If you have heard me talk about investing in financial markets, or read any of my articles, you know that I do not believe in the powers of prediction. How much longer can this bull market go on before we see a significant correction? I have no idea. I have never claimed to be a market prognosticator. Throughout the entirety of my investing career, I have yet to meet a successful market prognosticator, I would not know who to call for accurate market predictions.
You might be asking yourself why you have hired me to manage your most important assets if I have admitted to not knowing how the markets and individual investments are going to perform over the next year and beyond. I hope you put your trust in me not because I am an expert at predicting market movements (I am not), but because I am an expert in the process of making investment decisions that maximize the probability of achieving long-term investment success.
My process for making investment decisions is what sets 3Summit apart from other investment firms. I use my expertise in markets to design comprehensive mathematical models for making evidence-based, systematic and repeatable investment decisions. This style of managing portfolios is called quantitative investing. Quantitative investing seeks to eliminate human discretionary decision making from the investing process because simply put, humans suffer from behavioral patterns and biases which make us all uniquely bad at making consistently good investment decisions. The ability to make good investment decisions consistently over long periods of time is what makes the difference in successfully achieving long-term financial goals. So why are humans so bad at making investment decisions? It comes down to human psychology.
Human psychology moves markets
Let us not forget, financial markets are a human construct, dominated by human participants. The actions of market participants is what moves markets over time. How humans respond psychologically to uncertainty, aversion to loss, and our drive to earn out-sized returns causes us to fall into psychological traps that negatively impact our financial success.
Most individuals who have purchased a stock can relate to the common psychological traps investors frequently fall into. Warren Buffet once said, “Success in investing doesn’t correlate with I.Q. once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” The growing field of behavioral finance can help define the urges Buffet was referring to that get investors in trouble. These urges are called psychological traps, let’s look at the psychological traps that are the most detrimental to investor success.
Overconfidence
Humans are overconfident. Rigorous studies regularly conclude that people overestimate their knowledge, underestimate risks, and exaggerate their ability to control events [1]. The quote below from a psychological study of human behavior explains why all humans might be susceptible to overconfidence.
“The brain is probably designed to make decisions with as much certainty as possible, after receiving little information. For survival purposes, confidence in the face of uncertainty is a characteristic.” [2]
Markets are uncertain and therefore investment decisions must be made with imperfect information. Security selection is very difficult because accuracy in picking winning securities is near chance levels, which is precisely when people exhibit the greatest overconfidence. The traps that investors fall into because of overconfidence include taking too much risk by having a portfolio that is too concentrated around a few securities, making bad investments by failing to realize they are at an informational disadvantage and excessive trading [3].
Loss Aversion
People tend to feel the pain of loss more strongly than they feel the pleasure of gain. The desire to avoid the pain of loss is what causes investors to hold on to losing positions too long. This behavioral tendency is incredibly damaging to a portfolio and is likely one of the greatest sources of investment losses and poor performance. Investors, like gamblers, tend to stay in the game too long by holding onto losing positions, reasoning that they will exit as soon as they at least get back to even. This behavior comes from a strong drive to avoid the pain of loss. The loss aversion trap investors fall into results in selling winners too early and holding on to the losers too long.
Anchoring
Salesmen regularly try to exploit anchoring to negotiate a higher price than the consumer might otherwise be willing to pay. A good salesman will always start negotiating with a high price as he is hoping the consumer will psychologically anchor to the higher price so when he offers a lower price the consumer will reason the new lower price represents a good value. The same concept traps investors when they buy securities based on past prices, the past price becomes an anchor for current prices. If the price of a security declines the investor may get trapped in their perception of the value of the security based on their anchored higher entry price and be unwilling to change their assessment, or worse, buy more because the security now represents a better value in their view. Just like loss aversion, the anchoring trap can cause an investor to hold on to losers too long or continue to increase the size of a losing position based on faulty assumptions of value.
Herding
Many psychologists believe that herding, the tendency to follow the crowd, is a hardwired human characteristic. Even if an investor is convinced that an investment is not a good idea or lacks fundamentals, they may still invest concluding everyone else must know something they don’t. Greed can also be a motivating factor for joining the herd as markets frequently irrationally advance over long time horizons causing even the most strong-willed investors to jump in. The herding trap is the best way to get caught in a bubble which usually ends very badly for those invested.
The first step is admitting you have a problem
Making good investment decisions first and foremost, requires an investor to acknowledge and understand their innate behavioral biases. However, understanding behavioral bias and the traps they set is just the first step, you must then avoid the traps all together! Easier said than done, as behavioral tendencies for bad decision making are hardwired into all of us and become more pronounced when hard earned money is on the line. No investor, not even investment experts are immune to falling into psychological traps. Worse yet, our emotions can make us all irrational at times, meaning that we often enter a trap even if we know we are likely doing so, emotions are powerful and can be very difficult to resist. Just spend 30 minutes watching CNBC or any other investment news program and that should become clear to you.
So how does one go about avoiding the detrimental interference of human emotion from the investment process? My solution is to eliminate human discretionary decision making all together by systematizing the decision-making process. Systematic decision-making is the goal of quantitative investing. Quantitative investing is not a process to predict market movements, but a systematic approach to avoiding psychological traps.
