Investing in Human Behavior – Value & Momentum
Last week I discussed some basic disciplines of my investment process. Today I want to briefly summarize two unique factors that exist across markets which have been extremely influential in shaping my overall investment philosophy.
Through years of trading and investing, one thing became very clear to me: assets are not priced based on economic data or business fundamentals. If they were, there would be no need for markets. Instead, market prices reflect the perceived value of an asset based on all available information. This perception is heavily influenced by exogenous factors such as investor sentiment and human emotion.
The ideas behind this phenomenon can be explained by Behavioral Finance.
Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.
Having lived through the frustrations of not understanding why stocks weren’t doing what I thought they should do, this theory rang very true to me. The more I read, the more obvious it became and the more interested I became in figuring out ways to take advantage of it.
Almost all investment strategies are based on extrapolating historical statistics into predicting the probability of future gains. While we might have 50-60 years of charts, historical data and business fundamentals to draw conclusions from, the timeline we can reference to review basic human behavior is much larger.
Two factors driven by human behavioral biases that consistently surface in markets are momentum and value.
Momentum is the idea that securities that have done well recently, will continue to do well in the future. It is based on the simple belief that trends exist in markets.
“Trend following is motivated by a very broad interpretation of the universe. The underlying belief is that economic systems adjust to changes in fundamentals gradually and over long periods of time, and that the consequent trends are evident everywhere in human history and commerce. Political, economic, and social regime changes trigger price adjustments in markets that don’t happen instantaneously.”
-Paul Mulvaney, CIO Mulvaney Capital Management
Nothing crazy right? I think that is something most people can agree with. In markets and elsewhere, trends exist.
Momentum is one basic phenomenon present in markets that is influenced by human behavior. The herd mentality. Are herds always right though? Not necessarily. A lot of times they overreact. And that’s where our second behavioral factor becomes important; the value anomaly.
Value investors actively seek securities that they feel the market has undervalued. There are many reasons why a market might undervalue a security but here are three basic examples:
- Investors overreact to growth aspects for growth stocks, and value stocks are therefore undervalued.
- People project the immediate past too far into the distant future (i.e. company reports poor earnings for one quarter and stock is sold off heavily).
- Loss aversion. Investors don’t like losing money. If a security becomes volatile and investors worry, they may sell the stock out of fear. (sell now, ask questions later).
Sometimes a good company gets priced at a very attractive valuation based on what could be considered irrational human behavior. That creates opportunity.
There are countless factors that can influence how a market prices assets but none greater than the behavior of the market participants themselves. Despite the studies and increased awareness of human decision making, this fact is unlikely to change any time soon. In his book Thinking Fast and Slow, Daniel Kahnerman uses the term “cognitive illusions” to explain that even though we may be aware of ways we are being irrational, it doesn’t stop us from being irrational in the future. Psychology is a very hard thing to overcome.
In summary, I’m more confident in the tendency of human behavior to repeat itself than any other market statistic or correlation. For that reason, strategies based on behavioral factors such as value and momentum play a big role in how I manage money for my clients.
Next week I will wrap up this discussion by detailing a few other specifics related to value and momentum and why I think non-traditional portfolio construction will become more popular in the future.
This is part 2 of a 3 part series on my general investment philosophy.