Behavioural Finance and the Art of Execution

With increasing adaption of AI, the world of Money / Portfolio Management is likely to witness shrinkage in information asymmetry. However, do you expect two top portfolio managers with same information to generate similar returns? As per Mr. Lee Freeman-Shor, it is not the case. Over a period of more than seven years (from Jun’06 to Oct’13), Mr. Lee examined 1,866 investments, made by 45 of world’s top investors. While each of these 1,866 investments represented the best money-making ideas, only 21 (or 1% of all investments) returned more than 100%. The question then arises, if money making ideas are not enough, then what do you need as an investor/Portfolio Manager?

W e believe, as an investor, you need to understand various aspects of behavioural finance and master the art of execution. In behavioural finance, Prospect theory states that people make decisions based on the potential value of losses and gains rather than the final outcome. As a result, investors are no longer rational and instead of being risk averse they exhibit loss aversion. Further, investors often exhibit cognitive and emotional biases, impacting their ability to generate consistent and high profits, illustrated by some of these biases faced by investors:

Confirmation – Looking for information / data on the company to support one’s belief, discounting contradictory information.

Loss aversion – Assigning higher negative value for losses than positive value to gains of same amount. Self-attribution – A belief that one’s success is due to one’s own abilities vs. situational factors. Endowment – Valuing what one has more than something they do not own. Regret aversion – Doing nothing for fear that decision could turn out to be wrong.

Driven by these biases, investors of ten hold-on to their losing positions. For example, since the early 2021 peak in the China market, many investors held on to the falling Chinese Technology stocks driven by loss aversion, regret aversion and confirmation bias. On a similar note, investors at times hold on to stocks that have consolidated for decades due to endowment and self-attribution bias.

If you go by the classification of investors made by Mr. Lee Freeman-Shor, in his book – “The Art of Execution”, you will want to be: a. Assassin – One who recognises that market has turned against and cannot rely on himself to do the right thing – Kills all losers at 20-30% b. Hunter – The investor who can ask the question – The stock price has fallen but nothing else has changed, is the thesis intact? And when the answer is Yes, he invests more. c. Connoisseur – Investor rides his winners far beyond other people’s comfort zone. And actively takes small-small profits to satiate their greed. As the same time, every connoisseur, is either an assassin or a hunter.

However, most investors behave like a “Rabbit” – holding on to their losers, even adding more to a losing trade, despite clear evidence of a thesis break. Other unsuccessful investors are like “Raiders”, who book profit as soon as possible. Often, those investors who are “Raiders” are also “Rabbits” in a losing trade. As a result, such investors have a very high kurtosis and a negative skewness (lots of small winners, few big losses and no big winners).

The other solution, over and above the application of behavioural finance, is shrewd application of structured products to provide downside buffer and reduce behavioural biases. This is the solution, that we target at Lamer Capital Ltd., but this aspect, we can discuss another time.

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