Learning from gamblers
I believe investing and gambling are distinctly different activities and for that reason I generally shy away from making comparisons between the two. However, in this case I believe a gambling comparison may be helpful in explaining the advantages that can be gained in the markets through quantitative investing techniques.
If you have ever been to Las Vegas and seen the billion-dollar casino buildings, you can clearly see the house has the advantage in gambling. This is because the statistical odds are against the gambler and in favor of the casino. Casino games, by design, put the player at a built in statistical disadvantage, but even worse they are specifically designed to take advantage of the same psychological traps I have already explained, further pushing the odds against the players by forcing them into bad decision-making patterns. Despite the statistical odds of casino games being against the players, there have been many gamblers who have consistently won in casinos.
Gamblers who have managed to successfully win, have done so by utilizing the same tools used in quantitative investing. Successful gamblers develop a detailed understanding of the psychological traps and the statistical probabilities of the game they will be playing and create detailed rules of play that systemize the decision-making process. Systematizing decision-making eliminates discretionary decision making by the gambler, who is prone to psychological traps that arise from the emotions risk taking elicits within them. The rules created to systematize the playing of the casino game are designed to ensure each action taken by the player maximizes the odds of a successful outcome, thereby getting the odds as close to even as possible. Because the odds can never be fully in the gamblers favor the rules the gambler follows are also designed to manage risk by systematically changing the size of the bets depending on how close to even the odds are for the gambler. This way, when the odds are more favorable for the gambler the bet sizes are increased along with the potential winnings and when the odds are less favorable they are decreased along with the potential losses.
The gamblers only role in playing the game is to follow the carefully designed system without exception and place bets according to the defined rules, instead of on the fly judgement calls. By applying the rules consistently many people have been very successful winning money playing casino games despite the statistical odds being against them…quite an accomplishment indeed.
Quantitative investing works using the same principles described in the gambling analogy. I design quantitative investing strategies within a rigid framework of rules that can be quantified to systematize investment decisions and always seek the highest probability of a successful outcome while avoiding psychological traps. Investing expertise is therefore not used to try and predict the direction of markets or individual securities, but to design carefully crafted, rigorously researched, evidence-based investment rules that are repeatable and can therefore be applied consistently over long periods of time.
Turning the tables on psychological traps
Quantitative investing is such a powerful investing tool because the process enforces a rigid and repeatable framework for investment decision-making, additionally, quantitative investment strategies can be used to find and generate unique sources of returns. Quantitative investing can exploit the universal behavioral vulnerabilities of market participants that manifest themselves in financial markets into a unique source of returns. I design many of the investment strategies implemented in client portfolios to turn the tables on psychological traps and capitalize on market inefficiencies likely caused by innate investor behavior. These inefficiencies tend to persist over long periods of time and across different markets because human evolutionary behavior does not change quickly.
The traditional investing approach which most investors still widely use, attempts to beat the market by picking individual securities that the portfolio manager believes will go up more than the market over time. I believe beating the market by picking individual securities is very difficult and not possible to accomplish consistently and over long periods of time. I believe this for the simple reason that security selection strategies most often depend in a large part on human discretionary decision making by the portfolio managers. I will explore this topic in greater detail in future client letters.
Unique, uncorrelated sources of returns are the holy grail of investing, and quantitative investment strategies are exceptionally well suited for exploiting and generating unique sources of returns that have low correlations to each other. Not only do these quantitative investment strategies have the potential to generate attractive returns over time but they can also dramatically lower risk when combined with other strategies in multi-strategy portfolios like those I design for 3Summit clients.
Why is quantitative investing dominated by sophisticated investors?
Many people reading this may be getting their first introduction to the quantitative style of investing. A natural question is why have most investors not heard of quantitative investing when almost all the largest and most sophisticated investors hire quantitative managers and use quantitative strategies in their portfolios?
The most likely answer to this question is that believing in experts is an easier sell to less sophisticated investors. If there is one thing people generally dislike it is uncertainty. Investing involves a tremendous amount of uncertainty over long time-frames, so hiring an expert that claims to successfully predict markets or find the hottest investments sounds attractive to everyone. People like stories that are easy to understand. Telling a story about how an advisor and his team of 30 analysts scour the markets to find the best investment ideas is easy to understand, much easier than how one analyst using a computer creates quantitative algorithms that exploit market inefficiencies. If I eventually find a continuously successful market prognosticator I will hire them to manage my money! Easy sell.
Inertia in the investment management industry is another likely reason individuals usually do not have access to quantitative managers. Large investment management firms that have been managing assets for years are unlikely to take the business risk of telling clients they are eliminating the process they have used to invest for years and switching to a quantitative decision-making approach.
It is for reasons like these that quantitative investing is likely to remain within the realm of the largest and most sophisticated investors, no matter how successful the approach to investing may be[4].
[1] Nofsinger, J. (2001). The Psychology of Investing. Routledge [2] S. Schaefer, Peter & C. Williams, Cristina & Goodie, Adam & Campbell, W. Keith. (2004). Overconfidence and the Big Five. Journal of Research in Personality. [3] Shefrin, Hersh, Behavioral Corporate Finance. Journal of Applied Corporate Finance, Vol. 14, No. 3, Fall 2001. [4] Montier, James Painting By The Numbers: An Ode To Quant, Newsletter for Dresdner Kleinwort Watterstein
