Romancing Alpha, Forsaking Beta
How Cognitive Biases Lead to Performance Chasing & Investing Failures. The High Cost of Neuro-Financial Errors
Presentation by Barry Ritholtz New York Spring Conference St. Regis Hotel May 23, 2013
This is Your Brain. This is Your Brain on Drugs
1987 PSA
This is your brain
Your brain weighs 3 pounds, and is 100,000 years old. It is a dynamic, opportunistic, self-organizing system of systems. MRIs have revealed to Neurologists what our brains looks like when making decisions . We can observe it 1) in real time; 2) under actual conditions, and 3) in reaction to financial risk/reward stimuli. Once we begin trading stocks, however, our brains begin to undergo subtle physical change that we can actually see in the MRIs of Traders . . .
This is your brain on stocks
A brief intro to
Behavioral Economics & NeuroFinance
How Does Your Brain Interfere With Your Investing?
Behavioral Economics
1. Herding, Groupthink 2. Experts: Articulate Incompetents 3. Optimism Bias 4. Confirmation Bias 5. Recency Effect 6. Emotions impact perception
Neuro-Finance
7. Anticipation vs. Rewards 8. Selective Perception & Retention 9. A Species of Dopamine Addicts 10. Endowment Effect of Ownership 11. Monkeys Love a Narrative 12. Cognitive Errors Impact Processes
Herding
Mutual of Omaha Lone Gazelle
Source: Kal, Economist
Wall St. Groupthink: Buy Buy Buy!
1. Only 5% of Wall Street Recommendations Are SELLS
-NYT, May 15, 2008
2.
Why Analysts Keep Telling Investors to Buy
-NYT, February 8, 2009
3.
Equity Analysts Too Bullish and Bearish at the Exact Wrong Times
-McKinsey, June 2nd, 2010
4.
None of the S&P 1500 have a Wall St. Consensus Sell on them
-Robert Powell, Editor, Retirement Weekly, August 2011
It is better for one's reputation to fail conventionally than to succeed unconventionally. -John Maynard Kyenes
Sources: Ritholtz.com, NYT, McKinsey, Marketwatch
Optimism Bias
Here, Kitty, Kitty, Kitty
Dunning Kruger Effect: DK is a cognitive bias in which unskilled people make poor decisions and reach erroneous conclusions, but their incompetence denies them the metacognitive ability to recognize these mistakes. Metacognition: The less competent you are at a task, the more likely you are to over-estimate your ability to accomplish it well. Competence in a given field actually weakens self-confidence. This has devastating consequences in the investment world.
Over Confidence
Here, Kitty, Kitty, Kitty
How much information is required to make informed financial decisions?
Expert Forecasting versus Ambiguous Uncertainty
Bennett Goodspeed, The Tao Jones (1984) discussed The articulate incompetents: Expert forecasters do no better than the average member of the public; The more confident an expert sounds, the more likely he is to be believed by TV viewers Experts who acknowledge that the future is inherently unknowable are perceived as being uncertain and therefore less trustworthy. (Isaiah Berlin: Hedgehog vs Fox) The more self-confident an expert appears, the worse their track record is likely to be. Forecasters who get a single big outlier correct are more likely to underperform the rest of the time.
Source: Zweig, Your Money & Your Brain; Grants Interest Rate Observer,
Analysts: Over-Optimistic GroupThink
Analysts have been persistently overoptimistic for the past 25 years, with [earnings] estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent On average, analysts forecasts have been almost 100 percent too high -McKinsey study
Source: Ritholtz.com, McKinsey
Confirmation Bias Selective Perception & Retention
1. We tend to read that which we agree with; We avoid that which disagrees with our preconceived biases, notions or ideologies; 2. Our biases change the way we perceive objects literally, the way we see the world. 3. The same biases affect our memories we retain less of what we disagree with . . . 4. Expectations Affect Perception
Recency Effects Impact Your Thinking
WSJ: 2007 WSJ: 2010
Source: Ritholtz.com, WSJ
Sentiment Cycle
Source: Ritholtz.com
If u cn rd ths
When it absolutely positively has to deceive your eyes overnight
This animation . . .
