of the brain that responds to mortal danger."
BEHAVIORAL FINANCE: UNDERSTANDING OUR HUMAN TENDANCIES
We're often surprised to find that more professional investors and business executives are not familiar with some of our more common and predictable human failings. We theorize that it is due to the subjective nature of the topic. Conclusions in finance are very much "muddied" by presuming markets are less than efficient. Due to the short time period that students spend in business school, there is simply not enough time to delve into the failings of finance. Moreover, we want corporate executives and portfolio managers that are confident in their decisions – most leaders exhibit this unfailing self-assurance. However, this does come at a price, and in certain environments this price can be very steep. Finally, we would note that this is not to say that most financial models are worthless. As Richard Thaler explains "…while the standard economics paradigm has limitations and weaknesses, there is no good substitute available." ***
Notes:
*Shiller, R. 2002. "Bubbles, Human Judgment and Expert Opinion." Financial Analysts Journal, vol. 58, no. 3 (May/June):18-26.
**Shleifer, A. 2000. Inefficient Markets: An Introduction to Behavioral Finance. New York, New York: Oxford University Press. Page 11.
***Thaler, R. 1992. The Winner's Curse: Paradoxes and Anomalies of Economic Life. Princeton, New Jersey: Princeton University Press. Page 197.