. . . is not an animation
Applying Behavioral Economics To Hedge Fund Investing
What Dont You Know About Hedge Fund Investing
5 Things Not Often Discussed About Hedge Funds 1. Hedge Funds manage a small percentage of total financial assets 2. Fees are unusually high 3. Performance is unusually bad 4. Picking emerging managers is exceedingly difficult 5. Your own biases and emotions make the process even harder
Confirmation Bias in Action
56% said they invested in hedge funds for diversification purposes Hedge funds correlated with other vehicles, falling in crisis Is Your Original Investing theme valid? 81% of investors said Yes (as of 2009)
Hedge Funds = 1.1% All Financial Assets
The global hedge fund industry manages ~$2.13 trillion dollars Given what a relatively small asset class this is, they receive an excess of media attention. Perhaps because so many hedge fund managers have become billionaires, they have captured the investing publics imaginations
HFRX Global Hedge Fund Index Performance Data
How Have Hedge Funds Done? 2012 = Returns equaled 3.5% versus S&P 500-stock index 16% 2007-12 = Lost 13.6% vs. S&P 500-stock +8.6% 2013 = Gained 5.4% vs. S&P 500-stock +15.4% As a source of comparison, the average mutual fund is up 14.8% in 2013
Source: WSJ, HFRX
Hedge Fund Growth
1997 = $118 billion 2012 = $2.04 trillion.
Hedge Fund Manager Profit Capture
Managers Capture Investment Profits Mostly For Themselves
From 1998-2010 hedge fund managers earned $379 billion in fees. The investors in their funds earned only $70 billion in investing gains. Managers kept 84% of investment profits, investors netted 16%. As many as 1/3 of hedge funds use feeder and/or fund of funds. This brings the industry fee total to $440 billion thats 98% of capture. Investors are left with $9 billion dollars merely 2%.
Source: Simon Lack, The Hedge Fund Mirage
Hedge Fund Manager Profit Capture
Does not include Survivorship Bias, self reporting. Assume +3%
Selecting Active Management
The Daunting Math of Manager Selection
1. Only 20% of active managers (1 in 5) can outperform their benchmarks in any given year; 2. Within that quintile, less than half (1 in 10) outperform in 2 out of the next 3 years; 3. Only 3% stayed in the top 20% over 5 years (1 in 33) 4. Once we include costs and fees, less than 1% (1 in 100) manage to outperform (net). 5. What are the odds you can pick that 1 in 100 manager?
Sources: Morningstar, Vanguard
Paulson Hedge Fund
Manager Selection is Much Harder Than Most People Believe John Paulson launched his hedge fund in 1994 Hires Paulo Pellgrini in 2004 Raised $147 million in 2006 for Subprime Bet Greatest Trade Ever in 2006-07 Assets under management had swelled to $36 billion. Subsequent losses were 52% in one fund, 35% in another.
Pellegrini PSQR Hedge Fund
Manager Selection is Much Harder Than Most People Believe Paulson gave Pellegrini a $175 million bonus . . . Response: F#$% you, I quit Formed PSQR in 2008 Returns: 2008 = 40% 2009 = 61.6% 2010 = -11% August 2010, Pellegrini returned all outside investor capital
Sources: Greg Zuckerman, The Greatest Trade, WSJ
Comparable Compensation
Source: Forbes
Top Hedge Fund Manager Compensation
It takes the average family 18.5 years to make what these hedge fund managers make in 1 hour
Source: Forbes
Two Smart Guys
2 smart guys leave Goldman Sachs to set up a hedge fund; They raise $1 billion dollars: Performance: Year 1: +15% Year 2: +10% Year 3: -5% , (return capital) Earnings (2 + 20%): Year 1: $20m + $30m Year 2: $22m + $22m Year 3: $24m + $0 Total Comp = $118m (Total S&P500+Div=17%) (S&P500 = 14%) (S&P500 = 12%)
We have met the enemy, and he is us. -Walt Kelly, Pogo, 1971
for more information, please contact
Barry L. Ritholtz
CEO, Director of Equity Research Fusion IQ 535 Fifth Avenue, 25th floor New York, NY 10017 516-669-0369 RitholtzCapital@optonline.net
My favorite books on these subjects can be found at http://www.ritholtz.com/blog/behavioral-books
